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A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand
Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank
© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term country does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines
List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51
2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance
53 53 55 55 60 62 65
iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214
v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226
4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References
229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277
1 Listed Firms with Positive Economic V alueAdded. 1988-1996 Table 1.19 DER and ROE of Publicly Listed Companies by Sector.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.15 V alue of Stocks Issued and Stock Market Capitalization.2 Foreign Capital Flows.6 GrowthandFinancialPerformanceofState-Owned Companies. 1992-1997 Table 1. Republic of Korea Table 2. 1997 Table 1.21 Nonperforming Loans by Type of Bank.vi List of Tables 1. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .5 Financial Performance of Publicly Listed Companies by Sector. 1992-1997 Table 1. 1992-1999 Table 1. 1993-1997 Table 1. 1990-1997 Table 1.1 Growth of the Banking Sector. 1996-1999 Table 1. 1990-1998 Table 1.18 GDP Growth by Sector. 1986-1996 Table 1.13 Presence of Board Committees in Listed Companies Table 1. 1992-1997 Table 1.4 Development of the Stock Market.14 Banking Sector Outstanding Loans. Indonesia Table 1. 1992-1995 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 1992-1999 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1. 1992-1997 Table 1.4 Growth Performance of Publicly Listed Companies by Sector.3 Subsidiaries of the 30 Largest Chaebols Table 2. 1996-1998 Table 1.12 CharacteristicsoftheBoardofDirectors Table 1.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1992-1998 Table 2. 1996-1998 2.2 KeyMacroeconomicIndicators Table 2.8 OwnershipConcentrationofPubliclyListedCompanies. 1993-1999 Table 1.20 ROE of the Banking Sector.10 Anatomy of the Top 300 Indonesian Conglomerates.7 Growth Performance of the Top 300 Conglomerates.
1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.13 Table 2.27 Table 2.21 Table 2.12 Table 2. 1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio.15 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1997 Ownership Concentration ofAll Listed Firms. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.22 Table 2.14 Table 2.11 Table 2.28 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.23 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1995-1997 Ownership Composition of Listed Companies. 1999 InternalShareholdingsofthe30Largest Chaebols.16 Table 2.19 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies.26 Table 2.vii Table 2.24 Table 2.8 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size. 1994-1998 Financing Patterns of the Top 30 Chaebols.30 Private Capital Flows to Korea.5 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 .29 Table 2.17 Table 2.18 Table 2.7 Table 2.9 Table 2.20 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.25 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.10 Table 2.6 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1997 Ownership Composition of Listed Firms in Selected Countries.
1988-1997 Table 3. 1995-1998 4. 1978-2000 Table 4. 1992-1999 . 1988-1997 Table 3.31 Table 2.14 Philippine Stock Market Performance.2 Public Offerings of Securities.11 TotalandPerCompanySales. 1989-1997 Table 3. 1989-1997 Table 3. 1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.1 GDP Growth of SoutheastAsian Countries. Leverage Table 3.20 Financing Patterns by Industry.17 Composition ofAssets and Financing of the Publicly Listed Sector. The Philippines Table 3. Thailand Table 4.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1997 Table 3.12 Control Structure of the Top 50 Corporate Entities.000 Companies. andAffiliated Banks of Selected Business Groups.13 ADB Survey Results on Shareholder Rights Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.Profitability andFinancial .viii Table 2.SectorOrientation.1989-1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType.21 OwnershipConcentration.32 Table 2.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.15 Financing Patterns of the Corporate Sector. 1983-1997 Table 3. 1997 Table 3. 1989-1997 Table 3. 1989-1997 Table 3. 1988-1997 Table 3. 1988-1997 Table 3.22 Foreign Investment Flows.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1997 Table 3.33 Net Profit Margins of Chaebols. 1990-1998 131 137 138 158 159 160 161 163 164 166 173 175 176 180 184 191 201 203 204 205 206 207 208 209 212 235 236 3.2 Growth and Financial Performance of the Top 1. 1992-1996 Table 3. 1988-1997 Table 3.1 Public Companies Registered. 1990-1999 Table 3. 1985-1997 Number of Firms with Dishonored Checks. Flagship Company. 1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct.18 Financing Patterns by Control Structure. 1988-1997 Table 3. 1986-1998 Nonperforming Loans of General Banks.19 Financing Patterns by Firm Size.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.
1 Figure 3. 1990-1998 Merger and Acquisition Activities. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability. 1993-1999 Key Financial Ratios of Publicly Listed Companies.ix Table 4.14 Table 4. 1992-1999 Offerings of Debt Securities. 1985-1996 Average Key Financial Ratios by Company Size.5 Table 4.4 Table 4.10 Table 4.6 Table 4.1 Figure 1. 1992-1999 Common-Size Statements for Companies Listed in SET. Ownership Concentration. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies. 1993-1999 Size and Composition of the Thai Financial Sector.13 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand.7 Table 4. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1.16 Table 4. Leverage.2 Figure 3.15 Table 4. 1990-1996 External Debt.11 Table 4. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1990-1996 Financial Ratios of All Listed Firms.3 Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.12 Table 4.8 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.9 Table 4.
Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADBs financialsectorworkinitsdevelopingmembercountries.
Arvind Panagariya ChiefEconomist
Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.
ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholdersmeeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter
xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation
Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
how it has affected corporate financial performance and financing. Vol.6 percent) and trade (-18 percent). followed by finance (-26. All sectors. These banks were allowed to operate even if they violated minimum capital adequacy requirements. and responses to the financial crisis. and how it contributed to the crisis. except utilities. It analyzes the weaknesses of corporate governance in Indonesia.5 percent. Lending activities of affiliate banks that were not sufficiently backed by owners’ equity and the reliance by foreign lenders on the strength of political connections paved the way for risky investments. On the other hand. regulatory framework. patterns of financing. The construction sector was the worst hit. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. Section 1. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. When the crisis hit the country. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. no doubt. and . the Indonesian economy seemed to be in generally good shape. short-term loans were used to finance long-term investments.2 Corporate Governance and Finance in East Asia.3 looks at patterns of corporate ownership and control. these controlling families had political connections that allowed their companies to enjoy special privileges. Section 1. Foreign creditors. this left the Indonesian economy extremely vulnerable. highly leveraged companies.5 percent. Foreign debt reached more than $100 billion. or Thailand. posted negative growth. placed a high premium on these political connections in assessing the chances of being repaid. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. were the ones most affected. This study reviews the Indonesian corporate sector’s historical development. Malaysia. However. and analyzes their importance to the corporate sector in Indonesia. particularly those with large foreign loans. The highly concentrated and family-based ownership structure of corporate groups and companies resulted in a governance structure where corporate decisions lie in the hands of controlling families. To facilitate even easier access to credit. the currency composition and term structure of corporate foreign indebtedness were causes for concern. patterns of ownership and control. contracting by 36. The study also identifies family-based companies and corporate groups. In many instances. prior to the financial crisis. II rate reached 58.2 presents an overview of the Indonesian corporate sector. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea. In this setup.
With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. while Chinese and indigenous entrepreneurs ran some large businesses in trading. Not all items in the questionnaires were answered by the respondents.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. The industries that emerged were highly import-dependent and reliant on tariff protection.4 analyzes corporate financing patterns. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.2 Section 1. Despite the oil revenues. However.2. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. 1. .2 1. in the course of the fight for nationhood from 1942 to 1950. Section 1. Subsequently. and its response. medium. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). In the early 1970s. textiles. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. and tobacco industries. substantial volumes of private investment entered the scene. It also examines the statistical relationship between corporate performance and corporate governance characteristics. a gradual shift in public investment away from manufacturing took place. how it was affected by the crisis. Up until the mid-1960s.5 examines the corporate sector during the financial crisis in terms of its role.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics.and large-scale companies were dominated by state-run industrial concerns.1 Overview of the Corporate Sector Historical Development The marked permeability between the State and business in Indonesia goes back to the country’s struggle for independence. Section 1.
Third. many founding owners of companies were reluctant to go public and dilute their corporate ownership. which dominated their respective sectoral outputs and markets. Vol. Partly as a result of various government policies. the dilution of corporate ownership. These were families with strong links to the political elite of the New Order. Generally speaking. exports of nonoil products (particularly textiles and footwear. potentially subjects companies to greater regulatory scrutiny.2. The equity market remained largely unappealing due to a number of factors. But until the end of 1988. mostly nonbank financial institutions and stockbrokers. But these proved counterproductive because they limited the potential for capital gains to prospective investors. In the 1980s. wood. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. During this period. and related products) had shares in total exports that were rapidly increasing. the number of firms quoted in the stock market was only 24. and employed the bulk of the industrial labor force. investors were reluctant to supply funds to the stock market because they did not know whom to trust and the mechanisms that could protect small investors and shareholders against expropriation by controlling shareholders were underdeveloped. A number of underwriters emerged. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. there were also many rapidly growing large-scale companies and business groups or conglomerates.4 Corporate Governance and Finance in East Asia.2 The Capital Market The Government reactivated the stock exchange in 1977. First. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. the Capital Market Executive Agency and National Investment Trust tried to attract small investors to the stock market by setting prices and preferring small orders in initial public offerings (IPOs). In 1992. the value of manufactured exports overtook the value of oil and gas exports for the first time. By 1987. the Government shifted its industrial policy toward the promotion of labor-intensive exports. the Indonesian industrial sector was quite diverse. even when new shareholders do not threaten the control exercised by the original owners. 1. a distinct industrial elite started to emerge. Second. Last. While most of the companies were small. produced consumer goods. .
The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. state-owned banks were still among the biggest. which up to then was channeling oil revenues to priority sectors. Through the years.1 shows that from 1994 to 1998. which were previously constrained to 4 percent per day. Partly as a result of these reforms. The banking sector.Chapter 1: Indonesia 5 At the end of 1988. The Government also allowed foreign investors to buy up to 49 percent of listed shares. Thus. with a total value of Rp16. the capital market played an increasing role in raising long-term funds needed by the corporate sector. During this period. 1. private domestic banks dominated the sector in terms of number and total assets. In 1988. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). However.3 The Banking Sector Despite the development of the stock market. six SOCs had issued equities in the market. began to face competition. with a total value of more than Rp8 trillion. to date. the controlling shareholder of these SOCs is still the State. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. the banking sector has undergone many reforms. the banking sector has been and still is the major source of credit for the corporate sector. However. Table 1. companies could no longer enjoy low-interest credit from state banks. But in terms of assets per bank. .5 trillion.2. the number of listed companies in the stock exchange increased substantially. However. more significant reforms were introduced. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. reduced restrictions on foreign exchange transactions. Interest rate regulations on state banks and credit ceilings in general were removed. Since 1977. Conglomerates carried out 210 out of 257 IPOs. The dominance of state banks started to erode. Consequently. and increased access of domestic banks to international financial markets. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. the number of private domestic banks increased. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. These included the opening of the banking industry to new entrants. The initial banking sector reform was introduced in 1983. from 24 in 1988 to more than 300 in 1997.
8 27 147. In terms of assets. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector.0 234 1994 104.4 10 35.6 34 14.9 248.9 10 11.3 30 7.3 201.5 165 308.4 789.8 10 19.9 31 9.9 762. The other banks among the top 10 were state banks.9 304. . banks could earn profits even when they did not gather and process information about risk. Vol.1 240 1995 122.6 7 7.9 27 113.6 164 144 130 92 387.7 27 37.8 31 10. while BUN has been closed down by the Government.5 7 7 7 5 15.6 7 12.8 10 37.5 27 66. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).5 27 88.3 27 51.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.1 Growth of the Banking Sector.2 161 214.5 528. the 10 largest were all affiliated with major business groups. Bank Danamon.2 10 14. Of these. 1993 100.8 27 200. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).6 240 1996 1997 1998 1999 141.5 7 9. II Table 1. Among private domestic banks. 1993-1999 Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks Source: Bank Indonesia. But the banking system proved incapable of performing its intermediation function.9 291. Both BCA and BUN have shareholders linked to the former President Suharto.8 166 248.1 10 47. Because regulation was weak.7 351.9 39 18.8 29 6. Bank Danamon (ranked 7th).8 391. and Bank International Indonesia (ranked 9th). BCA.4 34 12.6 Corporate Governance and Finance in East Asia.3 10 17.
88) — — — — — — 8. 1.01) (0.59 billion in 1996. Net FDI flows increased to $5. such as metal goods. and footwear. there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers.09) (0. IMF. except in certain strategic sectors. there was a phenomenal growth in direct borrowings by Indonesian corporations.2 Foreign Capital Flows.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs). foreign investment also had a strong presence in the services and infrastructure sectors.81 3. In the 1990s.88 4.Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way.78 2. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). Indonesia received capital inflows averaging about 4 percent of GDP. as shown in Table 1.2. FDI flows were strong.10 5.2.09 1. In 1994.11 3. But FDIs were only one form of foreign capital inflows to Indonesia. . Increasingly. Between 1990 and 1996.50 (0. Most FDIs came in through joint ventures with business groups having strong political connections.15) — = not available. they still amounted to a large sum for the economy to absorb.59 4. November 2000. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.40) (0.09) 1. From the mid-1980s until July 1997.33 (13. Table 1. textiles.74 5. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. Until the onset of the crisis. Source: IFS CD-ROM. when the financial crisis hit Indonesia. the Government allowed foreign investors to own 100 percent of an Indonesian company.48 1. especially through bank loans.00 2. September 2000.01 (2. In effect. foreign creditors were eager to provide financing to Indonesia. initially from Japan and the Republic of Korea.63) (1. Successive policy deregulation facilitated FDIs in various light manufacturing industries.87 7.
In the 1990s. foreign investors began to dominate daily trading. This increased to 30 percent by the end of 1993. The following section looks at the growth and financial performance of the corporate sector. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 devaluation under the managed floating system. By the end of 1997. II Up until the late 1980s. the analysis focuses only on publicly listed companies. increasing the total trading value from Rp8 trillion in 1992 to Rp120.2. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. participation in the Indonesian stock market was exclusive to domestic investors. Due to data constraints. In November 1998. foreign banks became a significant source of financing for the corporate sector. Domestic corporate debt was about $50 billion equivalent. more than 50 percent of total Indonesian private debt and 60 percent of total foreign exchange debt were owed to 175 foreign banks and other foreign financial institutions. with the onset of the Asian crisis. total corporate debt reached nearly $118 billion. Between 1989 and 1992. plus 4 percent for the depreciation of the rupiah. The external corporate debt owed to foreign commercial banks was $67 billion. Private borrowers preferred foreign loans since these were relatively cheaper. state-owned companies (SOCs).8 Corporate Governance and Finance in East Asia. and conglomerates. From 1987 to 1996. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. the average foreign ownership of listed companies was 21 percent. the average borrowing rate for dollar loans was 9 percent. the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. 1. Vol. The Government relaxed this restriction in 1988. Consequently. especially the short-term ones. of which two thirds were rupiah-denominated. In September 1997.4 trillion in 1997. This is lower than the average borrowing rate of 18 percent for loans in domestic currency.5 Growth and Financial Performance While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis. but declined to an average of 25 percent during 19951997. .
3 shows the growth and financial performance of Indonesian publicly listed companies.6 3. 1996.2 1995 37.6 percent in 1997.4 percent. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. 174 firms. but fell to 24.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.7 — = not available.0 33.1 220.6 48.5 240.0 12. When the crisis battered Indonesia in 1997.4 1993 45. Table 1. a Value added was assumed to be 30 percent of total sales. while total assets grew at 43 percent.8 percent between 1992 and 1996. although the contribution increased over time.0 6.2 7.0 1.5 34.0 12.0 3. Source: JSX Monthly (several publications).5 37. In 1997. Note: The number of firms is not identical for each year.5 3.5 34. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.7 — 250. 248 firms. 1994.0 12. Asset turnover was above 30 percent until 1996.3 6.9 310.6 1994 50.3 Growth and Financial Performance of Publicly Listed Companies. 246 firms.0 10.1 0. averaging 3.4 1996 18. total sales of listed companies grew at an annual average rate of 31 percent. b Asset turnover is defined as sales over assets. ranging from 220 to 250 percent between 1992 and 1996. Return on assets (ROA) was also relatively stable during 1992-1996.3 3. Despite such rapid growth. During 1992-1997. 226 firms.4 31. and 1992. but dropped to 1. there were 204 firms. Average return on equity (ROE) of listed firms was 11.4 1997 7.0 11.1 4. 1995.8 6. The growth of listed companies was sustained by continuing investments. publicly listed companies as a group contributed less than 10 percent to GDP. but turned negative in 1997. but declined to 0.9 37. the average DER increased to 310 percent from 230 percent the .1 percent in 1997 when the crisis began to buffet Indonesia. 250 firms.4 38.6 24.7 3. 1993.0 64.2 30.8 220.8 230. 1992-1997 (percent) Item Growth Indicators Sales Growth Share of Value Added in GDPa Asset Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb 1992 — 3.7 percent in 1997.
and services. consumer goods. infrastructure.4). For instance. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. followed by agriculture (Table 1. the mining sector ranked first. and trade) even posted . ROE fell drastically because the sector had one of the highest DERs. miscellaneous industry. property.64 percent in 1997. investment. Meanwhile. Vol. But the sector’s ROE fluctuated a lot. During those years. miscellaneous industry. In terms of share of value added to GDP. and services. due mainly to the domination of the International Nickel Company of Canada. the property sector was severely affected by the crisis. The finance sector’s contribution to GDP. Also. averaging 17. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. increased from 0. Overall. This sector was less affected by the crisis. indicating its reliance on equity to support growth. the dominant sector was the finance sector. However. real estate. averaging 21. From 1995. the companies in the sector did not operate with a high leverage. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. trade. Four sectors (basic industry and chemicals. mining.5 presents the financial performance of listed companies by sector. The same applied to the trade sector. The consumer goods sector ranked second in terms of ROE. helped in part by the relatively strong demand for consumer goods. the banks eagerly provided credit to property development companies.10 Corporate Governance and Finance in East Asia.73 percent in 1992 to 1. investment. When interest rates increased.3 percent between 1992 and 1996. The finance.2 in 1997. although asset turnover was slow. still posting a positive but lower ROE. II previous year. ROA of all sectors dropped in 1997. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. Table 1. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. Before the crisis. meanwhile.7 percent during 1992-1996. and building construction. in terms of growth of sales and assets. with ROE falling to -11. In terms of sales and asset levels in 1997. finance. real estate. property. basic industry and chemicals. only two sectors (mining and finance) showed a consistently increasing trend from 1992. which operated in nickel and copper mining in 1992 and 1993. the mining sector had the lowest DER. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. and property. the mining sector had the highest ROE. when the property sector was booming during 1993-1997. and trade.
1 1. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.4 21.2 35.0 22.2 0. Constn. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.9 36.7 62.7) 17..2 11.9 31. Investment.5 92.7 (82.6 (0.1 71.0 0.0 0.5 9.1 1.1 0.3 340.1 23.9 8.4 Growth Performance of Publicly Listed Companies by Sector. Real Estate.4 1993 155.2 5.7 21.3 0.5) 13.0 1.8) 0.5 23.9 123.1 0.9 .9 64.8 29.8 62.5 53.4 (149. Constn.1 0.5 45.4 0.7 28.8 1.5 28. Investment.0 (192.6) 119.1 — 39. Source: JSX Monthly (several publications).4) 6.5 (11.4 31. Real Estate...1 16.6) 19.6 0.4 1.5 (8.6 1. and Services — = not available.6 0.2 59.9 (7.5 1..7) (27. Infrastructure Finance Trade.8 50.3) 53. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.8 24. Constn.0 24.1 1.9 0.9 54. Industry Consumer Goods Industry Prop.8 (76.4 44.7 43.7 24.4 43.3 17.4 170.7 — 36.5 1.2 14.7 40.9 0.1 0.4 30.3 0.6 26.1 (11.2 41.1 (41.5 13.5 68.9 53.0 1996 1997 58.6 (41.0 16.2 0.1 0.8 27.0 (28.6 1994 (75.3 0.4 64.7 34.1 0.7 0. Constn. Investment.0 0.4 77.3 92.6 133. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.9 1.8 51.8 28.6 85.7 90.1 0. and Bldg.1 0.1 1.5 61.1 28.5 1.3 0. Industry Consumer Goods Industry Prop.8 66.0 0.2 41.2) 0.4 38. and Bldg. Industry Consumer Goods Industry Prop. and Bldg.8 32.6 0. and Bldg.1 42.0 18.5 0.5) 6.6 0.9 59.6 51.3 0.7 — — 11.9 54.3 51.4 1.1 67.9 14.0 64.3 1. Real Estate.6) 25.7 112.4) 8.4 1.7) 26.0 (20.2 13.6 28.0 31.1 0.8 1.1 0. Investment.4 30.Table 1.7 17.7 1995 51.0 0.4 103.6 24.6 83.0 68.9 25.0 43.7 0. Industry Consumer Goods Industry Prop.5 95. Infrastructure Finance Trade.3 31.3) 39.3 31.6 22. Infrastructure Finance Trade.1 35.3 (203.1 32.0) 46.7) (113.6 135.1 1.8 0. Real Estate.7 54.5) 49.8) (12.0 0.6 15.5 0. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.7 133. Infrastructure Finance Trade.
6 1.7 46.3 17.0 680.4 6.1 1.8 382.7 10.0 120.6 8. 1992 20.8 44.1 4.1 6.7 1.2 7.0) 7.4 35.0 120. Constn.9 38. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.0 170.5 14.2 7.6 13.0 39.0 80.0 1997 230..6 8.5 5.0 66.0 8.9 87.0 100. and Bldg.0 630.0 150.5 13.7 5.4 79.7 4.7 9.0 180. Industry Consumer Goods Industry Prop. Constn.5 4.7 13.0 150.1 (5.6 (11.0 160.6 18.3 73. Industry Consumer Goods Industry Prop.4 13.5 Financial Performance of Publicly Listed Companies by Sector.0 46.0 3.1 1994 80. Real Estate.0 15.9 38.7 4.0 210.3 13.0 11.6) 18. Infrastructure Finance Trade.0 110.1 10. Infrastructure Finance Trade.0 120.5 4..1 4.0 190.9 10.9 4.6 19.1 1996 100.7 12.0 50.0 180.4 5.0 86.1 65.2 53.6 (2. and Bldg.1 89.8 20.5 11.0 8.1 7.7 10.4 .3 18. and Bldg. Investment.3 7.0 650.7 12.4 46.0 100.0 110.7 8.0 110.8 3.1 10.4 46.0 120. and Bldg.6) 36.3 64.6 23. Investment.0 90.8) 8.0 100.. Investment.2 1993 130.0 (0.1 4.8 11.2 8.7 10.2 3.9 40.1 3.2) 7.3 0. and Services Source: JSX Monthly (several publications).0 150.0 700.3 17.4 20.5 43.4) (1.1 9.8 81.7 1. Infrastructure Finance Trade.6 74..9 7. Real Estate.1 13.2 3.0 19.0 160.0 9.0 12.0 380.8 25.0 60. Industry Consumer Goods Industry Prop.2 13.0 110.7 (3.4 1.8 67.0 14.2 11.2 6.0 110.0 140.0 650.1 (3.7 71.0 100.4 6.7 12. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.6 14.3) 5. Constn.8 9.4 17. Industry Consumer Goods Industry Prop. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.2 15.2 30.7 4.1 63.9 14. Infrastructure Finance Trade.0 110.4 4.3 1.0 80.0 190.0 80.0 110.0 70.4 71.3 7.7 5.1 2.0 220.7 26.8 168.7 8.6 13.0 160.0 69.0 70.1 10.5 56.0 17.Table 1.5 19.9 42.4 35.9 41.0 140.0 130.8 5. Investment. Real Estate.8 11.9 29. Constn.3 5. Real Estate.2 111.1 8.9 17.0 180.4 13.3 33.8 16. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.2 23.7 61.1 11.0 190.1 9.8 479.5 1995 80.0 560.2) 15.8 8.3 38.5 17.0 3.0 70.5 7.2 39.2 (4.
SOCs diversified into many businesses. SOCs actively operated in various sectors4 under the supervision of “technical” departments. By 1995. banks (seven companies).8 percent between 1992 and 1995 (Table 1. SOCs’ sales growth fluctuated during 1990-1996. there were 58 SOCs with subsidiaries and affiliates. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. The DER was slightly higher than for listed companies.1 percent in 1993. This was relatively high compared to the 3.3 trillion. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control.Chapter 1: Indonesia 13 negative ROA. and basic industry and chemicals sectors had relatively stable ROA before the crisis. For instance.4 percent the following year. Just like private companies. respectively. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. insurance (11 companies). SOCs’ ROE ranged from 6. between 1993 and 1995.7 to 7 percent for publicly listed companies. there were 165 state-owned companies (SOCs)3 in Indonesia.1 percent in 1992 to 28. increasing from 21.6). much lower than that of companies listed in the stock exchange. Asset turnover rates were lower relative to those of publicly listed companies. State-Owned Companies At the end of 1995.6 to 8. indicating SOCs’ declining contribution to GDP. averaging 24 and 31 percent.7 percent in 1990 to 6 percent in 1996. which collectively had the largest assets. The finance and miscellaneous industry. Assuming a fixed ratio of value added to sales. Six SOCs were listed in the Jakarta Stock Exchange. but dropped dramatically to 4.3 percent in 1995. Taken together. the ratio decreased from 8. ROA had been at high levels from 1992 to 1995.7 percent. However. the subsidiaries and affiliates number 459 with total assets of Rp343. and finance company (four companies). Trade had the highest ROA of 39. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. Similarly. growth of net profits and assets was erratic. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. registering an average annual rate of 10 percent. These growth rates were low compared to those for listed companies during the same period. the Department of Finance supervised 30 SOCs. . This was due to large sales by the National Oil Company (Pertamina). The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies).
8 21.0 8. Source: Indonesian Data Business Center.1 6.3 30.7 16.7 1994 (9.0 8.1 19.2 18.1 32. .8 11.4 percent in 1994. II companies consistently declined over time.6 percent in 1994. Table 1.0 24.6 28.2 — = not available.7 (2.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.2 percent in 1997 (Table 1. a Value added was assumed to be 30 percent of total sales. Assuming a constant ratio of value added to sales.1) 5.0 12. Source: Indonesian Data Business Center. In 1997.4 7.3 12.8 percent in 1990 to 13. SOCs’ asset turnover rates showed a downward trend from 32.4 13.7 13. but dropped to 11.7). the contribution of conglomerates to GDP increased from 12. 1992-1995 (percent) Indicator Growth Indicators Sales Growth Share of Value Added in GDPa Assets Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb — = not available.2 — 370.6) 260.5 3.0 6.4 percent in 1992 to 28. Their total sales increased from Rp90.6 Growth and Financial Performance of State-Owned Companies.4 16.14 Corporate Governance and Finance in East Asia. b Asset turnover is defined as sales over assets.8 12.4 1993 16.766 business units.4 13.1 310.6 1995 25. Table 1.1 trillion in 1990 to Rp234 trillion in 1997.4 13. but climbed to 30.0 17.0 28. mostly private companies. 1992 — 7.0 7.1 30. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.3 250.2 23. these conglomerates owned 9.7 Growth Performance of the Top 300 Conglomerates.1 12. Vol.5 percent in 1995. a Value added was assumed to be 30 percent of total sales.6 28.
and the board of directors (BOD). The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. the legal and regulatory framework of the corporate sector was far from adequate. as representative of shareholders. shareholders lose control. and the attendance should at least be two thirds of total shareholders. such as the appointment (or replacement) of directors. the decision to use certain company assets as collateral for bank credit might need BOC approval. is the only shareholder mechanism for monitoring and controlling the BOD. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. the Government promulgated a number of laws and regulations to protect investors. mergers. The company charter details the issues that need shareholder meeting approval. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. an approval needs the majority (50 percent plus one) vote. however. For mergers. If the BOC does not perform well. In general. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). For example. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. tasked with supervising the firm. except in strategic issues stated in the law.Chapter 1: Indonesia 15 1. acquisitions.6 Legal and Regulatory Framework During the 1990s. and declaration of bankruptcy. The law also holds the directors and commissioners jointly responsible for decisions made by the company. For instance. commissioners. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). tasked to provide direction to the company. the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. and consolidations. . The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. This guards against shady intercompany dealings within a group of companies. and the accountant. The BOC. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders.2. For instance. The meeting decides on important issues. The law replaced an earlier statute that was based on the Dutch system. By international standards. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake.
II acquisitions. It regulates the requirements of investment companies. decrees of the finance minister. underwriters. (ix) mandatory shareholders’ approval of interested transactions. and the attendance should at least be three fourths of total shareholders. (iv) cumulative voting for directors. and (xviii) severe penalties for insider trading. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. Vol. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange.16 Corporate Governance and Finance in East Asia. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. (ii) proxy voting. Controlling shareholders have no vote on the matter. (xii) mandatory disclosure of connected interests. Because of such requirements. Examples in the area of corporate governance are guidelines for situations that can potentially lead to conflicts of interest and for acquisitions of substantial shares of listed companies. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. the decision should be approved by three fourths of the shareholders present. (vi) one share one vote. It also regulates reporting and auditing procedures. (xvi) independence of auditing. (iii) proxy voting by mail. (xi) mandatory disclosure of transactions by significant shareholders. (xiii) mandatory disclosure of nonfinancial information. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. and bankruptcy. The law is supplemented by Government regulations. investment managers. (x) mandatory shareholders’ approval of major transactions. some listed companies sell no more than a small proportion of shares to the public in order to retain the freedom of the founders to make strategic decisions. brokers. transparency requirements. (xv) mechanisms to resolve disputes between the company and shareholders. A tender offer is also required for acquisitions of up to 20 percent of listed shares. securities companies. and administrative and legal punishment. (viii) the right to make proposals at the shareholders’ meeting. investment advisors. (v) preemptive rights on new share issues. . and guidelines promulgated by the head of capital market supervision. (vii) the right to call an emergency shareholders’ meeting. (xvii) mandatory independent board committee. such as custodian banks and the securities registration bureau. and other supporting agencies. consolidations. insider trading (including market rigging and manipulation) investigation.
the collateral could take the form of nonphysical assets (e. It reveals characteristics of controlling shareholders. The old bankruptcy law based on the Dutch system was biased in favor of debtors and made it almost impossible for creditors to seek court resolution when debtors defaulted.. the viability of a project). A Commercial Court was also set up to deal with bankruptcy cases. Discussions on corporate ownership cover listed companies and conglomerates. net open positions. or financial institutions.g.3. . creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. the Banking Law (1992). The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. whether they are individuals. It aimed to protect creditors by providing easier and faster access to legal redress.3 Corporate Ownership and Control This section looks at the ownership structure of the corporate sector and reports the results of an ADB survey on corporate management and control of publicly listed companies. for instance. amended in October 1998. families.Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. However. states that a bank is not allowed to provide credit without collateral. etc. Banking regulations also set lending limits. 1. 1. holding companies. For instance. or 20 shareholders. The two most important elements of ownership structure are concentration and composition. capital adequacy. five. Unsecured creditors could proceed against a debtor in default based on loan covenants and through the legal process of collection against the latter’s assets.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. Ownership concentration is usually measured by the proportion of shares owned by the top one. A new bankruptcy law was passed in August 1998.
0 0. The pattern of ownership concentration changed little over this period. Rig Tenders Indonesia (shipping services) issued 51.3 1995 47. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.2 67.8 1.5 1997 48. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.8.7 1996 48.2 11.8 68. II Publicly Listed Companies Table 1.5 Average 48.0 67. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.6 4.9 0. Zebra Nusantara (taxi services).6.4 2. mining.9 Source: The Indonesian Capital Market Directory. respectively.0 1.7 3.8 68.0 0. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. Vol.0 4. consumer goods. Meanwhile.2 1.1 1.9 14. 13. This is because a few companies in the transportation sector issued high proportions of shares to the public. and 0. the founder usually continues to own the majority of shares through a . the controlling shareholders usually act as standby buyers.7 1994 48. When a company makes a rights issue. 2.1 4.6 3. When a company goes public. and basic industry and chemicals sectors than in others. This preserves the pro rata share of existing shareholders.4 percent.18 Corporate Governance and Finance in East Asia.6 3. issued 93. for instance.9 2. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.5 percent.9 2.5 16.6 13. Table 1.6 68. the five largest shareholders owned 68.6 percent.8 Ownership Concentration of Publicly Listed Companies. Table 1.0 2.6.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.1 13.9 percent of total outstanding shares. 3. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). The percentage owned by each of the five largest shareholders was 48.1 0.5 12.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.9.5 72. On average.
7 6.2 0.1 1.3 0.9 50.7 13. Indonesia has the largest number of companies controlled by a single family.7 9.5 4.8 14.9 Ownership Concentration of Publicly Listed Companies by Sector. (1999) also found.2 This is confirmed in Claessens et al. Real Estate. Industry Consumer Goods Industry Prop.4 6. Util. In terms of capitalization. In fact.1 percent) of Indonesian publicly listed companies were in family hands. and corruption.1 1. (1999). and only 0.6 percent were widely held.6 8. and the efficiency of the judicial system. the rule of law. is strong.1 11.4 4.4 11.9 0. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.5 58.9 44.. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.4 44.1 2.6 1.1 0.3 2.6 2.4 54. and Bldg.1 1. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.7 percent of the market.9 44. in a cross-country study.3 48.5 1.6 9. as well as the existence of corruption.0 5. The findings suggest that the concentration of corporate control in the hands of few families is a major determinant of the evolution of an inefficient legal and judicial system. and Services Average Source: The Indonesian Capital Market Directory.1 0. that the correlation between the share of the largest 15 families in total market capitalization.3 0.1 1.2 2.1 2.7 4.2 15. the top family controls 16.2 46.2 10.9 3.1 2. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.6 percent of total market capitalization while the top 15 families control 61. on the one hand. which shows that in 1996.. and Transportation Finance Trade. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in . Table 1.4 1. two thirds (67. on the other.3 14.1 13.6 0.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).7 1. Claessens et al. Infrastructure. Constn.3 36. Investment.9 1.
ethnicity.5 Conglomerates Table 1. However. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. foreign ownership increased to 21 percent.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. During 1988-1996.55 percent in August to 25. Indigenous businesspeople include the Javanese. . it rose to 30 percent. the onset of the crisis negated this development. Indian. In September 1997. the Government allowed foreign investors to buy up to 100 percent of listed shares.20 Corporate Governance and Finance in East Asia. Coordination is easier because informal communication channels exist. with all its regulations. or other ethnic groups. the proportion of foreign ownership declined from 27. If the role of a limited number of families in the corporate sector is so large and the Government is heavily involved in and influenced by business. their number increased to 5 In 1997. II the small number of families and the tight links between companies and the Government. political affiliation. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. But these benefits are few and often dubious compared to the high costs of concentration. In Indonesia. In 1993. Among the top 300 conglomerates. but later declined and steadied at around 25 percent. numbering 162 in 1988 and 170 in 1996. Sundanese. was able to create a favorable environment for business development. This may indicate that the New Order Government. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates.42 percent in December. The nonindigenous businesspeople are usually Chinese. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. conglomerates established before 1969 dominated in terms of sales. Batak. However. and family origin. From 193 in 1988. Vol. the legal system is less likely to evolve in a manner that protects minority shareholders. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. resulting instead in a decline in the proportion of foreign investor ownership. most were established during the New Order Government. and Padang. accounting for 64 percent of total conglomerate sales in 1988-1996.
7 89.1 58.9 73.7 106.4 86.6 34.7 40.9 billion.7 28.4 59.0 15.1 87.7 49.4 18.9 35.8 38.1 179.0 58.4 trillion in 1996. sales of the Bakrie group before it went public in 1990 were only Rp369.7 95.1 percent of total .4 15. Their total sales also increased from Rp38.1 103.8 36.8 49.2 12.0 31.9 47.6 17.8 57.8 Source: Indonesian Business Data Centre.4 57.9 77.0 116.5 21.2 23.9 137. In 1996.4 31.0 44. more than five times its 1988 level. Conglomeration Indonesia 1997.1 33.8 28.6 114.4 68.3 101.1 46.0 18.10 Anatomy of the Top 300 Indonesian Conglomerates.1 21.5 22.7 64.3 80.3 20.8 30.2 48.1 41.0 58. due to their “go public” activities.2 159.9 42. 1988-1996 Item Number of Groups Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily Sales (Rp trillion) Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily 1988 1989 1990 1991 1992 1993 1994 1995 1996 13 125 162 86 193 21 260 40 176 124 13 125 162 83 196 21 259 41 175 125 13 123 164 80 196 24 260 41 171 129 13 120 167 76 199 25 260 40 174 126 13 118 169 76 198 26 262 38 172 128 12 122 166 71 201 28 263 37 171 129 12 122 166 69 205 26 262 38 172 128 11 120 169 71 204 25 260 40 177 123 10 120 170 68 204 28 259 41 175 125 9.9 13.8 68.4 31.4 16. Meanwhile.2 29.4 32.Chapter 1: Indonesia 21 Table 1.4 19.0 28. While they supplied 20. 204 in 1996.5 120.9 trillion.3 120.9 14.4 22.2 33.3 43.1 52. its sales reached Rp1.1 42.2 76.3 134.8 12.5 106.4 48. the number of mixed groups declined from 86 in 1988 to 68 in 1996.1 25.4 59.4 69.1 46.6 95.3 36.4 52.8 25.6 12.6 77. For instance.4 81.2 30.4 37.6 54.6 trillion in 1988 to Rp137.7 24.
Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. In November 1997. Bambang Rijadi Soegomo. their contribution declined to 13. and Fast Food (restaurants). there were 175 groups that originated from a family business. including Indofood Sukses Makmur (food industry). Djuhar Soetanto. Only about 13 percent were formed by official or ex-official families. II sales in 1988. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. or have resulted from alliances between entrepreneurs and officials. compared with the less than Rp700 billion of a nonofficial-related conglomerate. Indocement Tunggal Prakarsa (cement industry). In 1997 and 1998. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Vol. In 1996. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. The Suharto family is the largest stockholder in Indonesia. and Wisnu Suhardhono of Apac-Bhakti Karya. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. which is the largest conglomerate in Indonesia. Most of the top 300 conglomerates were established by ordinary citizens. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families).2 trillion. Conglomerates were also classified into nonofficial. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). and Ibrahim Risyad of the Salim group. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo.22 Corporate Governance and Finance in East Asia. Prudential credit analysis tends to be ignored. 117 are jointly owned by the family and 57 are owned by individual family members. Out of 174 companies.7 percent in 1996. But only a handful of these companies are listed in the market. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. owns four groups with many subsidiaries and affiliate companies. for instance. Bank Indonesia.and officialrelated groups. Some of them later became public companies by listing in the stock market. In 1996. average sales of official-related conglomerates reached Rp1. The Salim group. collectively controlling . But listed companies within conglomerates were few.
If the family members cannot actively manage the companies as directors. While the source of the . continue receiving some kind of protection and special treatment. as well as other relatives and business partners. He or she could either be the biggest shareholder. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. families mostly manage the groups and make strategic decisions themselves. Cross-holdings between financial and nonfinancial firms potentially create more serious problems. they maintain their position as commissioners.1). Both are listed companies and members of the Salim group. or someone very close to and trusted by the controlling shareholders. Cases in point are the Bank Papan Sejahtera and Bank Niaga. In 1996. or both. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. and hence. This is because cross-owned banks had to consider not only their own interests. In so doing. Semen Cibinong. the controlling shareholders are able to maintain their special relationship with officials. they still control the work of the directors. Indonesian law allows cross-shareholdings. many of whom. 1999). Some of the groups related to officials have a unique share ownership structure. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). Although some groups employ professional managers. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. The families retain control of the companies through ownership. The Salim Group is also in part controlled by the Suharto family.. for instance. Although they are not actively involved in the daily operations of the companies. The BOC chairperson often represents the controlling party of the company. management. But it is difficult to obtain data on cross-shareholding among firms. besides Suharto himself. served in some government function (see Figure 1. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al. with no restrictions. but those of the entire group.
Financial Sector Practice Department. and Larry H. Lang. World Bank. Simeon Djankov. 1999). Who Controls East Asian Corporations? Financial Economics Unit. .1 The Suharto Group Usaha Mulia Group (cousin Hasim) Cemen Cibinong Hanurata Group Suharto Family Citra Lamoro Group (daughter Mbak Tutut) Bank Yama Bob Hasan Group (Mohamad Hasan) Gatari 22 firms with control over 20% Citra Marga Persda Tollroad Trias Sentosa Bank Central Indomobil Mercu Buana Group (step brother Probo) 11 firms with control over 20% Kedaung Indah 14 firms with control over 20% Kedaung Group (Agus Nursalim) 18 firms with control over 20% Tirtamas 21 firms with control over 20% 262 firms with control over 20% Salim Group (friend Soedono) Sempati Air Humpuss Group Bank Utamar 17 firms with control over 20% Bimantara Group (son Bambang) TPI Andromed Tripolita 8 firms with control over 20% Kabelindro Kiani Murmi Sakti Source: Stijn Claessens.Figure 1. P. (Feb.
the directors. the BOC has the right to obtain any information concerning the firm.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. seek an audience with directors. Therefore. Shareholders are at the top of the organization. The BOD leads the company and makes strategic and operational decisions. 1. both controlling and minority. Figure 1. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange.2. the BOC supervises the work of directors. including the boards. The managers execute the BOD’s decisions and lead employees in their departments. . role and protection of minority shareholders. request a shareholders’ meeting. As the owners’ representatives. and accounting and auditing procedures.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia Shareholders Board of Directors Board of Commissioners M a n a g e r s Employees The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed companies.3. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. management and managerial compensation. and.Chapter 1: Indonesia 25 problem is inconclusive. This is based on the Dutch system. if necessary. one possibility is that legal lending limits had been violated.
Corporate Governance and Finance in East Asia, Vol. II
Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
Chapter 1: Indonesia
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
Corporate Governance and Finance in East Asia, Vol. II
Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
Chapter 1: Indonesia
provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
Corporate Governance and Finance in East Asia, Vol. II
Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were
The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. . the owner of Tirtamas group. Most Indonesian state companies are 100 percent owned by the Government. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. In the massive restructuring of the banking sector that commenced after the crisis. Before the financial crisis. The Government appoints the BOD and BOC of these firms. it was common for the Government to invest in certain private companies. The bank was reported to have high NPLs and had broken the legal lending limit. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. One famous takeover was Bank Papan Sejahtera. to Hashim Djojohadikusumo. 6 7 Later in March 1999. with the minister’s approval. except for publicly listed SOCs. This used to be a common practice in companies associated with the Suharto regime. Since the NPLs reached up to Rp300 trillion. State ownership for listed SOCs ranges from 25 to 35 percent. In these two latter cases. appointment of management. which was acquired by Yopie Wijaya in 1995. A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. restrictions on market entry. or direct subsidies. Bank Niaga was under a recapitalization program. the acquiring interest was apparently seeking economic profits. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. the bank was liquidated. who was acquiring his second commercial bank. a state-owned insurance company may invest its funds in a private firm. Control by the Government Government control could be in the form of state ownership. For instance. IBRA found itself tasked with managing large amounts of assets in the private sector. In April 1999. the Government took over NPLs and put them under IBRA management.6 In this case. However. They then replaced the BOD and later sold the bank.Chapter 1: Indonesia 31 external acquisitions. Wijaya and his friends bought shares of the bank on several occasions until they gained control. at a large profit.
9 234.7 122.6 292.5 42.4 trillion in 1998.2 71.4. the share of private national banks in outstanding total loans increased to 44. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.7 50. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.1 220.5 80.0 93.6 6. because of the restrictions discussed below. companies considered alternatives to bank loans.6 percent in 1997. jointly providing almost 90 percent of loans until 1997. II 1. Since then. this market was not well developed. however.14.4 1. 1992 1993 1994 1995 1996 1997 1998 1999 68.3 60.3 66. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates). Bank Credit As shown in Table 1.7 18.4 percent in 1992.0 3. Vol.6 4. remain the major financing instrument for the corporate sector. equities became available to the corporate sector.6 150.6 3.2 5. Table 1. From 34. when the Government reactivated the stock exchange.3 14. Data from Bank Indonesia show that from 1994 to 1997. and others offered by nonbank financial institutions or finance companies.0 6. Private national banks and state-owned banks were the biggest domestic creditors.3 9.2 6. private national banks overtook state banks as the dominant credit source.0 487.3 111.4 225.4 86.3 188.5 7.9 150.1 Equities In 1977. However.1 Corporate Financing Financial Market Instruments Prior to 1977.9 153.5 108.6 48.0 168.4 56. stocks.9 378. new instruments have been introduced to the corporate sector.8 193.7 112.2 27. . bank credit surged from Rp122.32 Corporate Governance and Finance in East Asia.9 trillion in 1992 to Rp487. Bank loans.14 Banking Sector Outstanding Loans. including bonds.4 24.
9 1999 76. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.15).g.6 859. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. Overall. however. The ratio of funds raised by finance companies to credit disbursed by the banking sector has been increasing from about 5 percent in 1992 to 13 percent in 1996.Chapter 1: Indonesia 33 Some companies went public.15 Value of Stocks Issued and Stock Market Capitalization. factoring. the stock market has gained a bigger role in corporate sector financing (Table 1. It gradually increased again starting in 1991. Table 1. Prior to 1995.7 14. legal lending limit. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. thus increasing the role of the capital market in raising long-term funds. i. and consumer credit. The ratio reached 8.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. They were not. In 1988. 1992 1993 11.5 333.7 9.6 310. when foreign investors were not yet allowed to purchase listed shares.1 17.1 18.6 301. During the 1990s. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.1 1994 26. credit cards.7 15.0 15.. capital adequacy ratio. offering services such as leasing.5 1995 35.1 10. finance companies were increasingly used as channels for the inflow of foreign loans.2 16. allowed to accept deposit accounts from the public.0 206. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.e.4 207.6 91. the Government issued regulations to supervise and promote prudential practices in finance companies. shooting up to 18.0 70. In 1995.6 123.. . funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.4 1996 1997 1998 50.9 406.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares.7 percent in 1997.8 48. and net open position).
2 Patterns of Corporate Financing Table 1. they were not rated by a rating agency.34 Corporate Governance and Finance in East Asia.0 1986-1996 17.7 22.4. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases. which are unsecured negotiable promissory notes with a maximum maturity of 270 days.8 percent. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments). publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings). In the second half of the 1980s. averaging 26.8 17.3 16.4 23. While banks had some exposure to these instruments. respectively. Vol. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. at 81 percent of total borrowings.5 (0. Table 1. II Commercial Papers Commercial papers.0 3. 1.4 8.5 21.6 100.8 7. In terms of composition.5 — 26.0 1991-1996 16.6 100.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. have been popular in Indonesia since 1990.3 37.3 14. This is in contrast to the lower share of borrowings during the same period.16 Financing Patterns of Publicly Listed Nonfinancial Companies.6 12. short-term borrowings were greater than long-term debts.3 (0.6 8.0 39. 1996.1) 23.0 — = not available. . PACAP Research Center.0 100. Thus in November 1995.4 13.1) 23.5 11. otherwise it would be classified as a loss in the banks’ books.2 26.5 percent and 36. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.6 23.9 16.
Two telecommunications companies. except Semen Gresik (an SOC). also suffered from foreign exchange losses but managed to post profits of Rp0.3 Corporate Financing and Ownership Concentration It has been suggested. the pattern changed. Bank loans also surged when the banking sector was liberalized in 1988.2 trillion. in the context of Indonesia and some other countries. These liabilities grew significantly because corporate expansion was largely financed by debt. This amount doubled in 1997. Corporate debts grew over time. They also do not want to dilute corporate control and are more likely to finance growth with debt.9 trillion in 1996. Table 1. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. The analysis of ownership patterns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. All companies in the cement industry suffered from foreign exchange losses. that ownership concentration may be associated with heightened risk-taking by companies. For instance.4.1 trillion. Hence. which was masked by the rapid growth in investments. .Chapter 1: Indonesia 35 In the 1990s. the corporate sector’s high leverage. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. while Semen Cibinong’s losses reached Rp2. rising from Rp54.3 percent during 1991-1996.6 trillion and Rp1.4 trillion in 1993 to Rp112. which managed to post significant profits due to low exposure to dollar-denominated loans. 1.9 trillion. Indosat and Telekom. Indofood registered losses of almost Rp1. Of the various financing sources. Most corporate charters require commissioners to approve debt issues or sign debt agreements. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. respectively.2 trillion (mostly foreign exchange losses).17 compares the DER of listed firms by degree of ownership concentration. The results indicate that firms with higher ownership concentration tend to have a higher DER. corporate debts accounted for 39. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. was due largely to a rapid rise in long-term debts. reaching Rp229. with longterm debts increasing rapidly.
Source: Author’s estimates.17 DER of Listed Companies by Degree of Ownership Concentration (percent) Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699. As a result.0 386. II However. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inadequacy of the regulatory framework under the financial liberalization. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. to maintain control of the company. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. and high ownership concentration among families with political affiliation. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom.5 1. the borrowings swelled. the private sector borrowed heavily in unhedged dollars.358.36 Corporate Governance and Finance in East Asia. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. 1.56 significant at the 10 percent level.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. decisions on debt are made with the implicit endorsement of owners. Vol. Between 1987 and 1996. Controlling parties rely on external financing to maintain their equity share and.0 1.0 351. aided . heavy reliance of companies on bank credits to finance investments. In addition. ultimately. since commissioners represent the controlling party. The test of the difference between the two means found the t-value of 1. Table 1.5.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders.
This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. However. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. The large supply of foreign funds. after all. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. Heavy Reliance on Bank Credits to Finance Investments Companies relied heavily on bank loans to finance rapid corporate expansion because internal financing was insufficient and the capital market was not developed. There was also a smaller demand for equity compared to external debt financing since controlling shareholders preferred the latter to maintain their control of the companies. to circumvent these banking regulations.. As a result. the level of corporations’ foreign debt could not even be ascertained. The Government later specified the legal lending limit and the net open position that banks had to follow. The supervising agency was caught unprepared. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. It is not known if these regulations had an effect on nonbank intermediaries. only created to serve the companies to which they lent. It was doubly difficult to exercise supervision when groups with political clout owned the banks. A director at Bank Indonesia revealed that in 1995. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. In the process. This often led to the violation of prudential credit management practices. did finance many viable ventures. and the negative net open position (short position in dollars) continuously rose to precarious levels. However.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. many firms became highly leveraged. averaging about 4 percent of GDP. It was only in 1995 that some regulations on the activities of finance companies were contemplated. They were. . The removal of entry barriers in the banking sector caused the number of private national banks to soar from only 65 in 1988 to 144 in 1997. large amounts of credit were directed to the companies within the group. those with high DERs) established their own banks.e. Conglomerates that had difficulty in getting loans (i. A lot of short-term foreign funds were used to finance long-term investment projects.
banks did not lend on the basis of the soundness of the project. politicians. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. most often to people who were close to the ruling regime. In many cases. and in the process maintain control of the company. . of which $64. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. They enhance their control over companies through cross-shareholdings. Vol. where private banks are usually in the hands of big businesses. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. Collusion between big businesses and the political elite was widespread in Indonesia. Since the Government could not afford to undertake these projects. by setting up their own banks. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. II By mid-1997. and power generation) require huge capital. but on the basis of who the borrower was. partly because they used nominee accounts to register ownership rather than set up a holding company. Projects involving massive capital investments and long-term operating deals (in telecommunications. contracts were granted to the private sector. Families retain control by keeping the majority percentage of outstanding shares. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections.5 billion was owed directly by corporations. In early 1998. or both. as they had done so in the years before the crisis. there was also almost universal confidence that the economic growth would continue indefinitely. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year.5 billion. total private sector foreign debt stood at $72. toll roads. This was often the case in the banking industry. This fact was usually not disclosed in financial statements. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. Corporations were certain that they could roll over short-term loans when these fell due.38 Corporate Governance and Finance in East Asia. and investing shares among nonfinancial companies within the group and in other groups’ companies.
and Water Supply Construction Trade.1 5.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. 1996-1999 (percent) Sector Agriculture. Hotels.9 3. posted negative growth rates. real estate. This continued in 1998. 53 companies reported negative equity of Rp6.1 6.8) (11.18 GDP Growth by Sector.6 4. The construction sector was the worst hit. Most sectors showed significant increases in leverage. when all sectors.3 12.1 (1.8) (13. Sectors with lower ROE generally had higher DER. The average DER was found to be 1. Only 86 companies reported profits.0) (15.8 1997 1. much higher than the 307 percent registered in December 1997.370 percent.7) (2.0 2.1) 1. DER and ROE were calculated per sector.52 trillion.7 1998 (0. followed by the finance and trade sectors. Gas. and Fisheries Mining and Quarrying Manufacturing Electricity.58 trillion (meaning their losses were greater than the paid-up capital).6) (3. and building construction. and Restaurants Transport and Communications Financial. except utilities. The consumer goods industry reported the lowest ROE.4) (0.8 8.6 12. and 128 companies reported a total loss of Rp46.18 shows that growth in most sectors significantly fell in 1997.4 7. indicating a rapid rise in .24 trillion for the first six months of 1998.2 8.1) (26.7 6. Real Estate.0) 1999 2.6 13. Livestock.7) (8.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. Forestry. as shown in Table 1.Chapter 1: Indonesia 39 1.5) (18.6) (0.0 5.4 5.3 11. Table 1. and Business Services Other Services GDP 1996 3.8 7.6 8.8 0.0 3.7) 2.2 (1. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.6 (36. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. BPS).5. followed by property.19.4 7.4) 2.
0 92. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.4 (6.0 1.370. Second.0 163.1 1. . and would have kept on increasing if interest rates had not declined.0 72. the NPL ratio rose to 25.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity. losses in operation were due to declines in sales and increases in the cost of imported inputs.4 5.8 (373. II Table 1.1 (3. Financial and banking analysts estimate that by September 1998.0 307.1 30.19 DER and ROE of Publicly Listed Companies by Sector. Source: JSX Monthly.0 229.0 158.4) 18.625.0 177.0) (78.0) 10.0 1997 234. the NPL ratio had reached more than 60 percent.0 2.0 108.8) 36.1 (5.8 17. small foreign banks enjoyed the highest profits.1 (124. private banks posted negative ROEs in the same year.5 8. As the rupiah weakened and interest rates increased. Impact on the Banking Sector Table 1.0 12. a Actual data for 1st semester only.40 Corporate Governance and Finance in East Asia.271.0 2.0 1.0 1.0 105. several publications.0 205.2 (4.0 635.5 percent in April 1998. This figure further increased to 47. foreign exchange losses came about with the use of unhedged foreign debt.0 65.6) (115.097. but annualized to approximate full year values. Vol.0 97.0 111.0 631.1 (92.7 percent in July 1998.7 1.0 108. Mostly suffering from a liquidity squeeze.0 864.4) 8.2) (264. The huge losses suffered by most companies were caused by three factors.8 percent in 1996. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.2 23.9 12.0 193.0 191.0 219.0 1998 186.395.20 reveals that the banking sector’s ROE decreased significantly in 1997.7) 6. from only 8.2 13. First.0 697. Third. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.1) 7.6 (11. as shown in Table 1.21.0 a ROE 1996 1997 1998a 14.0 177.6) 15.3 7.
July No.2 10.6 — 1.1 274.2 8.28 5.Chapter 1: Indonesia 41 Table 1.2 — 19.1 198.1 13.21 Nonperforming Loans by Type of Bank.45 — 1993 15.09 11.4 7. Source: Infobank.9 percent.44 15.89 27.73 30.68 1996 1997 8.91 21.84 27.37 19.67 8.8 11.3 Private National Banks — 179.6 — 13.30 5.81 13.7 106. State-owned banks initially had the highest NPL ratio.2 1.1 1.9 11.06 20. private national banks overtook State-owned banks when their NPL ratio jumped to 57.1 30. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.5 2.07 1994 14.7 4.7 29.70 1995 7.72 16.09 (11.0 622. Source: The National Banking Association.38) 11.0 — 32. however.7 Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998 Total 331.3 22.9 Regional Foreign and Development Joint Venture Banks Banks — 9.2 — 8.86 11.1 47.3 445.7 — = not available. coupled with negative spreads (deposit rate was higher than the credit rate).12 15.0 — 4. .9 297.69 14.8 8.8 187.2 48.5 34. 1996-1998 (Rp trillion) State-Owned Banks — 140.20) Table 1.24 (4.5 128.5 31.2 47.6 6.0 129.45 21.50 9.25 22.47 20.39 13.8 14.5 222.24 15. put pressure on the banking sector.2 8.3 361.7 — 1.15 20.34 16.43 10. 1992 7.9 — 11.20 ROE of the Banking Sector. In July 1998.8 3.2 37.6 — 4. 230/1998.5 57. The high and increasing NPLs. 227/1998 and October No.07 13.
7 billion of foreign exchange debt.2 billion debt. By end-November. Corporate debt accounted for 46. such as Garuda (a national flag carrier). The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Astra International (automotive). The scheme encourages negotiation between creditors and debtors. only a .000/$1) in debt from domestic commercial banks. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. II 1. the committee launched the Jakarta Initiative. about 80 percent of which was private. a number of prominent companies. In November. Aside from being described as overly complicated. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. and Ciputra (property business).42 Corporate Governance and Finance in East Asia. Since September 1998. few companies were in a position to resume interest payments. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. assembling the legal and policy framework to facilitate corporate restructuring.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. Vol.4 trillion of domestic debt and $6. More than two thirds of private debt was short-term and the average maturity of all private debt was estimated to be only 18 months. none of the 2. by mid-September 1998. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. In addition. On 9 September 1998. particularly in terms of debt resolution. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. Thus. One premise of the initiative was that creditors should agree to a standstill for a certain period (creditors would desist from exercising their claims on a distressed company’s assets) to allow debtors to operate normally after obtaining fresh financing. a more comprehensive scheme to tackle domestic and foreign corporate debt. the Government and private sector formed a committee to help corporates deal with the crisis. Unfortunately.000 eligible firms had signed up for the scheme.5.7 percent ($64.6 billion) of Indonesia’s total external debt in March 1998. have been subject to restructuring deals under the initiative. However. companies were not servicing their debts. In June 1998. the scheme failed. While the process of restructuring was in progress. IBRA was formed to offer Mexican-style resolution for private sector foreign debt.
for equity infusion. For instance. and mining equipment. consolidate business units. some companies attempted to restructure their businesses on their own.. Astra International. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process . and sell noncore businesses or nonoperating assets. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. Standard Chartered. Debtors. plantations. limitations will be imposed on the ability of secured creditors to foreclose on their collateral during bankruptcy proceedings (as is provided for in the bankruptcy laws of most other countries). Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. Moreover. who fail to reach agreements with creditors in out-of-court workouts under the Jakarta Initiative or fail to gain the requisite creditor support for the workout plan can resort to the Commercial Court.e. Bank Bali agreed on a debt-to-equity swap with its creditor. Meanwhile. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. lay off workers. When credit from the banking sector became unavailable and interest rates increased significantly. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. a publicly listed company operating in the automotive industry. with the requirement that adequate compensation and protection will be provided to such creditors during that period. under which the latter would become one of the bank’s shareholders.Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. A Commercial Court was set up to handle corporate restructuring and debt settlements. i. Bank Niaga also negotiated with some of its creditors. especially in preventing unjustifiable delays in the adjudication of bankruptcy. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. In the banking industry. forcing them to cut costs. mining. as well as general commercial disputes. Rabobank and Citibank. the companies’ financial performance deteriorated.
44 Corporate Governance and Finance in East Asia. Vol. There will be changes in the implementation of the bankruptcy law. the Government did not impose restrictions nor did it attempt to regulate capital flows. The Government. (iii) the merger. legislation against corruption. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. companies were allowed to sell shares only by issuing stock rights. reform. the measure had only a minimal impact. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. Realizing that they undermine investors’ confidence. collusion. Rather. The Court has also declared only two companies bankrupt. Capital Market Reform In the capital market. To push bankruptcy reforms. The significance of a sound bankruptcy system cannot be understated as it provides a backdrop for negotiations in the workout and restructuring process against which parties often gauge their legal rights. including procedures for handling operational issues and processing bankruptcy cases. the monitoring system for foreign exchange transactions will be strengthened to improve transparency and better assess the credit exposure of the corporate and banking sectors. II to achieve liquidation of the company. However. with only 17 cases filed as of November 1998. is also reviewing the Bankruptcy Law. and (v) a strengthened banking supervision system. and nepotism (anti-KNN) was signed in 1999. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. since the market reflects the condition of the economy. and recapitalization of state banks. The Government has also been concerned with the issue of capital controls. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. However. in consultation with IMF and the World Bank. The bias in favor of debtors has retarded the pace of corporate restructuring. . Previously. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. the Court’s early record has been a disappointment. (ii) the resolution of nonviable private banks. In the longer term. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia.
Conclusions.Chapter 1: Indonesia 45 In 1997. it is doubtful whether pure holding companies are able to enter into swaps. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans.1 Summary. providing Bank Indonesia with substantially enhanced autonomy. A new central banking law. It has also drafted regulations to remove obstacles for converting debt to equity. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. Banks deemed ineligible for recapitalization will be closed. BBD. The Bank Indonesia 21st package includes recapitalization. Liquidity support given to troubled banks should be repaid in four years. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. or sold (after transferring NPLs to the AMU). The merger process will be finished within two years. However. In particular. merged. 1. depositors will be fully protected by the Government. the Government established IBRA to supervise problem banks. To obtain a clearer picture of the banking sector. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. Bank Indonesia has announced a recapitalization program for potentially viable private banks. Some 175 groups that originated from family businesses controlled . and Bapindo) will be merged into one bank named Bank Mandiri. improvement of rules and prudential regulations. The importance of this legislation may need to be emphasized. The four state banks (BDN. the Government required banks to be audited by international external auditors. Other Regulatory Reforms To push corporate restructuring further. In October 1998. and follow-up action on bank restructuring. To overcome these problems.6. BEII.6 1. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. was enacted in 1999.
On the one hand. not all of the conglomerate-affiliated companies are publicly listed. families control 67. On average. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. Among those listed in the Jakarta Stock Exchange. lacked the information necessary to allow them to assess projects’ risks and chances for success. Vol. Rapid growth in investments masked the corporate sector’s increasing leverage. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. Foreign creditors.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. Indonesian companies borrowed short term. Companies relied heavily on bank credit. Financing Patterns Controlling shareholders opted to use debts to finance expansion. However. allowing them to maintain their equity shares and. But because foreign creditors were reluctant to lend long term.7 percent. conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. The restructuring and resolution of financial distress may. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. the majority remains family-controlled. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion . banks were unwilling to provide credit to highly leveraged companies. retain ownership control of companies. corporate debts grew over time. when barriers to entry in the banking sector were lifted. II 53 percent of total assets of the top 300 Indonesian conglomerates. These figures show the extent of power wielded over the corporate sector by a small number of families.1 percent of publicly listed companies in Indonesia. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. These banks also obtained cheap offshore funds. However. meanwhile. Companies preferred to borrow in dollars because interest rates of foreign loans were lower than for domestic loans and the exchange rate was relatively stable. thus. Therefore.46 Corporate Governance and Finance in East Asia. however. When the Government regulated the legal lending limit and the net open position of banks. As a result. while a single family controlled 16.
the high domestic interest rates that prevailed from 1998. Impact of the Financial Crisis Prior to the crisis. NPLs rose and capital adequacy ratios fell.1 trillion in 1997 from Rp13. At the height of the crisis.1 percent in 1998. particularly those with large short-term foreign loans. Sales of conglomerates as well as those of publicly listed companies were increasing. corporate-initiated debt restructuring . the highly leveraged companies. were the most adversely affected.Chapter 1: Indonesia 47 without diluting their control. To restructure the corporate sector. The Government introduced reforms to improve bankruptcy procedures. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. and the rapid decline in equity due to losses. As the rupiah weakened and interest rates increased. The Government and the private sector responded with measures to mitigate the negative effects. and registered a net loss of Rp39.370 percent in 1998.24 trillion in the first half of 1998. followed by the property sector. Total profits of publicly listed companies dropped to Rp3. financed by issuing nearly $80 billion worth of bank restructuring bonds. and strengthen prudential regulations and supervision of the financial sector.21 trillion in 1996. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). facilitate debt restructuring. On the other hand. DER increased to 307 percent in 1997 and further surged to 1. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. the consumer goods industry was the worst hit. although at a declining rate. ROE dropped from 1. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. The financial crisis led to the closure of several dozen banks. Meanwhile. the corporate sector was in quite good shape in terms of growth and profitability. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. When the crisis hit Indonesia. Bank Indonesia extended emergency loans to many banks.1 percent in 1997 to -124.
1.6. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. If the role of a limited number of families in the corporate sector is so large and the Government is either heavily involved in or influenced by business. Specific recommendations include protecting the rights of minority shareholders. (ii) delineating the functions of the board of directors and commissioners. The Government should ensure that all laws and regulations are effectively enforced. Vol. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . and (iii) strengthening transparency and disclosure requirements. but inadequate protection to minority shareholders from the dominance of large shareholders. and protecting creditors’ rights.. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. but it is not clear whether in practice these standards are in place. improving the legal and regulatory framework for bank supervision. Most companies claim to have adopted international standards of accounting and auditing procedures. In particular. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. II measures included internal business restructuring (e. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study.48 Corporate Governance and Finance in East Asia.g. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. Amendments should include (i) empowering minority shareholders by raising the majority percentage of votes required on critical corporate decisions and mandating minimum representation of minority shareholders on the board. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders.
and liquidation of corporate assets. Further. Banks should be required to provide data on such transactions and charged penalties for noncompliance. In the first place. However. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. The regulatory framework was also weak in supervising and monitoring foreign transactions. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. With credit being coursed through the domestic banking system rather than directly to numerous local corporations.Chapter 1: Indonesia 49 financial institutions. recapitalization. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. it has been difficult to implement standstills. This is a significant factor in . When finance companies were used to channel offshore loans in lieu of commercial banks. The Government should also continue strengthening the monitoring system for foreign exchange transactions. with necessary legal sanctions for violations. orderly restructuring. Consequently. the Government lost monitoring and control powers over foreign fund flows. most of banks’ NPLs resulted from credit to companies within the same group. Protecting Creditors’ Rights To protect creditors’ rights. Because foreign creditors are faced with more information asymmetries than domestic creditors. the Court has been slow and ineffective in processing bankruptcy suits. in contrast to the Republic of Korea and Thailand. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks.
Only when creditors have the confidence that their rights are protected will they resume financing companies. The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing.50 Corporate Governance and Finance in East Asia. . despite the smaller level of capital inflows (as a percentage of GDP). Vol. II explaining the greater depth of the crisis in Indonesia.
Large and Medium Manufacturing Statistics. and Remuneration. and Larry H. P. John Wiley and Sons. various publications. John Wiley and Sons. Indonesia Country Profile. 14 May 1999. Letter of Intent of the Government of Indonesia to the IMF. Michael Krill. 1995. 1997. Lang. Manuscript. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Indonesian Capital Market Directory 1992-1998. 1996. The Private Debt Anatomy. Jonathan. K. .Chapter 1: Indonesia 51 References ADB Programs Department (East). 1996. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. Embassy of Indonesia Homepage.. University of Maryland. and M. Embassy of Indonesia. P. 1999. Financial Sector Practice Department. Conny Tjandra Rahardja. Indonesia: Sustaining Manufactured Export Growth. Unpublished thesis MMUGM. Asia in Crisis: The Implosion of the Banking and Finance System. Economy of Indonesia. Yogyakarta. Corporate Governance: Responsibilities. Simeon Djankov. JSX Monthly Statistics. 1995. F. various publications. Bank Indonesia. various publications. Indonesian Central Bureau of Statistics. 1997. 1998. Wright. Delhaise. Indonesian Business Data Centre. The Economist Intelligence Unit. Stijn. Risks. Institute for Economic and Financial Research. Economic and Financial Statistics. 1998. Who Controls East Asian Corporations? Financial Economics Unit. Indonesian Business Data Centre. Jakarta Stock Exchange. Indonesia: An Emerging Market. Forest. Maryland. Center for International Business Education and Research. and Richard Turtil. Working Paper #58. The Economist Intelligence Unit. World Bank. 1999. Indonesia Country Report. Keasey. various publications. Claessens.
the Government and business sector had good reason to reflect on the causes of the crisis. the Republic of Korea. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. Business managers and controlling shareholders were maximizing firm size at the expense of profits. timely exit of poor performers from the market. David Edwards. . The country’s winners would then emerge based only on economic efficiency. and Graham Dwyer for his editorial assistance. the Korea Stock Exchange for its help and support in conducting company surveys. markets.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. Chung and Yen Kyun Wang1 2. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. a practice that was not checked by creditors. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. The authors wish to thank Juzhong Zhuang. A national consensus is emerging that a democratic system based on free market principles should be firmly established to promote more intense competition in every sector of the economy. Further. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. internal control mechanisms. Seoul.1). 1 Professors. and corporates were sent reeling. banks as major creditors had governance problems of their own and failed to monitor or exercise the control rights generally afforded to lenders via loan agreements. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. As the Korean currency. Chung-Ang University. This has been the crux of the corporate governance problem in Korea. or capital market discipline. both of ADB. Department of Economics.2 Republic of Korea Kwang S. Korea) in November of that year.
and J Murrin (1995).1 1995 560 163 29. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. especially chaebols. capital market discipline.1 1996 561 163 29.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. T. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. accountability of controlling shareholders and boards of directors.4 1993 513 174 33. The EVAs are the same as the economic profit as explained in T.1 1997 518 104 20. and improvement of bankruptcy procedures. Self-dealings by controlling shareholders—crosssubsidization and cross-guarantees among member firms within a chaebol (a conglomerate/large business group)—and the lack of transparency hindered the development of an efficient capital market capable of mobilizing low-cost equity funds. and individual companies. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. Koller. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. Government reform goals for the corporate sector include enhancement of corporate transparency. June 1999.9 1994 531 165 31. Copeland.1 Listed Firms with Positive Economic Value Added. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. Source: Korea Stock Exchange. Vol. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Weaknesses in the overall corporate governance system in Korea had many ramifications. Many firms left some questions unanswered. II Table 2. This study collects and analyzes data on the Korean economy.54 Corporate Governance and Finance in East Asia. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance.1 1998 490 164 33. the corporate sector. which distributed and collected the questionnaire. . The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35.
the board of directors system. Section 2.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. clothing.2.2. . Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. and naturally adopted an import substitution policy.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. Section 2.2 presents an overview of the corporate sector. creditors. It then presents recommendations for further reform in corporate governance and financing. Section 2.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. Section 2.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. and Yim (1998). It reviews such elements as shareholders’ rights. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Section 2. which account for a substantial portion of the Korean economy. reviewing government policies responsible for the development of the modern corporate sector. Major economic indicators for some of these periods are shown in Table 2. and other necessities domestically.2 2. Yang.5 describes the state of the corporate sector in the financial crisis and draws on the results of the foregoing sections to outline the causes of the crisis. corporate control by the Government. This chapter is composed of six sections. From 1948 to 1961.4 contains analyses of corporate financing and its relationship to performance. In the period 19481961. and employees and their role in shaping corporate governance practices. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. 2. The Government tried to produce food. The evolution of the modern Korean economy can be divided into four periods. It traces the country’s economic development.
9b 15. c Refers to 1989. largely because of political instability.2 32.1 15.265. e For maturities of one year or more. Vol.2 757. This goal required very high savings and investment rates.102. the Government was not successful in solving the problems of slow growth. high unemployment and inflation. a Refers to 1971.9 794.9 — — 21. modernizing the industrial structure. d Refers to 1997.0) 492.1 29.6 11.1 35.7 30.8 (8.5 250.2 1980-1989 8.2 1. Large amounts of aid in the form of agricultural goods from the US kept prices of local goods low and discouraged efforts to increase agricultural production.753. IMF. and large current account deficits.7c 11.4 10. Export Drive: 1962-1971 Between 1962 and 1971.2 Key Macroeconomic Indicators Annual Average (percent.7 14.5) 8. b Refers to 1979.2 31.0 41. Economic Statistics Yearbook.4 1990-1997 7. the Government called for an unprecedented average annual economic growth rate of 7.1d 9.4 29.1 9. International Financial Statistics.8 (724.2 6.8 24.3 8.8 15.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries. II Table 2. and implementing new budget and tax measures. In the Plan.2 452.8 12. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.5) (1.1 — = not available.7 37.9) (7.4 29. Source: Bank of Korea. and inconsistent economic policies.1a 21.4 24. However.9) 1.56 Corporate Governance and Finance in East Asia.0 27.855. The Government tried .949.447.2 30.0) (297. unless otherwise indicated) Indicator GNP Growth Rate Inflation Rate Savings Rate Investment Rate Manufacturing/GDP Interest Rate on Time Depositse Exchange Rate (won/$) Export Growth Rate Import Growth Rate Trade Balance (million $) Current Account (million $) Capital Account (million $) 1962-1971 1972-1979 8.4 (1.332.5 38.2 314. lack of strong drive. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).
the Government tried to provide exporting firms with a free trade environment.3 percent to 60. However. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported.5 percent. imports of consumer goods and luxury items were highly restricted. This change raised the import liberalization rate from 9. channeling funds from curb markets into the banking sector. the growth of gross domestic product (GDP) raised domestic savings.4 percent. Bank deposits increased rapidly. a modest improvement over the 4. But the liberalization trend turned out to be short lived as current account deficits continued. In 1971. resulting in high real interest rates. but tariff rates were raised to 40 percent in the 1960s. due to continuous current account deficits. The exchange rate system was a kind of crawling peg until 1974.2 billion in 1972. During this period. boosting internal investment resources. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. the import liberalization rate was 55 percent. During the first five-year plan period. and cheap labor force was well utilized by the export-led growth strategy. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system.3 percent average between 1954 and 1959. up from 30 percent in the late 1950s. which laid a solid foundation for a steady growth path. The interest rate reform enabled banks to allocate large funds to the industrial sector and reduced the high inflationary pressure that had built up in the economy. The average growth rate of the economy from 1960 to 1964 was 5. In 1964. while the average tariff rate was 39 percent. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. Exports increased sharply from $41 million in 1961 to $2. Also. but the average growth rate for 1965-1969 shot up to 10 percent. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. abundant. The well-educated. and maximizing mobilization of domestic savings on the other. In 1963-1964. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). .
Third. overburdened with debts and high interest rates. the domestic economy was stagnant and many businesses. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation. shipbuilding. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. where preferential export credit was given to almost every exporter. The Government targeted six industries—steel.6 billion between 1973 and 1981 into these sectors. the emergence of competition of other low-wage. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. Second. machinery (including automobiles). The Government encouraged a variety of business projects. and chemicals—as future core industries. less developed countries forced Korea to adjust its industrial structure. By promoting HCIs. nonferrous metal. it tried to substitute imports and export high value-added HCI products. Vol. and assigned them to specific chaebols. the Government felt the need to strengthen the defense industry. Unlike the previous system. electronics. in the face of a world economic slump. faced the danger of bankruptcy. In 1972. investing a total of $9. and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. this new strategy had the Government explicitly allocating credit only to those firms deemed vital to HCIs in the form of below-market interest rates . There were three reasons for the switch: first. The HCI promotion policy was much more comprehensive than past economic development plans. reducing or exempting debts of farmers and fishermen. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). announcing rescue packages for businesses and banks.58 Corporate Governance and Finance in East Asia. It promoted HCIs by supplying massive capital for construction and development. The Government took emergency measures. and giving low interest rate loans to banks from the central bank. These practices contained an implicit government guarantee that large businesses and banks could never fail. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. These included rescheduling business debts. becoming a seed of the economic crisis in 1997.
the policy wasted substantial amounts of resources in the short and medium terms. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. including denationalization of banks. Economic Liberalization and Globalization: 1980-1997 In 1979. low . coupled with political uncertainty due to the assassination of President Park in 1979. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. especially between 1979 and 1985. In 1986-1989. a heavy foreign debt burden. however. various measures to increase competition were taken. price controls were abolished. as it had to control only a few large chaebols. This required industrial restructuring by the Government. such as widespread underutilization of capacities of HCIs and related plants. the Government restructured some large businesses through forced liquidation and M&As. Meanwhile. fiscal expenditure maintained zero growth. The two important ones were import liberalization and deregulation of the financial sector. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. However. Such an approach gave the Government increased control over the economy. The incentives available became more market-based. and the large excess capacity of HCIs. the Government adopted comprehensive measures to promote economic stabilization. imports were further liberalized while tariff rates were lowered. met increased difficulty. Cheap credit and distorted prices resulted in overexpansion in the HCIs. with many turning into the now well-known chaebols. The growth rate of the money supply was reduced drastically. Macroeconomic policies became hostages of the industrial strategy. Evaluations of HCI promotion policies are mixed. In order to improve economic efficiency. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. The plan of the 1970s was thought to be successful in the long run. including forced liquidations and mergers and acquisitions (M&As).2). exacerbated the overcapacity problem.Chapter 2: Korea 59 through state-controlled banks. and their utilization ratios were very high. New start-up firms. Firms that followed the Government expanded greatly. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. The severe world recession caused by the second oil shock. Meanwhile. faced with high inflation.
2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies.9 percent. 4. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. the import liberalization ratio reached 98. The Government tried to adjust economic policies and regulations to meet global standards.2. which gradually widened. The most important element characterizing chaebols is the concentration of ownership.1 percent. In 1988. Korea adopted a market average exchange rate system. with the 30 largest in the total economy in 1997 standing as follows: value-added. further increasing its pace of import liberalization. The birth of chaebols can be traced to the selling of Japanese colonial properties that were reverted to the Korean Government after World 4 The historical review of chaebols draws substantially from the paper of Lee and Lee (1996). while continuous and large current account surpluses saved Korea from the foreign debt problem. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996.3 percent. the Government committed itself to further liberalization of the goods and capital markets. In 1990. The official rate fluctuated within a band. whose business activities are controlled by an identical person. The low value of the dollar led to a low won and high yen. Korea began participating in many multilateral trade negotiations during the Uruguay Round. 13. II world interest rates. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. giving up its foreign exchange controls related to the current account. total sales. and declaring that it would follow Article XI of GATT.9 percent.1 percent and average tariff rates 8. Vol. Industrial and trade policies were modified to be consistent with WTO. and acceded to the World Trade Organization (WTO) in 1994. the importance of chaebols was increasing. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems.” A large-scale business group is called a chaebol.60 Corporate Governance and Finance in East Asia. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. total debts. . 2. and total workforce. and low oil prices. 45. total assets.9 percent. 47. Meanwhile. but it chose to liberalize gradually.2 percent. In 1993. in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. 46.
The Government provided subsidies. the number of subsidiaries declined drastically due to corporate restructuring. Table 2. Important managerial decisions are made primarily by owners. the ownership and management of a chaebol’s subsidiaries are not separate. Since the 1960s.Chapter 2: Korea 61 War II. it was more effective to deal with a small number of companies to secure tangible outcomes. of Subsidiaries 604 616 623 669 Average No. and they are aided and supported by one another. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries.3 Source: The Fair Trade Commission. However. Since the Government controlled most business activities. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. From the standpoint of the Government. reaching 669 in 1996. One reason for this controlling power is inter-company shareholding among subsidiaries.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993.1 20.when the Government put a great deal of emphasis on development of the HCIs. . of Subsidiaries per Chaebol 20. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. and tax breaks to key industries to promote exports and industrial upgrading.8 22. Chaebols are also excessively diversified. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. In the mid-1970s. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. In this sense. This policy contributed greatly to the expansion of chaebols. Table 2. financial assistance. This galvanized the fast growth of chaebols. 1993-1996 Year 1993 1994 1995 1996 No.3 Subsidiaries of the 30 Largest Chaebols. chaebols that maintained a close relationship with the political authorities were able to grow fast.5 20. after the financial crisis. Chaebols have a history of substantial concentration of ownership.
profitability. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. which may ultimately lead to the decline of social efficiency.2. In the early years after the enactment of the law. For example. diversification can make chaebols stable through the portfolio effect. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. . there are many negative assessments of organizational structures and practices of chaebols. This could ensure their stable growth and enhance their investment abilities. chaebols can benefit from synergies. including the “economies of organizational size” inherent in multi-product and multiplant firms. Under this law.62 Corporate Governance and Finance in East Asia. II Theoretically. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. in addition to the usual economies of scale. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. etc. Since chaebols are engaged in many different businesses. However. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. Diversification may raise chaebol profitability but could also work to eliminate more efficient competitors because bigger chaebols have a higher capability to enforce unfair methods of competition. They had to meet certain requirements in terms of firm size.3 Role of the Capital Market and Foreign Capital In the 1960s. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. The law also contained provisions to afford tax and other benefits to firms that went public and to impose tax-related penalties on those that refused to comply with government recommendations. On the other hand. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. they can reduce uncertainties and dilute risks through sharing of information and diversification. and were allowed extra depreciation charges for tax purposes. Vol. 2. years since establishment. Meanwhile.
was established to invest in domestic shares beginning in September 1985.. however.9 833. 1985-1998 No.1 16.4. continued until 1989. Second. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. a country fund. The policy to expand the size of the stock market.0 79.2 44.217 141. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.0 965.9 34. several important policy measures were implemented to promote the development of the stock market. especially those paying small or no dividends. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. Also that year. the stock market grew rapidly during the 1980s. First.370 70.5 406. the number of firms listed on the Korea Stock Exchange almost doubled in the five-year period from 1985 (342 firms) to 1990 (669 firms).0 49.7 934. Beginning 1990.1 Market Capitalization (W billion) 6.4 Development of the Stock Market.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.570 95. Third.151 117.476 79.020 151.1 30.6 747. the Government announced the gradual opening of the capital market to foreign investors in January 1981.989 137. As shown in Table 2. Inc.798 Market Capitalization as a Ratio to GDP (%) 8. In this regard.4 40. Because of government policies and the booming economy. The Korea Fund. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. The aggregate Table 2. Korean firms were allowed for the first time to issue in international financial markets equity-related securities such as convertible bonds (CBs) and depository receipts. .4 654. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.9 918.Chapter 2: Korea 63 During the 1980s and 1990s. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.
and stayed at the 30-40 percent level up to 1996.59 percent in 1998 and to more than 50 percent in the early months of 1999. Korean companies borrowed substantial amounts of foreign capital due to the excess of investments over savings and chronic current account deficits—except in the period 1986-1989. II market value of all listed firms represented only 8 percent of GDP in 1985. Vol. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. . Table 2.149 13.546 (2.017) 1.141 4.433) (9.542) (1.553 8.642 21. The growth in the number of listed firms also slowed in the 1990s.924 (1.742 (3.264) (3.001 4.440 1. and other liabilities. trade credits.571 2.414) 5.737 (333) (297) (607) (2) 218 2.339) (9. Source: Balance of Payments. However.868 (518) (418) 63 1.942) 42.2 percent by 1989.852) (2.86 percent of GDP in 1997.910) 2.450 24.817 16. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2.352 471 3.239 19.255 2.694) 2. due to declining stock prices. and 1993.785 (1.382 Permit basis. Table 2.534) 1.347 3.455) 13.183 12.650 (1.123 3. Bank of Korea.500 7.008) (3.944) 8.858 4.583 25 10. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.287 (340) 73. Other investments include loans.413) 56.870) (1.714 1.150 5.296) (6.126 (1.800 (7.338 4. but rose again to 34. but increased sharply to 79.658) (3. The relative size of the stock market diminished to 44 percent in 1990.326 1. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.453 (2.64 Corporate Governance and Finance in East Asia.953 10. The aggregate market value of listed shares bottomed at 16.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.5 Private Capital Flows to Korea.085 2. currency and deposits.875 21.
Japan’s was consistently higher. Return on equity (ROE) and return on assets (ROA) showed similar patterns. The ratio is generally in the same range for Japan and Korea. In addition to FDI. increasing to 76 percent in 1997. equity. Net private capital inflow. and high production costs were the main reasons for low FDI in Korea. The dismal performance of the Korean corporate sector compared to the .4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. excluding FDI. and US. and sales of the aggregate sector during this period were very high (Table 2.China and the US. Taipei.6 percent in 1997. but between 1988 and 1993. Of this. 2. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Table 2. The contribution of the corporate sector to GDP was 73.Chapter 2: Korea 65 Complicated government regulations.5).9 billion. The growth rates of total assets. portfolio investments amounted to $73. This indicates that a substantial proportion of debt was denominated in dollars. weak incentives for attracting FDI. However. Between 1986 and 1989. the growth rates of equity and sales dropped sharply in 1996 and 1997. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations.6).2 percent in 1987. Profit rates of Korean firms were relatively low compared to those of Taipei. following the sharp depreciation of the won. The same categories will be analyzed in later sections. other net private capital inflows amounted to $130 billion during 1985-1998.7 billion and loans $42. (ii) listed firms.China. but dropped in 1996 and were negative by 1997.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. and (iii) chaebols.2. Korea had substantial current account surpluses and experienced net private capital outflow. Corporate sector net proft margins increased from 1993 to 1995. This would lay the foundation for evaluating the effect of corporate governance on performance. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.
9 13.2 9.3 21.4 4.1 6.0 10.0 13.3 312.4 2.4 19.5 2.5 0.0 0.9 2.9 18.6 1.0 4.4 2. Table 2.8 8.1 2.1 2.5 4.3 3.6 13.9) DER = debt-to-equity ratio.3 308.8 2.2 18.6 4.1 5.3 14.0 7.3 6.7 15. Source: Bank of Korea.0 3.2) (0.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.2 1.3 — 3.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.9 2.0 6.0 305.8 1.6 318.8 21.7 1.8 1.8 22.9 5.7 4. Note: Ratio of ordinary income to sales = (ordinary income/sales).7 3.4 — 6.9 18.2 1.4 1.7 4.9 3.9 2.1 2.3 1.5 (0.4 10.9 16.0 8.4 1.6 9.6 3.5 1.6 424.5 1.4 1.6 (4.9 8.0 13.8) 297.5 3.5 1.9 5.7 15.3 11. ROA = return on assets (ratio of net income to total assets).7 3.2 13.9 4. Financial Statement Analysis Yearbook. 1990-1997 (percent) Growth Performance Year Total Assets Equity Sales Financial Performance Net Profit Margin DER ROE ROA 1990 1991 1992 1993 1994 1995 1996 1997 23.9 3.3 17.2 19.1 — — — = not available. Source: Bank of Korea.2 13.7 4.9 16.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.9 5.7 325.3 21. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).1 8.5 4.6 2.0 (0.7 2.6 1.8 3.2 1.Table 2.5 7.3 335.3) 5.4 2. Net profit margin = ratio of net income to sales. ROE = return on equity (ratio of net income to stockholders’ equity). . Financial Statement Analysis Yearbook.
However. the exception being the electricity. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis.8). The profit margin of listed firms was generally higher than that of the aggregate corporate sector. ROEs. with equity in wholesale and retail trade even contracting.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. sales of listed firms grew 18.5 percent while the aggregate sector recorded only 13. . gas. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. All sectors experienced a sharp decline in equity and sales growth in 1997. both ROA and ROE were lower for the listed firms compared to the latter. The growth performance of large firms for the 1988-1997 period was better than that of medium. and transport sectors recorded negative profit rates in 1997. The other financial ratios follow the general pattern of the aggregate corporate sector. The manufacturing. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. a year ahead of the other industries.6). This preference of Korean firms has its roots in the structure of corporate governance. the average ROE was lowest for large firms. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. Small listed firms were hardest hit by the financial crisis.9). with the wholesale and retail trade sector and the construction sector having the highest figures. This may be related to its having the lowest DER. In 1997. Profit rates of most industries are also quite low. this may be an indication of the bias toward large firms in terms of access to credit. followed by mediumsized firms and large ones. Net profit margins. Performance followed similar patterns across different industries (Table 2. The superior performance of listed firms in terms of sales growth may be due to large firms’ easy access to credit and the inclusion of financial firms in the listed firms category. However. but higher than that of small firms. Growth rates of total assets are generally high.10). A comparison of performance by firm size reveals some interesting results. It is notable that the construction sector’s profit rate began its decline in 1995.and small-scale firms (Table 2. In most years. construction. Again. trade. and steam supply industry.4 percent. while their average net profit margin was lower than that of medium firms.
8 2.8) 0.7 9.1 (0.8 3.0 15.9 1.3 15.0 (0.7 30.6 6.8 Real Estate.2 15.4 2.0 (0.9 13.5 473.0) 0.3 10.2 5.8 35.3 1.0 21.3 13.0 1.7 1.0 16.6 11.0 254.4 10.7 294.3 10.5 483.4 348.8 Growth and Financial Performance of Selected Industries (percent) Growth Performance Year Assets Equity a Financial Performance NPM b Sales DER ROE ROA Manufacturing 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 13.1 290.4 350.5 1.6 655.9 9.0 24.8 461.2 6.3 8.8 22.5 1.6 5.1 296.0 1.4 10.7 (3.0 2.8 16.4 3.1 1.5 1. Renting.3 15.6 318.9 14.4 2.0 18.6 17.5 16.5 1.0 2.8 14.1) 3.0 1.0 12.2 0.8 1.6 2.8 562.5) 0.9 19.3 8.4 15.1 0.1 1.2 0.9 428.8 526.7 7.0 37.7 5.6 3.0 22.3 15.5 338.0 18.9 29.7 16.3 2.9 (0.2 18.5 286.9 2.1 0.4 2.0 15.2 36.1) (3.0) 4.0 16.1 0.3 11.2 2.1 28.4 .8 10.1 (0.2 (1.4 14.7 228.9 (0.1 20.4 0.5 23.0 245.5 6.8 10.2 241.1 10.0 2.0 1.8 24.3 14.6 24.4 458.0 22.0 5.5 1.4 291.7 4.5 306.6 7.6 14.2) 15.5 14.0 1.2 315.6) (6.4 474. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.8 14.9 16.3 288.8 12.5 270.8 3.9 2.2 16.9) 1.3 11.9 31.2 25.2) 6.9 10.0 2.7 520.8 16.3 1.3 285.3) (1.6 0.2 12.5 5.7 (0.7 0.4 (0.4 2.4 4.8 0.8 2.7 514.5 (0.6 0.6 16.6 14.7 21.0 9.1 22.4) 0.4 12.8 616.3 2.7 10.8 345.2 5.4 0.4 2.3 8.2 0.4 740.4 5.4 10.5 569.1) 0.9 3.5 3.0 23.2 5.7 17.4 1.4 1.2 423.0) 0.4 10.0 7.5 27.0 1.0 1.2 7.8 7.9 538.0 24.3 8.8 24.5 30.1 2.0 (4.5 (5.9 16.1 27.8 0.4 5.Table 2.5 6.2 24.3 18.0 19.8 302.8 34.9 340.6 3.2) 22.5 239.6 12.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.9 25.8 17.3 15.2 16.4 9.0 5.5 13.8 32.6 14.2) (0.2 6.9 16.6 17.6 12.7 317.0 22.4 17.5 (1.9 5.9 (0.8 13.0) 1.9 10.8 12.6 15.1 7.1 1.1 1.7 22.5 1.6 375.5 28.9 0.1 16.1 396.4 5.3 14.8 1.5 4.5 19.6) 3.6 1.0 3.3 31.8 22.5 5.2 20.1 2.3 25.5 432.6 1.2 20.7) 2.8 23.1 17.1 21.8 2.8 16.
6 8.4 21.3 18.1) (0.1 14.6 12.4 6.2 11.7 187.5 47.6 9.9 10.3 4.8 12.0 (15.1 15.9 6.9 (10.6 21.1) 5.4 633.5 26.8 11.8 14.1 21.2 698.4 1.8 15.8 7.1 2.5 14.0 14.3 34. .2 90.6 6.7 16. a New equity does not include capital surplus.5 2.2 7.3 4.9 (11.9 3.4 1. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.2 3.4 (2.5 (2.6 16.4 0.5 11.5 117.0 89.2 10.3) 15.2) 13.5 13.6 12.5 15.8 14.8) (12.6 512.1 (11.7 0.5 11.4 16.8 6.6 8.0) 1.3) 11.6 34.4 9.7 12.5 16.0 7.2 14.3 1.4 (0.7 11.1) 1.0 14.2 122.0 1.5 0.4 12.9 8.6 18.3 112.7 510.5 14.9 456.7 2.1 15.1 12.3 524.9 18.3 12.6 172.0 98.9 332.6 (2.4 13.5 539.3 8.6 1.9 17.3 9.2 18.1 3.6 0.6 2.2 1.9 4.5 4.5 14.2 15.1 4.6 19.4 3.5) 22.8 12.3 17.2 10.7) (4.0 1.6 6.6 9.3 0.8 3.6 6.1 1.1 11.3 18.5 14.8 0.2 10.5 15.0 106.1 8.8 9.4 11. b NPM denotes net profit margin.4 0.4 7. Financial Statement Analysis Yearbooks.7 — — — — — 14.7 0.8 3.3 2.3 — — — — — 10.9) (8.0 13.5 344.9 9.6 4.1) (0.5 462.1 16.5 30.9 12.0) 1.0) (0.1 6.4 3.3 (2.4 10.3 0. Storage.5 307.1 323.1 (0.8 0.0 2.2 2. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.9 10.7 15.7 7.2 18.6 15.7) 0.4 341.1 (2.7 2.8 8.2 — — — — — 2.7 7.062.0 5.9 18.9 Electricity.4 3.4) (1.3 4.4 2.4 14.8 529.6 19.4 367.6 9.2 14.7 11.9 8.6 20.3 125.5 612.3) (1.6 8.9 12.5 8.6 14.0 (1.8) 1.6 3.9 7.6 4.Table 2.3 3.0 21.7 11.7 — = not available.0 921.0 5.8 (Cont’d) Growth Performance Year Assets Equitya Sales NPMb Financial Performance DER ROE ROA Wholesale/Retail Trade 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average — — — — — 31.4 30.3 23.5 12.1 11.6 (2.4 2.6 1.3 740.4 1.4 0.3 1.4 12.4 6.6 — — — — — 17.7 116.3) 4.4 169.2 18.0 2.7 14.7 20.7 19.9 4.4 — — — — — 448.8 111.2) 9. Gas.0 1.0 Transport.8 6. Source: Calculated using data from Bank of Korea.1 17.8 4.4 7.6 — — — — — 0.5 482.9 321.3 19.9 17.9 9.3 543.9 1.1 15.3 8.4 15.2 143.2) 0.
6 23. It should also be noted that when the financial crisis struck in 1997.2 0. of which 16 were publicly listed (Table 2. 1998.1) 4.6 1.2 2.7 percent) of the corporate sector.9 0. 1985-1997 (percent.7 (5. Chaebols have been the most important actors and engines of growth in the Korean economy.0 18.7) 0.4 1. Between 1993 and 1997. Vol. In 1995. The criteria for selection of largest chaebols have changed a few times.9 2.9 6. sales (45.4 22.5 5.7 1.9 11.6 22.7 Net Profit Margin 0.8 6. The number of Hyundai member companies rose to 57 in 1997. the top 11-30 chaebols experienced a decline of .3 (0. The smallest group had 16 members in 1995.3 percent).6 3. of which four were listed. followed by the top 6-10 (Table 2.1 1.3 2.0 3. Performance of Chaebols This section uses available data on the top 30 chaebols. but the number of designated groups has been fixed at 30 since 1993.3 20.5 0. and net profits (46.9 2.0 0. it is the chaebols’ large firms that are listed.4 1. the largest chaebol.4) 1.12).5 ROE 3. The top five chaebols registered the highest growth rates.1 6.5 19.4 0.12).2 6. had 46 member companies.1 1.5 19. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2. and close to half of total assets (46.9 percent).3 0.7 1.1 percent of the economy’s total value added (excluding the financial sector).70 Corporate Governance and Finance in East Asia. In 1997.3 15.5 ROA 0.3 4.9 percent).9 Source: Constructed using data from Korea Investors Service.9 21. the 30 largest chaebols accounted for 13. Kis-Fas.6 2. II Table 2. debts (47.2 9.9 1. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.4 1.6 0.6 (1.6 and 2.2 9.8 5. Generally.9 Growth and Financial Performance of Listed Companies. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.8 24. Hyundai Group.11).9 26.4 2.8 0.
4 3.6 2.5 3.8 10.8 0.7 (1.8 0.4 Medium Small Large Medium Small ROA Growth Performance Large 17.4 1.6 13.2 3.2 0.4 1.3 6.1 11.Table 2.9 (0.1 0.5 5.3 15.6 3.6 2.5 0.0 1.2) (1.8) 6.2 7.1) 5.9 5.3 Medium 14.9 6.6 3.0 19.9 2.0 4.6 (1.0 1.6 0.9 0.6 8.5) 1.9 14.7 (1.5 1.2 2.1 2.9 25.7 1.9 22.3 (0.4 5.3 (0.7 3.5 17.8) 1.6 9.7 2.3 3.5 (1.3 1.2 13.9) (6.3 15.7 18.0 10. 1988-1997 (percent) ROE Large 9.0 17.7 2.0 6.3 11.6 5. Others are medium firms.9 0. Kis-Fas.0) 0.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.6 0.8 (5.4 11.8 1.1 8.5 25.6 7.0 1.9 1.9 1.6 2.2 (0.2 Small 13.3) 5.9 2.2 12.8 16.7 (0.4 16.8 3.4 6.10 Growth and Financial Performance of Listed Companies by Size.4 3.6) 0.1 2.3 9.0 16.8 0.6 1. 1998.2 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.6 6.0 1.6 (0.0) 1.9 3.4) 1.9 2.8 6.9 0.5 2.2) (1.9 6.2 10.8 17.7 4.0 15.8 6.6 1.2 13.0 (4.8 7.5 5.8 0.6 1. Source: Korea Investors Service.1 1.2) 0.2 1.4 2. .5) 1.3) 0.
11 Features of the 30 Largest Chaebols Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43.766 3.599 — 2.131 3.455 22.956 3.090 6.180 2.574 3.927 16.486 6.990 2.798 — No.996 1.309 14.597 351.690 3.433 3.475 2.398 — 2.458 6.395 31.677 3.158 1.423 5.995 2.457 14.501 13.774 7.445 4.158 7.376 35.346 3.853 1997 53. .313 14.929 12. Source: Fair Trade Commission.951 3.651 38.Table 2.364 5.873 2.967 7.246 11.640 4.147 5.303 3.177 — 6.910 3.117 4.935 2.756 5.370 6.427 9. of Member Companies 1995 46 55 49 25 32 23 24 16 31 28 27 26 18 21 16 17 16 16 14 19 22 19 24 11 14 8 8 11 18 16 1997 57 80 49 30 46 25 24 28 31 30 26 25 21 — 19 18 18 17 24 24 24 6 8 2 15 — 7 — 18 — No.761 31.287 10.743 40.129 2. of Listed Companies 1995 16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4 — = not available.924 2.
3 19.7) Source: Bank of Korea.4) 1.2 3.0) 3.9 3.2 11.1) 0.5 20.2 20.9 24.7 15.5 27.5) (0.0) 12.3 15.0 17.3 1.7 0.4) (14.6 1.3 1.1 2.9 20.4 30.8 27.3 0.1 10.8 0.4 (2.7 15.0 0.5 32.2 0.0 31.7) ROE 5.0 19.0 2.2 (2.6 4.7 13.5) (0.7 4.0 0. .9 18.6 Financial Performance Net Profit Margin 1.0 2.0 1.1 (1.7 10.2 (16.3 0.Table 2.3 3.4 26.5 2.6 19.2) 1.0 6.3 27.3 9.1) 0.5) (0.5 (0.2) (2.2 0.1) (0. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.5 19.7 10.8 18.2 (5.2 (2.7 1.8 Assets 12.5 5.4 0.4 38.2) (0.1 (3.6 18.1) (0.4) (0.9 3.3 14.1 27.2 1.3 16.3 11.9 1.4 12.2 0.0) ROA 1.9 20.3) 0.6 25.1 (2.1) (1.9 17.12 Growth and Financial Performance of the 30 Largest Chaebols.1 19.6 (0.0 2.
765 percent (Table 2. 2. The Commercial Code stipulates the basic governance framework and applies to all corporations. However.5 Founding families are mostly still the largest shareholders and. In general. includes the largest shareholder. it refers to the degree of concentration and shareholdings in the hands of an “identical person. II 2 percent in their sales and a very low 4.” in Korea’s legal and regulatory framework. 2. internal and external control mechanisms. his/her relatives. and vulnerable balance sheets. resulted in the chaebols’ excessive leverage. and access to credit. from 190 to 3.3. the average DER of the 30 largest chaebols reached 519 percent. Only the top five chaebols registered a positive net profit margin in 1997. There has been a wide range in DER among chaebols.95 percent. and the companies that are under the control of the largest shareholder. . Attempts to rectify the corporate structure were halfhearted and it was only after the onset of the crisis that many of the most serious reforms were instituted.7 percent growth in total assets. Their worst year was 1997 when ROE hit -15. However. except for 1995. loopholes and inconsistent policies spawned strategic behavior and agency problems.74 Corporate Governance and Finance in East Asia. more important. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. a pyramidal structure of corporate ownership is prevalent.” This “identical person. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. The better showing of the top five chaebols was a direct result of their dominance in human resources. weak corporate control. and government intervention interacted through a set of laws and regulations to bring about the existing structure. technology.13). in this instance. coupled with weak corporate governance. By the end of 1997. 5 While “ownership concentration” can be defined and measured differently in different contexts. Ownership patterns.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. The absence of a well-developed equity market and the provision of subsidized credit.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. Vol. and led to a high concentration of ownership. chaebols had a higher average DER than the corporate sector as a whole.
Dongah 14. Hanjin 8. Kia 9.5 337.6 2. Jinro Debt-to-Equity Ratio 376. Kumho 12.6 936. Sunkyung 6. Tongyang 22.4 175. Ssangyong 7.0 506. Hanwha 10.8 313.1 3.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.1 674.5 3.3 328.5 2. Hyosung 18.855.5 343.1 385. Samsung 3. Hansol 17.7 688.7 621. Halla 17.1 278.8 312. Lotte 11. Kukdong Construction 29. Doosan 15. Dongkuk Steel 19. Jinro 20. Haitai 26.2 328.2 346.2 2.6 .4 622.3 572.0 370.9 321. Samsung 3. Daewoo 5.4 205. Daewoo 5.2 292.0 218. Sammi 27.2 471.2 924. Newcore 30. Daelim 16.441.7 620.1 477.6 516. Dongbu 24. LG 4.9 751.244.764. 1995-1997 (percent) Chaebols 1995 1. LG 4.4 192. Ssangyong 7.7 267. Kohap 25.5 464.6 409. Hyundai 2. Kolon 21.1 190.7 416. Sunkyung 6. Hyosung 18. Hyundai 2.065. Dongah Construction 16. Daelim 14. Hanjin 8. Hanbo 15. Kumho 12. Hanwha 10. Kia 9.3 315.2 423. Dongkuk Steel 19.8 336.5 383.4 556. Byucksan 1996 1.0 486.7 354. Hansol 23. Lotte 11. Doosan 13.3 297. Halla 13.Table 2.0 436. Hanil 28.
1 472.5) 404.5 1. Halla 13.1 438.Table 2.0 907.6 478.7 370.8 468.4) 513. Hyosung 17. Tongyang 24. Daewoo 4. Financial Statement Analysis Yearbook.5 261.6 Sources: aFair Trade Commission.1 375.498.3 676. Keopyong 29. Miwon 30. Dongkuk Steel 20. Hansol 16.225.3 347. Hanwha 9. Anam 27.0 419. .5 (893.6 424.7 1.7 944.0 305. Kumho 10.1 359. bBank of Korea. Ssangyong 8. Shinho 26. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.5 (1.9 490. Lotte 12. Dongbu 21. Haitai 25. Dongah 11.5 519.8 338. Daelim 14. Newcore 26. Tongyang 24. Jinro 23.9 472.600. Daesang 27.0 505.13 (Cont’d) Chaebols 20.1 433.3 399. Hanjin 7. Samsung 3.8 647.6 335.9 465. Haitai 25. Kolon 19.4 1. Kolon 21.8 658. Kohab 22. Newcore 28.8 590.784. Hyundai 2. Kohab 18.9 578. Doosan 15. Anam 22. Kamgwon Industrial 30. Dongbu 23.9 216.5 323.3 1. Keopyong 29. Hanil 28. Shinho 1997 1.5 576.5 386.6 416.8 307.9 1.214. SK 6.8 399.8 347. LG 5.6 590.501.
the year the stock market was in a frenzy due to buying sprees. resorting to extensive use of pyramiding to maintain control. Thus. the extent of ownership by these individuals declined gradually after 1988. However.6 percent by 1997. Composition of Ownership Among listed companies.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. the incentive effect once again dominates.14). the ownership structure can bring about an incentive effect. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. Among listed nonfinancial companies. and then steadily declined after 1993. managerial entrenchment becomes more likely.7 percent by 1997. that is. while those owned by banks. The reduction can be . When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. including banks and other financial firms. and state-owned companies and securities companies declined. From 69. the Government. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. but their shares declined to 21.” foreigners.1 percent. 10 to 30 percent). fluctuated widely during the period. with a given range of managerial shareholdings (for instance. i.” followed by banks. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. The percentage of shares owned by “other corporations. The next important group was “other corporations. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms.e. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. the entrenchment effect outweighs the incentive effect. The pattern of distribution changed little through 1992-1997.. and insurance companies increased during the period. the percentage of holdings by individuals slipped to 60. Beyond that range. individuals were also the largest shareholder group. However. large ownership can also bring about the entrenchment effect. The holdings of financial institutions. Theoretically. including investment trust companies.
0 9. b “Banks.5 62.5 6.0 8.0 5. a The State covers the Government and state-owned companies.2 18.7 9.2 7.5 12.0 5.8 2.7 14.” includes commercial banks.1 68.5 1.2 1.1 21.0 28.3 5.1 1.9 17.3 18.2 B. investment trust companies.6 16.8 2.3 18.1 21.9 2.6 Year No.5 1992 508 2.6 2.3 39.1 3.0 60.2 17.5 4.8 4.0 4.9 37.6 22.4 13. c Data from Korea Stock Exchange.3 17.9 15.b A.Table 2. and finance companies.5 1.1 10.7 18.0 27.2 3. of Firms The Statea Banks.3 1994 521 1.8 1995 548 2.2 4. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.1 8.1 17.9 36.1 60.6 13.5 16. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.9 1.8 59.9 5.4 Insurance Firms Other Corporations Foreigners Individuals 39.8 5.14 Ownership Composition of Listed Companies.1 11.7 8.7 59.5 Note: Ownership is based on number of shares. merchant banks.2 8.3 1996 570 2.1 4.3 1.7 3.3 5.7 6.4 13.2 5.2 8.4 14.9 1.8 69.5 60.8 17.6 1991 505 0.6 8.6 16. etc.0 7.6 20.5 7.7 9.3 1.1 18.9 26.9 2.6 9. .3 8.9 4.6 9.6 19.2 1993 511 2.6 16.5 1989 498 0.2 9.8 17.5 6.3 17.5 18.4 34.2 5.5 7.3 2.2 2.9 19. d Constructed from data files of the Korea Listed Companies Association. mutual savings.4 18.2 9.4 1997 551 1.1 8. etc. Listed Nonfinancial Companiesd 1988 406 0.1 18.4 5.7 4.3 26.7 1990 531 0.0 59.8 5.8 59.1 2.6 12.6 36.4 5.7 7.4 6.
The holdings of other corporations are mainly equity investments in affiliate companies. The ownership distribution in listed nonfinancial firms. financial institutions had more shares in the manufacturing sector than in primary industries. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted.18). Corporate holdings averaged 16 percent throughout 1988-1997. electricity. categorized into large. indicating their heavier reliance on inter-firm financing investments. and small companies. Institutional investors. In general.16). and US (Table 2.15). medium. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . UK. of some banks. In 1998. whether partial or absolute. did not vary significantly (Table 2.Chapter 2: Korea 79 ascribed to prudence in staying away from the stock market—as part of their risk management strategy—as the stock market was in doldrums throughout the 1990s. However. Compared with its holdings in all listed companies. However. Over the years. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms.17). government ownership in nonfinancial companies was remarkably smaller and more concentrated. foreign holdings were derived from purchases through country funds and direct capital investments.8 percent of listed shares in 1997. as distinguished from individual and foreign investors. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. held 26. In most instances. Before such liberalization. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. a more detailed breakdown of the data on majority shareholdings in the next section shows significant differences in the two groups’ composition and level of majority shareholdings. Individuals held the majority of the shares in all industries except in telecommunications. other corporations’ holdings shifted toward service industries. and service of motor vehicles (Table 2. This trend can be explained by government ownership. the Government was the sole owner. indicating their increased investments particularly in the service industries with high growth rates. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. This is low compared with those in Japan.
1 0.15 Ownership Composition of Listed Nonfinancial Firms by Industry.9 4.4 8.2 0.9 15.7 14.9 19.3 57.7 17.4 0.8 5..5 — 0.7 20.1 7.3 9.6 — — 2.7 2.5 — — 0.3 0.2 7.8 73.1 10.0 2.5 17.7 1.5 0.5 0.3 0.3 1.1 88. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average . and App.7 64.1 0.0 1.3 2. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.2 2.8 3.2 17.3 7. Rubber.3 1.9 0.8 7.2 0.5 12.4 1.4 Banks.8 6.4 8.5 19.5 0.1 0.2 — 0.3 6.8 8.3 38.7 2.9 60.9 59.5 — 1.6 1.9 1. Motor Vehicles Electricity.7 59.0 — 39.5 4.6 3.7 2.1 27.3 4.6 24.4 62.0 0.4 5.0 9.9 8.0 7.9 66.8 1.6 8.1 8.2 54.6 11.8 3. and Printing Pulp.5 85.2 — — 0. Elecl Mach.3 62.8 7.2 22.0 9. Paper.7 6.1 1.9 42.2 9.9 52.3 0. and Printing Chemicals.1 8.5 3.5 7.9 10.8 7.9 16.0 10.4 56.1 65.3 10.6 5.7 22.0 9.4 7.2 9.0 9.2 64.9 55.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.7 20.8 Individuals 83.4 8.0 20.0 — 0.8 7.3 13.7 63.1 0.1 19.2 1. Etc.7 22.Table 2.8 7.2 0.4 1.1 4.3 11.9 1.4 14.3 2.7 29.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 0.4 56.5 6.2 1. Paper.2 9.4 2.4 — 0. Gas.6 18.9 23.2 0.0 8.7 14. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.
3 8.7 1.2 1.2 4.4 9.5 3.” includes commercial banks.9 1.3 65.1 1.0 11.4 2.6 14.6 — = not available. Paper.3 0.1 1.8 2.5 0.8 4.0 8.1 9.3 1.6 6.2 4.1 3.2 5.0 43.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.78 81.5 6.9 2.1 — 1.1 3.2 13.3 57.7 2.4 76.0 5.2 23.6 3.8 54. Motor Vehicles Electricity. a The State covers the government and state-owned companies.2 6.8 57. mutual savings.6 7.4 43.8 3.4 2.4 58.9 20.7 6.9 0.4 6.3 6.5 5.2 8.4 1. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.6 2.5 4.8 2.6 6.8 2.7 2.2 3.3 6.5 3.6 2.8 5.4 — 1.3 31. Rubber.2 0.5 12.0 3.0 1. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.7 23.7 17.7 19.3 7.2 7.4 4. and finance companies.9 7.1 — 0.3 60.4 4.6 0.4 0.8 0. Gas.5 7.9 20.2 4.4 68.0 6. Source: Constructed from data files of the Korea Listed Companies Association.8 12.8 6.9 57.5 1.4 16. Elecl Mach.1 18.9 1.0 7.1 2.5 59. b “Banks. and Printing Chemicals.1 6.8 27.9 2.6 59.2 1.7 2.9 2.1 9.7 4.9 7.5 3.6 5.9 5.1 25. etc.0 60.5 63.3 2.4 1. and Printing Pulp.6 0.9 6.2 5.6 75. Note: Ownership is based on number of shares. merchant banks.2 49.6 2.9 6.5 4.6 1. Paper.4 3.2 4.1 4. investment trust companies.9 69.3 15. .9 2.9 18.6 20. and App.5 3.6 18.4 1.1 54.8 0.5 — 2.4 45.2 0.9 78.9 1.7 2.8 5.4 2.7 5.1 2.0 4.4 20.0 6.6 60.8 11.3 1.9 5.4 58.
8 6.1 Banks. Source: Constructed from data files of the Korea Listed Companies Association.8 4.4 2. b Table 2.1 2. etc.5 Individuals 60.6 60.” includes commercial banks.4 61.0 1.5 4.7 4.9 2.4 61. The State covers the government and state-owned companies.8 2.9 4.5 8.8 1.1 6.5 18.4 5. 1997 (percent) The State 1.5 2.6 16. mutual savings. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association. Others are medium firms.8 3.7 0.3 6.c Securities Firms Insurance Firms Other Corporations Individuals 58.4 2.0 6. and finance companies. Securities Firms Insurance Firms 2.4 4.8 4.5 6.7 Control Type No.17 Ownership Composition of Listed Nonfinancial Firms by Control Type. merchant banks. 1997 (percent) The Stateb Foreigners 4.4 17.4 Firm Sizea No.7 Foreigners 4.5 62.7 8.4 5.Table 2. of Firms Large Medium Small Total 211 208 80 499 a Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.2 1. etc.7 1.4 1.9 5.4 21.5 19.16 Ownership Composition of Listed Nonfinancial Firms by Size.5 16.3 Banks. investment trust companies. c “Banks. etc. .8 60.0 Other Corporations 16.7 6.1 8.
Chapter 2: Korea 83 Table 2.3 6.6 Individuals 23.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. Institutional Investors 42.8 9. defined as those holding less than 1 percent of shares. the majority shareholder group in all listed companies consists of the corporate. At the moment. including those of the largest shareholder.18 Ownership Composition of Listed Firms in Selected Countries. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. his/her family members. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group.1 financial institutions’ establishment of corporate pension fund accounts. In 1997. for example. 1997 (percent) Country Japan Korea Taipei.5 45. Generally. while family members accounted for only 30 percent.5 20. and the companies under the control of the largest shareholder.3 47.8 10.8 56. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder.3 54. investors (Table 2. minority shareholders. only closed-end investment companies and traditional investment trust companies are allowed. corporations held 70 percent of the controlling blocks of shares. Foreign holdings of Korean shares were 9. This has had profound implications for corporate governance and the market for corporate control in Korea. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. Among nonfinancial listed firms. The more popular open-end investment companies (mutual funds) were expected to come into existence by the end of 1999 with the Government’s deregulation of the capital market. But these may .China United Kingdom United States Source: Stock Exchange of Korea.19).20).6 Foreigners 9.6 39. rather than the individual.1 8.7 16.4 26.
2 2.6 22.3 30.1 14.5 43.7 6.2 2.0 25.9 Individual 2.4 5.6 73.3 18.9 7. 1992-1997 (percent) Majority Shareholders Corporation 15.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.9 32.2 Minority Shareholders Subtotal 71.4 3.1 5.0 22.7 7.3 2.8 72.7 44.2 26.0 1.0 69.4 7.7 Note: The majority shareholder includes the largest shareholder.9 6.1 5.1 37.1 32.1 23.8 8.0 66. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.Table 2.1 21. his/her family members.8 73. Minority shareholders are those holding less than 1 percent of shares. Source: Stock Exchange of Korea.6 26.19 Ownership Concentration of All Listed Firms.0 2.0 4.9 3. .6 2.7 18.0 29.1 15.8 Individual Subtotal Other Shareholders Corporation 3.1 4.3 Subtotal 5.6 46.9 2.1 28.6 5.9 33. and the companies under the control of the largest shareholder.7 16.
Besides. Ownership concentration tended to be lower in large compared to medium and small listed firms.21]). have been underestimated because it was widely believed that the largest shareholder often had hidden shares registered in the names of relatives and subordinates of the company.0 20. The percentage of shares held by minority owners (with less than 1 percent of outstanding shares) was highest for large firms at more than 55 percent (Table 2. In such cases.7 18. In telecommunications.22). utility companies have a relatively higher degree of ownership concentration with the majority shareholder owning nearly 45 percent of an average company (partly because these companies were owned solely by the Government before their privatization [Table 2.8 12.20 Ownership Concentration of Listed Nonfinancial Firms. collectively owned less than 50 percent of an average firm.6 11. The practice of hidden shares seems to have been less prevalent in recent years. thereafter. It was highest in medium-sized firms before 1993 and.5 13. In most industries.8 54.2 15.3 62.9 27.1 50.0 58.9 29. minority shareholders. the Government has retained a large number of shares.5 23. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53. .9 Other Shareholders 18.8 28. hiding shares offers no additional tax or other benefits.8 57. Across industry. ownership was relatively diffused due to government regulation.9 12.8 Majority Shareholders 27.6 58.0 22. Majority ownership is also high in the chemicals.Chapter 2: Korea 85 Table 2.9 25. the majority owner held more than 20 percent of an average firm. which held less than 1 percent of a company’s outstanding shares as of 1997. in the small firms.8 25.4 28.5 60.4 Source: Constructed from data files of the Korea Listed Companies Association.4 23. and mining categories.9 48. Meanwhile.5 12.6 57.3 25. rubber and plastics. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.
Paper. Motor Vehicles Electricity.8 24.9 10.2 34.1 19.8 44.3 39.8 41.0 21.2 26.0 54.5 41.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.3 19. Gas.7 24.0 39. and Printing Chemicals.0 51. .6 53.2 22.9 Minority Shareholders Majority Shareholders Other Shareholders 12. Paper.1 49.8 25.7 27.5 44.5 19.4 11.4 16.8 51. and Printing Pulp.0 30.8 31.2 48.1 43.5 23.7 21.7 26. and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total Source: Constructed from data files of Korea Listed Companies Association.6 38.5 21.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.2 19.5 20.5 16. Rubber.2 20.7 36.2 37.8 29.2 23.5 52. 1997 (percent) Number of Firms 3 2 43 49 12 16 90 39 31 71 34 8 9 49 40 15 1 10 29 551 36.9 44.2 46. Elecl Mach. and App.1 17.8 55.7 17..6 50.Table 2.6 34.8 21. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.7 29.9 26.3 26.6 19.5 47.6 25.4 53.
0 26.4 21.3 25.4 29.7 14.5 19.7 15.6 24.2 50.1 27.3 19. 1988-1997 (percent) Year Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Medium 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Large 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 No.2 55.2 12.8 50.3 27.8 28.9 21.0 66.2 21.2 52.5 28.5 12.8 56.1 58.9 26.7 57.2 21.5 26.0 24.3 21.9 60.4 30.8 52.6 55.8 62.3 55.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.9 17.2 Source: Korea Listed Companies Association.9 55.7 28.9 28.0 59.9 22. of Firms 66 81 72 76 80 67 78 102 134 115 148 197 219 212 210 217 216 216 215 215 165 213 220 217 218 217 227 230 231 221 Minority Shareholders 53.4 47.2 Majority Shareholders 26.1 16.1 20.Table 2.5 27.2 21.7 57.9 56.6 31.6 65.3 26.5 51.2 18.6 59.5 12.9 16.7 16.1 48.2 32.9 12.2 26.5 19.6 62.5 49.4 51.5 Other Shareholders 19.9 53.8 17.6 11.8 11.5 10.5 21.9 23.8 27.7 22.7 31.6 15.1 15.6 27.4 30. .0 55.2 11.2 56.5 33.4 30.7 17.8 52.
The study by Kim. often at terms unfair to one of the transacting parties. thus a firm destroys value. and Kim (1995) reached a similar conclusion. In Korea. H. although turning points in the value of firms are different. Shleifer. and Vishny. If SCS is below 10 percent. is effective control of a certain group of companies even with a smaller investment. If TQ is higher than 1. Vol. The relationship between TQ and SCS shows a similar pattern. Hong. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. affiliated companies have been able to conduct inter-firm transactions. if TQ is lower than 1. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. Hong. which can then pass the equity capital to a third. If SCS is below the range of 20-25 percent. If SCS reaches 10 percent. thus a firm creates value. one company can still place equity investments in another. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork.88 Corporate Governance and Finance in East Asia. The Code prohibits a subsidiary company from owning shares of its parent company. II Ownership Concentration and Financial Performance J. Kim (1992) found the relation between TQ and SCS to be nonlinear. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. which is the company holding more than 40 percent of outstanding shares of its subsidiary. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. Where direct cross-shareholding is not allowed. J. Kim (1992) and Kim. TQ has a maximum value. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. TQ increases as the SCS increases. TQ is below 1. They analyzed firms in which controlling shareholders participate as managers. one company from a chaebol group could obtain debt payment . One of the merits of pyramiding. TQ is above 1. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. If SCS is above 20-25 percent. the firm destroys value. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. H. it means the firm creates value. 1988). This type of inter-firm investment. For example. from the standpoint of the controlling shareholder. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea.
Thus. there are instances of direct cross-shareholding in Korean firms. and 319 foreign subsidiaries. not individuals. For the whole sample.5 corporations and two individuals. Until recently.5 percent of shares. the top five shareholders consisted of 2. Thus. 53 percent were domestic nonfinancial firms. together owning an average of 37. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. The extent of pyramiding can be seen in some of the previous tables.9 percent of shares. or about five subsidiaries each. or an average of 13 firms per company. and about 11 percent were domestic financial institutions. for example. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. Partial results are shown in Table 2. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. although they are likely to be insignificant. or about four firms each.14. If we define the internal shareholdings of a . Of the 81 respondents. Twenty-two of the 81 respondents were independent.5 percent. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. the top 30 chaebols’ shareholding by subsidiaries was 34. Among the 81 listed firms in the ADB survey.23.4 corporations. In many instances. In Table 2. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. together having a total of 292 domestic subsidiaries. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. Among the subsidiaries or firms receiving investments. the average shareholding of the controlling owners and their families was 8. The fact that corporations. Among chaebol affiliated firms. For the same year. 62 percent (16 out of 26) had a corporation as the largest shareholder. standalone setups. 59 were parent firms with one or more subsidiaries. 59 parent companies collectively had investments in 759 firms. In the case of the 30 largest chaebols. These shares should be added to the control block although the financial institutions belonging to the 30 largest chaebols are prohibited from exercising their voting rights in the member firms of the chaebol. together owning an average of 38. 34 percent were foreign companies.Chapter 2: Korea 89 guarantees from other members of the group at no cost. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms.5 percent as of 1997.
5 4.0 17.6 34. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.1 1.2 37. a Number of shareholders.7 39.0 13.1 22.4 21.8 31.9 5.4 2.5 2.5 31.Table 2.7 37.1 3.3 26.5 38.0 21.4 1.0 1.4 42.8 38.0 3.2 25.5 4.0 2.5 24.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.3 12. .9 21.4 18.7 5.5 1. A few companies reported less than five largest shareholders.6 3.5 18.9 29.7 0.6 3.8 37.4 11.0 1.5 2.4 38.23 Ownership Concentration in the Survey Sample of 81 Listed Firms. 1999 Five Largest Shareholders No.4 25.6 16.7 19.9 34.8 18.8 8.6 3.5 2. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.0 3.5 2.
0 8. 15 October 1998.2 12. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. 79-95. edited by K.” In Korean Managerial Dynamics.7 31. .1 1997 43.24 Internal Shareholdings of the 30 Largest Chaebols.4 13. Lee. Jae Woo. Ungki Lim. Chung and H. 6 7 Hattori. 34. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. As of 1997. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.4 1993 43. it appears that the chaebol families have had a strong desire to expand their business bases. 1997. Table 2. Lee.5 34.2 1994 42.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. the controlling families owned 8.5 percent. Hattori (1989) identified three patterns based on data in the early 1980s. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. Chicago. Tamio. Table 2. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held.8 33. C.5 Judging from the historical record.24 shows the average internal shareholdings in the 30 largest chaebols.7 9. pp.2 33. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. “Japanese Zaibatsu and Korean Chaebols. 1987 56.5 percent and member companies.8 40. New York: Praeger. Based on these studies. H. 1989.” Paper presented at the Annual Conference of Financial Management Association.6 33.4 10.7 1992 46. 1998.2 15. Thus it can be inferred that their strategy in designing the ownership structure of their business groups was to minimize the financial resources required to maintain their grip on the management of the member firms while maximizing their control.4 1990 45.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. the ownership patterns can be described as follows. The family and member companies’ shareholdings have been declining over time.
” Here the family directly controls a base company and a nonprofit foundation. The second (Type B). A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. holdings of the nonprofit foundation. The fourth type (Type D) is “management control. Vol. The Hanwha Group can be classified as such a company.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. II The first (Type A) is called “direct family ownership. and his management team exercised full control over the group without much interference from major investors. The two base companies have investments in three other base companies. Investments between the lower level subsidiaries are rare. it had 18 listed and 39 private companies. subsidiaries have extensive investments in other subsidiaries. other firms. or merged into. The third (Type C) is “indirect control via complex shareholding. One of the . called the “indirect control via base company. Sun Hong Kim. which in turn hold shares in some of the other subsidiaries. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. But the former chief executive officer (CEO). The Hanjin Group. Hyundai Motors acquired Kia Motors via an international auction. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. As of 1997. The Kia Group was about the only management-controlled group but was out of existence by 1999. For example. consisting of eight listed and 16 privately held firms as of 1997.” Under this type of ownership pattern. the family controls the group’s member companies by its own shareholdings. and subsidiaries’ equity participation. financial. is an example of this type.92 Corporate Governance and Finance in East Asia. completely dissolved under financial distress. Thus.” shows a simple pyramidal structure. investments made by the base companies. and business activities. there is no controlling shareholder. The family itself holds shares in some subsidiaries. It consists of seven listed and 24 privately held firms. Also. Most of its member firms were acquired by. which then make investments in the subsidiaries. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. The controlling family has sizable investments in two base companies and smaller investments in many others. The Hyundai Group exemplifies this.
. and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets.Chapter 2: Korea 93 pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. At this early stage. The Government is also considering whether to allow consolidated taxation for pure holding companies. One condition requires that the DER of the holding company should not exceed 100 percent. An operating holding company is defined by the Fair Trade Act as one whose investment in others does not exceed 50 percent of its total assets. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. the Fair Trade Act). bankruptcy reorganization. only operating holding companies were allowed to be established. It remains to be seen whether they will adopt the holding company structure in the future. They hindered early exits (liquidation. A third disallows multiple layering of holding companies. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. These amendments prohibited holding companies and direct cross-shareholding. following the amendment of the law. This limit was also applicable to banks and insurance companies. This was the reason why chaebols chose to employ pyramidal structures. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. Until the end of 1998. Initially. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. Existing guarantees had to be resolved by March 2000. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. The prohibition of holding companies was also abolished in 1999. thus hurting the shareholders of stronger firms. Also. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. However.
who is universally called the “group chairman. The office established strategies for the group as a whole. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson.3.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. Chaebols maintain that the restructuring headquarters will exist only for a limited period. there have been no significant changes. and the capital market was almost nonexistent until the recent reform . and transferred funds generated by one firm to another. Their operating costs were borne by the member companies rather than by the controlling shareholder. Some chaebols have disintegrated or shrunk in size. II etc.) of nonviable member firms and helped afford a disproportionate advantage to chaebols in obtaining favorable bank loans because (it was generally believed) the Government would not let large chaebols go bankrupt. 2. The Fair Trade Commission has been deeply involved in promoting managerial transparency by exercising its power to investigate and levy penalties on “unfair internal transactions” among member firms of chaebols. The chairman’s office had its own chief executive officer. boards of directors. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government.2 Internal Management and Control Monitoring of corporate management by shareholders.94 Corporate Governance and Finance in East Asia. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. usually in the rank of a company president. planned for capital raising and allocation on a groupwide basis. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. Despite chaebols’ decision to dismantle the chairman’s offices. In 1998. The staff of these organizations were employees of member firms. Since the economic crisis. which put together the accounts of all members of a chaebol. The 30 largest chaebols are now required to publish “combined” financial statements. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. These offices were legally informal and functioned as the headquarters of chaebols. until urgent restructuring is complete. Vol.
control is not separate from ownership. Thus. corporations should have a board of directors consisting of at least three members. Even where the largest shareholder is not the representative director. Legal provisions to protect investors were limited. in most Korean firms. this was complicated by the prevailing attitude that large companies. and takeover codes were not accommodative to active monitoring. only the Government could play an effective role in monitoring corporations. or at least acts as the de facto CEO. As of 1997.Chapter 2: Korea 95 efforts. the concept of fiduciary duty of managers was not well established. the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. However. Loan agreements and debt indentures did not include strict covenants. creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. had their own governance problems. Meanwhile. Even when the covenants were violated. especially chaebols. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. . were too big to fail. the representative director was also the chairperson of the board. With few exceptions. but some large ones have two or more. The board elects one or more representative directors from among the board members. In most listed companies. This policy managed to hamper any monitoring initiatives from the capital market. There are many reasons for this. the creditors did not declare defaults. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. the controlling shareholder is officially the representative director and the CEO. Most companies have one representative director. Directors are elected at the general shareholders meeting for a term not exceeding three years. he or she generally approves major decisions made by the management. Banks. Under such circumstances. except for banks. The Government’s policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. Board of Directors General Characteristics of the Boards Under the Commercial Code. as the major creditors.
With the boards consisting only of insiders. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. members of the board. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. Vol. Further. The rules further require that the number of outside directors be not less than a quarter of the size of the board by the annual shareholders meeting in 1999. and their positions (accept or reject) on matters voted on in board meetings. were supposed to be outside directors. the listing rules restrict the eligibility of independent outside directors to those who have no family ties with the managers and no significant business transactions with the company. they were virtually under the full control of the CEOs and in practice functioned only as management councils without any decision-making power—at least until 1998. companies have to disclose in their annual reports the frequency of board meetings. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. other than the representative director(s). all of whom were managers. the attendance rate of outside directors.96 Corporate Governance and Finance in East Asia. However. almost all companies succeeded in adopting cumulative voting. Moreover. However. it has been common practice that candidates for directorship are handpicked by the controlling shareholder/CEO from among the senior managers and are automatically approved at the general shareholders meeting. In order to address this concern. II When the Commercial Code first introduced the corporate board system in the 1960s. In the 1999 annual shareholders meetings. the stock exchange recently amended the listing rules to require that companies disclose a detailed profile of the candidate and the person who made the nomination. A few large companies had more than 50 directors. Despite the qualification requirements. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. The exchange is also expected to recommend company charters to have provisions that allow for information demanded by outside directors to be promptly supplied to them. the listing rules of the Korea Stock Exchange were revised to require that listed companies have one or more “independent outside directors” by the 1998 annual shareholders meeting. Recent Reform Efforts on the Board System In 1997. .
Among others. This is because most banks. The controlling shareholder of some banks is the Government. inside directors owned 16.2 percent and the CEO 14. the Corporate Governance Reform Committee. who would comprise at least 50 percent of the boards. he or she held 6.1 percent and outside directors 1. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. the chairperson of the board was also the CEO and on average held 10. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. Among the firms with no outside directors. having no controlling shareholders. a blue-ribbon committee. they had a parent/child relationship in 20 percent of the cases. and a nominating committee. The average board had 8.5 percent of the shares. although some banks recently have established board committees. which had extended financial support in their recent recapitalization efforts. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. Where the two were separate.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. this committee adopted the Code of Best Practice in Corporate Governance. 88 percent had plans to hold elections in the near future. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. the Korean Code recommends that large listed firms should have at least three independent directors. These results are in accordance with the new listing rules introduced in 1998. are required to have a majority of outside directors. Where the chairperson was not the CEO. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. On average. an audit committee.1 percent of outstanding shares of a listed company. In March 1999.4 directors. Meanwhile. Directors were also chosen on the basis of their relationship with the controlling .9 percent on average. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). In September of the same year. In 78 percent of the responding firms.
the management determines the remuneration. According to the Commercial Code. In 13 percent.98 Corporate Governance and Finance in East Asia. the management nominated director candidates (64 percent of the directors). Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. In one case. Vol. one person was sitting on nine boards and this person was the CEO of a chaebol firm. most firms just began to elect a small number of outside directors to meet a new requirement in the listing rules and thus have no experience in the AngloAmerican type of board processes. In 1997.2 years on average. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). the board had no committees. These were established only recently. II shareholder (30 percent). However. About five directors per firm have been in office for more than one term. Most frequently. The current chairperson has been in office for 6. founders of the company acted as the chairperson (22 percent). and shareholding (10 percent). among the 81 sample firms. the package for the chairperson is directly proposed at the annual shareholders meeting either by the board (31 percent of the firms) or by the management (9 percent). As discussed earlier. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. the term of appointment of directors and board chairpersons is three years. relationship with controlling shareholders (21 percent). Less frequently. in some firms. In 91 percent of the sample firms. . The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. a total of 562 directors were sitting on two or more corporate boards. In some instances. In a very small number of firms. and fixed fees plus performance-related pay. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. The board or the management then determines compensation packages for individual directors. In most firms. in 23 percent. This rather long tenure must be due to their status as controlling shareholders in most firms. the board had a nomination and an audit committee. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. including stock options.
The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. CEO is also the founder in 52 percent of the firms. the payment is about five times the CEO’s annual salary. In less than 20 percent of the firms. In a handful of sample firms. it was proposed by CEO and approved by the board. he or she does not enjoy much power. and fixed salary plus performance-related pay including stock options in 13 percent. decides on important matters on his/her own in 13 out of the 44 firms. compensation is by fixed salary in 74 percent of the firms. When CEO is not the chairperson. In the 25 firms where CEO was not the chairperson of the board. CEO was given shares by the family. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. fixed salary plus net profit-related bonus in 9 percent. In cases where CEO is not the largest shareholder and chairperson. In the survey. In such cases. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. .2 years. shareholding in three firms. he or she was selected on the basis of professional expertise in 15 firms. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. A smaller number of firms consider maximization of a company’s market share and looking after the interests of such stakeholders as creditors and employees as very important. However. CEOs have been in their positions for an average of 9. CEO generally has the ultimate power to decide on corporate affairs. In 21 percent of cases. CEO simply follows the orders of the chairperson. It indicates that CEO. in which there is no controlling shareholder. who is not the chairperson.Chapter 2: Korea 99 Management CEO In the survey sample. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. According to the survey. and in another 21 percent CEO bought shares in the market. and was appointed by the Government in five firms. In 4 percent of the cases. In 20 percent. the survey tells a slightly different story than is generally believed in Korea. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO.
II Senior Executives In the past. Usually CEO suggests the maximum amount of all the directors’ compensation at the shareholders meeting to get approval and then sets the base salary and bonus for individual executives. The term of appointment of executives did not have any real meaning because they had to leave the company if and when the controlling shareholder demanded. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. Incentive stock options have become a popular compensation method since the Securities and Exchange Act was amended in 1996 to allow the issuance of stock options to managers and other employees. but in practice is fixed and understood as part of a fixed salary. and . Senior managers were even often called directors although they were not official members of the board. in particular. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. from IMF and the World Bank. it was common for all senior executives to be elected as directors at the shareholders meeting. The bonus is supposed to be linked to company performance. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. Reforms in accounting standards since May 1998 have proceeded in several areas: (i) revision of financial accounting standards that are primary sources of the Korean Generally Accepted Accounting Principles. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. and accounting standards. Penalties for fraudulent financial reports were increased. However. disclosure. Transparency and Disclosure Accounting Standards The Financial Supervisory Commission (FSC) was established in April 1998 to take charge of supervising the financial markets and institutions. This action was in response to calls by international investors and. The commission has played an active role in introducing new rules on corporate governance. (ii) establishment of accounting standards for financial institutions. Vol. but as of March 1999 only 27 firms actually had given stock options to their executives or employees.100 Corporate Governance and Finance in East Asia. Korean firms have rarely used shares for executive compensation.
In practice. Notwithstanding a regulation limiting the votes of the largest shareholder to a maximum of 3 percent of the outstanding voting rights in selecting an internal auditor. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. however. but 49 percent confessed that they have not followed international standards at all. Consolidated reporting was introduced before the outbreak of the crisis. Under the Commercial Code. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current year’s financial statements. 41 percent of the companies believed that they have followed some international accounting standards. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. Only 10 percent of the respondents have followed all international accounting standards. Thus. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. they also have the power and duty to monitor the activities of executive directors. In the ADB survey. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. the internal auditor is considered to be a subordinate of the .
the relevant laws and regulations were changed after the Asian crisis to require at least one of the internal auditors to be full time and to recommend that listed firms have outside (independent) auditors. The internal auditor in the Korean corporate system can be argued to be inferior to the Anglo-American audit committee and the German supervisory board. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. underdeveloped market discipline for accounting firms. but since 1998 a committee consisting of internal auditors. the board of directors had the power to appoint an external auditing firm. outside directors. If the company changes its external auditor for reasons that are not listed in the relevant regulation. . In order to increase independence. Vol. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. If the status of internal auditors is elevated to that of independent board members. then the Securities and Futures Commission can appoint a new one. Responsibilities of the External Auditors Committee include recommending a selection to the annual shareholders meeting and ensuring that external auditors conform to new transparency standards. The current external auditors have been associated with the surveyed companies for an average of 4. Big Korean accounting firms are affiliated with US accounting firms. however. In the ADB survey. Accepting these arguments. Previously. this problem will largely disappear. The Securities and Exchange Act will also be revised to require an audit committee for large listed companies with total assets equal to or exceeding W2 trillion. In the past. and creditors selects it. This is because the auditor. But this problem can be mitigated if auditors function under the umbrella of the board. II controlling shareholder/CEO.102 Corporate Governance and Finance in East Asia. and lack of strong professional ethics in the accounting profession.6 years. does not have the power to hire and fire the managers. About 100 listed firms will be subject to this requirement. External auditors are selected for a term of three years. Listed and registered corporations must publish financial statements audited by external accounting firms. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. the Korean Code of Best Practice also recommends that large firms adopt the audit committee structure with two thirds of its members consisting of independent directors. as a monitor of management in the Korean (and also the Japanese) system. almost all firms affirmed that the external auditor is independent from the company.
corporations cannot issue common shares without voting rights. respectively. attended the last annual general meeting.93 percent of the shareholders but 26. representing 62. or telephone. voting by the Depository can influence the outcome of votes because an “ordinary resolution” of the general shareholders meeting requires a majority of the votes attending and one quarter of total votes outstanding.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code.21 percent of total shares issued. The securities companies and banks are the second and third. Thus.3. One common share should have one vote. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. A total of 326 shareholders per firm.53 percent of the total shareholdings. small shareholders do not attend the annual meeting and that. for some firms. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). The above results indicate that. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. and dismissal of directors and internal auditors require a “special resolution. The Depository represented 20 percent of the shares attending the meetings. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares.Chapter 2: Korea 103 2. Internet. Approval of mergers and major divestitures. or 10. About one fifth of the listed firms issued nonvoting preferred shares. charter amendments. No companies have so far introduced voting by mail.” Companies can increase the number . the Depository is subject to “shadow voting. This shows that a relatively larger number of shareholders send in their proxies. the Depository is instrumental in getting resolutions passed.79 percent of the shareholders.77 percent of the shares. amendments of the articles of incorporation require a “special resolution. The Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally.” The survey shows that the Korea Securities Depository holds 69.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. These voters represented only 5. in general. The management is the most important proxy. However. Under the Commercial Code. However.
The amendment included a provision requiring the company management to get prior approval of shareholders to undertake major investments and raise capital in international markets. dividend proposals. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. and major investment projects (only five firms answered this question). the Tiger Fund. It also attended the shareholders meeting of several companies to present the views of outside shareholders. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. the requirement was lowered from 1 to 0. The company also agreed to the right of the fund . was able to force a change in the charter of SK Telecom. from 3 to 1.0 percent. the board of directors decides on issues of shares within the limit of the authorized capital. Shareholders have preemptive rights. Only two out of 62 respondents to this question have had cases in which proposals were rejected. Vol. demand changes in business policy. Those that are most likely to be rejected relate to election of directors. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. In four out of 62 respondents. As an example. Shareholder Protection Before the economic crisis. However. In February 1998 and again in March. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. Changes in the authorized capital require an amendment of the articles of incorporation.104 Corporate Governance and Finance in East Asia. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. Proposals put forward by management are rarely rejected at the general meetings.5 percent. For recommendations for dismissal of directors and internal auditors. laws and regulations were generally very loose in protecting the rights of minority shareholders. and for access to unpublished accounting books and records. or block charter amendments considered harmful to minority shareholders. II of votes required for a resolution to amend the articles. Due to the changes in rules for investor protection. mergers and acquisition plans. Various measures have since been taken to improve investor protection. but these can be waived by an amendment of the articles of incorporation. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. an institutional investor based in the US.01 percent.
2. For further protection of investors.3. and not strictly enforced. and transactions with major shareholders. As for bond issues. mergers and acquisitions. underwriting securities firms acted also as trustees. The Commercial Code has a new clause that regards the controlling shareholder as a de facto director if he or she uses personal influence to affect business decisions of the management. creditors did not interfere with the management of a debtor. the Government introduced the Credit Management Regulation system whereby chaebols were required to seek the approval of their main banks prior to undertaking large investments. This has strengthened the accountability of controlling shareholders as de facto CEOs. . there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. In fact. However. Banks have played some limited role in monitoring the investment activities of chaebols. The covenants in loan agreements and bond indentures were very loose. After the economic crisis. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management. managers were considered to be subject to the duty of care. In 1974. but it was not entirely clear whether they had the duty of loyalty as well. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. Before the amendment. The laws and regulations of the country protect shareholders from interested transactions. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. simple. affiliated lending or guarantees.Chapter 2: Korea 105 to recommend two directors to the corporate board. Thus. loans to directors. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers.
II acquisitions. the main bank system was introduced and has been applied to the 51 largest business groups to which banks extended more than W250 billion in loans and payment guarantees. In 1996. creditors now have a bigger say in court proceedings for receivership and composition. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. this proposal has only a slim chance of being accepted by the Government or legislature. and purchases of real estate. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. However. Under the system. 10 nonbank .106 Corporate Governance and Finance in East Asia. as discussed earlier. The view that is more popular among theorists is that creditors would pursue goals that are not in harmony with value maximization and the decision-making role should be bestowed on the shareholders as residual claimants. on average. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. In turn. Purchase of real estate should be financed by equity capital and not by borrowed funds. On the other hand. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. there have been concerns that the Government might use the system to intervene in the management of the business groups. 11 banks. However. Besides the setting up of an “External Auditors Committee” by firms. Vol. In 1994 the approval requirement was abolished. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. including. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. a main bank is charged with collecting and analyzing financial information of the firm and delivering its opinion on various applications and matters requiring consultation among lenders to the firm.
Among the creditors. holding companies. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). and 17 nonfinancial corporations. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. mutual guarantee agreements. One tenth of the firms received assistance from the Government in loan applications. payments were usually rescheduled through negotiation without any penalty.Chapter 2: Korea 107 financial institutions (NBFIs). while a third think that creditors have weak influence. Most of the financial institutions are not affiliates of the borrowing company. renegotiation took place after the crisis. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. A few creditors exercise influence through covenants relating to major decisions by the company. With respect to the types of loans. penalty was involved in rescheduling. or through their shareholdings. collateral is more likely to be required of loans for working capital than for fixed investments. whereas seven of the 17 nonfinancial corporations are. collateral was taken away. The assistance came from. For more than half of such firms. 16 percent . Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. The borrower’s relationship with most banks has lasted for more than five years. in order of importance: affiliated companies. Most firms feel that requirements for collateral have been tightened since the crisis started. NBFIs infrequently ask for collateral. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. or creditors filed for receivership. Only a few feel that creditors have very strong influence. and purchase or supply of raw materials. subsidiaries. More than half of the firms think that creditors have no influence on their management and decision making. holding shares of another company by both the borrower and the guarantor. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. For a small number of firms. controlling shareholders. Creditors usually exercise their influence through covenants relating to the use of loans. When loans could not be repaid on time. banks are most likely to require collateral. and other financial institutions.
Representative of the policy was the stipulation under the Securities and Exchange Act that no one can accumulate more than 10 percent of the voting shares of a listed company . and in continued monitoring of debtors. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. Separate from but emulating the CRA. the delegation has the right to approve wide-ranging financial activities of the firm. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. In this connection. the Korean Government maintained a policy of protecting the incumbent management of listed companies. Vol. Behind these new strengthened roles of creditors is the newly set-up FSC. Role of Creditors in the Corporate Restructuring Process In the current process of business restructuring and workouts of an unprecedented number of firms under financial distress.108 Corporate Governance and Finance in East Asia. 2 percent by holding companies. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. and 1 percent by the Government. are summarized below. Second. Under a contract signed between the creditors and the debtor. the main vehicle for implementing the workout concept (or the London Approach) is the Corporate Restructuring Agreement (CRA) signed by 210 financial institutions in July 1998. will get involved in the restructuring and workout processes. have been the driving forces for restructuring activities of the largest 64 chaebols.3. major creditors. In cases where the creditors are unable to reach an agreement on a workout plan. The new ways through which creditors. 2. especially banks. This committee was set up in accordance with the provisions of the CRA. Third. II by other affiliated companies. First. including commercial and merchant banks. banks and other institutional lenders are playing more important roles than ever before. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. 4 percent by subsidiaries.
. the outside shareholders did not want to sell shares because the share price went above the offer price due to a share repurchase by the target and anticipation of a competitive bid from a third party. hostile takeovers by tender offers began to appear in the capital market. corporations cannot limit the voting rights of large shareholders to a given maximum. a total of 13 hostile takeover attempts occurred. an acquirer of shares wishing to own more than 25 percent of the issued shares was required to make a tender offer to buy at least 50 percent). The policy to protect the incumbent owners/managers was formally dropped when the Securities and Exchange Act was amended in 1994 to abolish the 10 percent limit. it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. Companies have also utilized share repurchases. Between 1994 and 1997. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. and announcing competitive tender offers by the controlling shareholder. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. However. Publicly issued CBs require three months before their owners can convert them to shares. Takeover Activity As soon as the Act was amended. but were completely eliminated in 1998. turning to white knights. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998. A company cannot issue new shares to a third party without first amending the corporate charter. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. Unlike the UK. As far as institutional arrangements are concerned. listed firms rely mainly on shareholdings by the largest shareholder. Privately placed CBs cannot be converted into shares in one year. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Unlike Germany. It was generally believed that the securities authority would use its power to review and order revisions of the tender offer statement to halt any hostile takeover attempt. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. more than half of these attempts failed. The reasons for failure are diverse. In one case.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. Stock purchases by tender offer were also exempted. For takeover defense.
Golden parachutes are almost unknown in Korea because the total amount of director compensation has to be voted on at the general shareholders meeting each year.3. The Government-owned listed companies. In 1998. As of the end of 1997. Vol. Korea Telecom. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. in which the Government still holds the largest ownership. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. was newly listed. . Firms affiliated with a large group are generally regarded as difficult targets as the other members of the group will come to the rescue or act as white knights. Charter amendments have also been employed by some firms to limit the maximum number of directors. In 1999. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. As of February 1999. In their charters.110 Corporate Governance and Finance in East Asia. Currently the limit is 3 percent. Hostile takeovers in Korea will be rare in the future. and a bank had government ownership. an electric power company. it is not certain whether the Government will ever fully privatize them and whether it will hold a golden share in the case of a complete sale of Government-held shares. For the others. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. except for the banks. It is harder now to find such firms.7 percent on average as of the end of 1997 for nonfinancial listed firms). the limit will be eliminated when it is fully privatized in two years. II The Securities and Exchange Act was revised in 1998 to abolish the 10 percent limit on share repurchases and the Government simultaneously eliminated the limit on foreign ownership of shares of listed firms. Many of the takeover targets in the past did not have a controlling shareholder (group). For the steel company. are designated as public companies. Some had two or more large shareholders who had joint control of the firm but could not cooperate. a steel company. 2. Another reason is that many listed firms belong to chaebols.
But this rule. For example.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. Beginning in 1999. as applied to four large corporations. which limits the total amount of bonds issued by the five largest chaebols. only qualified firms could issue new shares.3. which was introduced in 1996.3. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. Control Over Private Companies One of the pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols (see 2. especially those belonging to chaebols. more state-owned corporations became subject to this new board structure. 2. In addition.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. each of the 10 largest chaebols was allowed to raise funds no more than 4 percent of the total market capitalization of the member firms. Meanwhile. the main bank system. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. The Government’s right to send public officials to the boards was eliminated. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. The nonexecutive directors are now recommended by a committee. It was abolished before the economic crisis but another regulation. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. Labor is not represented in corporate boards.1). There is no active debate or discussion going on about this potentially difficult issue. The Government has frequently imposed restrictions on the use of capital markets by large companies. administering through a self-regulatory committee of the securities industry. Further. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. nominated by the minister in charge of the company in question. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. the Government. and approved by the Chairperson of the Planning and Budget Commission. There were also limits on the amount raised and the number of issues per year. Even where employees hold .
1 in 1997. In actuality. and development of the company. 2. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. in principle. and 2. union members account for 54 percent of the employees. Under another law enacted in 1972 to induce private companies to go public. Under the Capital Market Development Act of 1968. The respondents of the ADB survey had 2. carried out at the enterprise level. Vol. . This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal.5 in 1990. which were generally much lower than estimated values. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees.9 in 1980. In these firms. About half of these firms considered the influence of the union on the management of the company to be weak. and 66 percent manual workers. of which 2 percent were senior managers. there are two federations of labor unions. Two thirds of the respondents had an organized union. At the national level. The percentage of shares held by the employee stock ownership plans in listed companies was 1. The union had no influence on the management in 17 percent of the firms. they delegate their voting rights to plans’ representatives. the council meetings have been superficial. the subscription rights given to employees when a company goes public and when a listed company issues shares were increased to 20 percent of the new shares. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. In 1987. II shares of their companies through employee stock ownership plans. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. Local unions in the same industry have established industrial labor federations. operation. the management usually consults the union on major issues relating to the management. but 27 percent of them felt that it was strong.654 employees per firm on average. The typical collective bargaining agreement has a one-year duration. In 70 percent of the firms with organized unions.112 Corporate Governance and Finance in East Asia. 32 percent technicians and professional staff. The relevant regulation was amended recently in order to facilitate voting by individual employees. Trade unions are organized on an enterprise basis. employers are required to meet with representatives of labor unions at least once every three months. Under the Labor Management Council Law. Collective bargaining is.
Chapter 2: Korea 113
Corporate Financing7 Overview of the Financial System
The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7
The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.
114 Corporate Governance and Finance in East Asia, Vol. II
counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.
Chapter 2: Korea 115
Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump
116 Corporate Governance and Finance in East Asia, Vol. II
after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the
Chapter 2: Korea 117
total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage
The Government adopted a cautious approach. depreciation.2 Patterns of Corporate Financing Corporate Financing Practices In this section. Since 1985. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. Meanwhile.5 percent in November 1981. was liberalized drastically in 1998 after the financial crisis. budget. The capital market. Also. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. Vol. With the privatization of nationwide commercial banks. 2. and organization of commercial banks.2. finance companies. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. listed companies. Some policy loans were also abolished. implementing the first stage in November 1991.1). which resulted in the establishment of a number of new banks. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. especially the domestic bond market. the Government simplified various directives and instructions regulating personnel management. . etc. the business scope of financial institutions was greatly widened from the early 1980s. mutual savings.4. On the basis of flows of funds. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets.118 Corporate Governance and Finance in East Asia. development of the money market. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. the Korean Government announced its Financial Liberalization and Market Opening Plan. II Interest Rate Deregulation Plan. In addition. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. Moreover. as a first step toward liberalization of capital account transactions. and the 30 largest chaebols. Internal funds include retained earnings. short-term finance companies. and liberalization of foreign and capital transactions. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. In June 1993. Korean firms have been allowed to issue CBs in international financial markets. It included such important issues as interest rate deregulation. revision of the credit control system.
Chapter 2: Korea 119 and net capital transfers from the Government. on average. The share of external financing.26 shows the four measures of corporate financing calculated from Table 2. depreciation. This means that internal funds after dividend payment were insufficient to finance growth in total assets. capital surplus. 1994. particularly in the 1990s in response to the liberalization of the capital market. The corporate sector used . but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment.25. comprising internally generated capital (retained earnings. was 71 percent during the period. except in 1991. Table 2. the proportion of foreign borrowings in total finance rose steadily. In securities finance. The use of additional debt to finance growth increases financial risks as the company may not be able to pay interest during periods of recession or high interest rates. Meanwhile. and allowances) and new equity capital. It measures the degree of financing growth in total assets by additional debts. Financing Patterns of the Aggregate Corporate Sector Table 2. except for the stock market boom of 19871988. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. particularly in the short term. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. the corporate sector’s most important source of external finance was bank borrowings. Securities finance became a more important source from 1988 onwards. including all sources other than retained earnings. The SFR averaged 28. financing by corporate bonds and CPs was more significant than by new equity. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. Equity capital represents the shareholders’ commitment to the business. It measures the degree of financing growth in total assets by additional equity. Before 1988.4 percent in the precrisis period 1988-1997. but it remained less than 10 percent of total financing. and 1997. and government transfers. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. depreciation. In 1988 when the stock market boomed.
Table 2.4 8.4 27.0 11.2 5.1) 4.1 1.5 0.2 6.4 27.3 27.0 22.2 10.7 13.1 0.8 0.3) 11.0 3. and Public Bonds Commercial Paper Corporate Bonds Stock Issuesb Equity Other than Stock Foreign Loans Foreign Current Bonds Trade Credit Direct Investment Others Others Government Loans Business Credit Other Financial Debts — = not available.0 10.5 16.6 9.0 (0.1 2.7 4. Bank of Korea.1 2.8 17. Bank of Korea.8 -2.8 1.4 71.2 34.2 26.1 (1.6 3.9 6.1 72.7 8.3) 15.4) 13.5 2.7 4.1 (0.6 4.1) 6.6 0.1) 4.6 5.7 1.0 3.6 (0.1 1.7 6.0 70.7 (0.7) 11.5 2.0 16.0 9. .8 56.4 2.8 15.9 72.6 2.7 15.9 34.6 0.6 8.7 — — — — 9.9 10.4 11.4 1.3 — — — — 8.4 (0.2 0.6 4.6 4.4 (2.3 — 30.3 1.8 (0.2 — — — — 9.7 2.4 27.6 11.4 0.1 10.7 32.7 71.3 6.3 3.2 1.4 21.8 4.6 11.7 10.0 0.2 2.8 1.1 1.3 3.1 17.9 0.8 1.6 77.0 5.8 8.5 13.7 1989 1990 1991 1992 1993 1994 1995 1996 22.1 36.5 2.7 2.5 9.7 7.1 3.7 1.3 1.0) 12.4 3.1 3.9 9.3 25. depreciation.7 11.0 2.0 3.1 12.6 9.9 73.3 1.2 — 28.6 3.4 9.2 13.2 6.7 14.2 (0.4 0.3 16.1 27. and Flow of Funds.8 27.1 3.7 10.9 10. and net capital transfers from the Government.2 13.25 Flow of Funds of the Nonfinancial Corporate Sector.0 9.3 6.7 8.4 2.3 10.6 25.1 0.0 1997 26.9 28.7 14.6) 5.2 14.0 0. b Includes capital surplus.8 — 26.9 38.3 30.1 23.8 30. 1988-1997 (percent) 1988 43.4 15.4 2.3 2.1 8.3 5. which is the excess of current value over issue value of stock. 1994.0 1.3 72.5 16.4 1. Source: Understanding Flow of Fund Accounts.4 10.2 15.0 — — — — 8.0 17.1 — — — — 12.6 0.7 73.6 1.7 2. a Includes retained earnings.9 2.6 14.1 — 27.5 0.4 — 28.5 29.5 0.5 2.8 1.7 12.6 9.6 0.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.6 10.8 1.4 2.7 10.3 6.
higher than the aggregate 28. and the total debt ratio was much higher in 1996 and 1997 at 62.6 percent. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43. Incremental financing from equity was 40. IDFR reached 73.3 percent in 1997.5 percent in 1997.4 percent. 1994.7 40.8 percent of its total asset growth through debts. There were significant time trends.1 39. but plunged to 5. higher than the aggregate 40.6 26. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.9 46.9 60. Source: Calculations from Understanding Flow of Fund Accounts.6 percent.6 Excludes capital surplus. It dropped to 28 percent the following year.2 percent of incremental asset growth was financed by equity. Across industry.3 73.3 60.4 percent. in the manufacturing sector.8 28. but also continuously fell.5 31. NEFR registered 20.7 40. respectively. . The balance.3 59. an average of 59. While SFRs.1 53. respectively.3 27.5 percent.7 percent in 1997.0 57.8 10.7 26.4 27. declining to 26.2 37.1 17.6 percent over the 10-year period. Lower income diminished the industry’s equity position toward crisis year 1997. 45.9 28. NEFRs.7 28.3 59.1 12.2 percent of the growth in total assets. and IEFRs were declining. the corporate sector relied heavily on external financing for its expansion.1 percent in 1988 during the stock market boom.5 12.6 62.3 11.0 5.4 37. and Flow of Funds.27).7 30. In periods of high economic growth such as in 1988.9 22. indicating a high financial risk position.9 percent by 1997 when net profit margins were negative. Bank of Korea.Chapter 2: Korea 121 Table 2.4 12.3 12.4 NEFRa 20.0 42. average SFR was 37.4 percent (Table 2.5 68.0 11. Manufacturing financed 54.4 IEFR 63. SFR peaked at 44 percent. was financed by additional debts.7 40. Its IEFR and NEFR dropped to 23.26 Financing Patterns of the Nonfinancial Corporate Sector.1 26.8 62.0 27.2 IDFR 36. additional equity to finance 12.7 9.5 and 76. On average. Bank of Korea. dropping to 26.6 percent and 1.
6 53.6 54. explaining partly the collapses of several construction companies in 1995. It had the highest average SFR in 1988 at 31.4 46.5 NEFRa 9.0 42. and fell to about 10 percent in 1997. Total debt financed an average 74. large firms showed more cyclical patterns in these financing ratios than small. their average SFR was higher. the two sectors also had low equity financing ratios and high debt financing ratios.0 3. Categorized according to company size.2 3.5 76. which decreased to 8.6 53. Since 1992. Equity financed an average 25.6 4.2 5. one year ahead of the other industries.4 63.3 52.3 28.5 1.6 45. II The construction industry showed the most cyclical pattern in annual asset growth. and steam) and the transportation.9 IDFR 34. Since large firms were more profitable. and low total debt and short-term borrowing ratios.9 percent of asset growth. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.2 percent in 1993.8 50. storage.0 30.1 29. Vol.6 37.2 62.6 36.4 54. and communication sector had relatively high incremental equity ratios. the utilities (electricity.122 Corporate Governance and Finance in East Asia.0 42.9 percent.1 percent of total asset growth for the period.8 4.7 percent in 1996. from 17. Table 2.7 47. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.5 23.0 57. this dropped further to 15.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent) Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.8 IEFR 65.4 45.5 7.7 47.6 3.9 6.7 37. On the other hand. In 1997. retail.and medium-sized firms. Financing patterns of the wholesale. gas.6 37. then increased to 20.8 percent in crisis year 1997.7 37. and hotels sector and realty/renting/business activities sector were similar.2 .4 37.4 3.6 62.2 21.4 47.8 percent in 1990. the proportion of short-term borrowings in total financing has been high.
8 25.3 1996 16.2 20.7 15.Table 2. Household Goods.0 10.5 1.1 25.1 Trasport.8 29.9 20.27 (Cont’d) Year SFRa NEFRa IDFR 53.0 .7 41.2 29.8 70.2 4.6 9.2 23.2 3.9 15.1 66. and Communication 1988 64.3 57.0 1992 24.2 70.8 54.4 62.2 8.8 76.1 69.5 1996 42.5 62.5 87.2 18.7 42.9 52.3 4.7 1989 26.9 80.0 34.8 1994 15.8 74.8 4.0 31.3 19.6 2.6 14.1 59.0 17.3 10.9 1992 56.9 29.0 65.6 8.7 53.3 21.5 23.5 29.0 82.2 1995 16.7 78.2 5.6 37.3 47.1 19.6 7.8 9.9 33.5 76.6 8.7 1997 8.9 1989 63.5 1993 22.0 1990 50.4 1995 53.9 1.6 9.6 37.9 1993 63.1 70.9 9.7 Wholesale/Retail Trade.3 7.4 28.7 15.1 1991 14.3 84.9 1.7 80.0 0. Storage.5 70.3 (9.6 73.0 68.0 40.1 84.6 1997 29.2 Average 53.3 8.5 21.9 30.6 4.9 47.9 1.8 81.0 1.2 74.7 1994 53.6 71.9 2.4 2. Hotels 1988 33.5 20.4 26.2 25.2 10.9 Average 19.0 4.7 78.3 4.0 60.9 16.5 12.4) 2.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.8 1991 51.8 2.0 74.1 4.0 3.4 IEFR 46.7 6.7 7.0 1990 12.2 46.
1 42.3 29.0 1.4 1994 72.and mediumscale firms. Source: Calculated using data from Bank of Korea.1 34.4 (107.9 65.6 1990 82.4 0. II Table 2.5 77.3 207.7 14. The large firms had a higher proportion of external financing in 1996-1997. NEFR = new equity financing ratio.0 1997 24.2 63.4 1995 62.0 43.0 53.0 79.9 29.27 (Cont’d) Year SFRa NEFRa 6.3 Electricity.1 70. Gas.9 64.1 1993 55. and Steam Supply 1988 118.5 8.4 1996 45.7 18.7 69.6 52.0 46.3 62. Vol.0 56. and Business 1988 51. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.0 1992 51.4 47.3 92.6 7. SFR = self-financing ratio. Financial Statement Analysis Yearbooks.7 1994 8.6 Real Estate.0 (0.124 Corporate Governance and Finance in East Asia.8 1990 19.3 85.9 Average 75.6 1.1 54.and short-term borrowings of these firms shot up in that period.4 1.9 45.6 1997 23.8 135.7 1996 18. however.3 81.6 1991 18.8 1993 11.2 1992 18.0 33.3 3.1 0.6 1989 118.8 Average 22. a Excludes capital surplus.4 5.1 1991 56.8) 7.4 IEFR 69.1 35. The trend was reversed in 1996-1997.0 21.0 0.4 0 0 0 0 1. IEFR = incremental equity financing ratio.0 67.5 22.7 70.1 71.8 17.4) 3.0 0.4 7. Renting.3 7.7 37.6 1995 17. when large firms had much lower equity financing ratios and higher debt financing ratios than small.8 36.1 1989 34.8) (35. Long.9 IDFR 31.3 31.6 IDFR = incremental debt financing ratio.9 28. .9 57. Their average IEFR was also higher and IDFR smaller.
about the same as that of the corporate sector as a whole. the average SFR was 28. 153.2 percent. External financing reached 94. Their shortterm borrowings accounted for 86. 91. All of the top 30 chaebols relied heavily on short-term borrowings. .28). the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. the IDFR of listed companies increased to 93.8 percent.5 percent and their total external financing. and using cross-payment guarantees among affiliated companies.6 percent. the lowest ratio of 58.3 percent of their equity capital in 1997 (Table 2.30).5 percent is lower than that of the corporate sector in general. The debt financing ratio of listed companies was high since they relied more on external financing.3 and 89. and were large borrowers. compared with 89. and higher than that of listed companies (Table 2.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2.7 percent. In 1997. The proportion of their short-term financing averaged 72. The average IEFR of the top 30 chaebols of 29. The average IEFR and IDFR were 10. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. but higher than that of listed companies. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. Group-member firms borrowed less. In 1996-1997. Cross-payment guarantees have been declining since 1993 and reached 91. for listed companies.7 percent for all listed companies.1 percent of their equity capital. They were able to borrow easily from banks by issuing corporate bonds and CP. In 1997. the top 11-30 chaebols had the highest guarantees commitments at 207.8 percent of their total finance in 1997. The chaebols’ drive to expand their empires resulted in heavy borrowings. compared with the entire corporate sector’s 35 percent and 65.9 percent. at an average 70. and the top five chaebols. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. The largest borrowers were the top 11-30 chaebols.4 percent. respectively.9 percent.29).7 percent. the top 6-10 chaebols.6 percent of total asset growth. Financing Patterns of Chaebols For chaebols.
1 93. Source: Calculated using data of Seung No Choi.8 22.6 1.1 8.4 88. 1994-1997 (percent) SFRa 41.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.8 89. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.3 5.5 2.9 7.2 36.4 38.4 29.8 76.5 2.5 91.2 1.9 6.6 61.5 8.7 13.3 IDFR 57.29 Financing Patterns of the Top 30 Chaebols. Largest Business Groups in Korea. Korea Federation of Industries.6 0.1 1.Table 2.3 86.28 Financing Patterns of Listed Companies.6 IEFR 42.2 10.4 1.6 70.9 NEFRa IEFR 14.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.6 11. Table 2. .5 8.7 12.2 23.2 NEFRa 1.4 12.3 28.3 1.7 1. 1994-1998 (percent) SFRa IDFR 85.
Few firms ranked loans from NBFIs as their first preference.9 153. especially in the 1970s when real interest rates of bank loans were negative. loans from banks. company preferences in financing investment projects before the crisis were. Korean firms preferred debt financing (bank and nonbank borrowings). . bond issues. And fifth. and reserves and retained earnings. Financial institutions did not strictly screen their loan projects and monitor their debtors. This change implies that firms now give more attention to financial risks. rights issues. the Government provided implicit guarantees on bank lending and large businesses.30 Cross-Payment Guarantees of the Top 30 Chaebols.1 — — — 1995 161. more than half of bank loans were priority loans with low interest rates.7 150. in order of ranking. bond issues. These are followed by loans from banks. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. According to the ADB survey. inefficient investment and excessive diversification of corporations.1 — = not available. There were several reasons for this. First. poor financial and corporate governance resulted in overlending by banks. Source: Fair Trade Commission and the Federation of Korean Industries.3 58. the Government applied high tax rates on net profits of corporations. Fourth. Firms now prefer internal funds and new equity capital. and loans from NBFIs. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. Third.0 207. Interest payments on debts were considered a loss when calculating taxes.9 — — — 1994 258. Second. the Korean economy was plagued with high inflation. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control.9 — — — 1996 105.3 64. so that the firms engaged in lobbying to gain access to them.0 1997 91. Further. Factors Influencing Corporate Financing Choices Until recently. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. and extended loans based on cross-payment guarantees.Chapter 2: Korea 127 Table 2.3 200. and underdevelopment of the stock market.
3 Financial Structure. and others (29 percent) expected the local currency to appreciate in value. and reduction in tax burden. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). ensuring the liquidity of the company. Among the responding companies that had foreign currency denominated loans. Among those that never hedged against exchange rate risks. firms give their first consideration to minimization of transaction and interest costs. Nonetheless. Korea now provides a better environment for financial risk management. A futures exchange launched in 1999 trades foreign exchange options. The most important reasons why they chose to borrow foreign currency denominated loans were that terms of foreign loans were more favorable and/or these loans were considered cheaper. and Corporate Performance Corporate Performance and Financial Structure Many chaebols were vulnerable to unfavorable cyclical shocks such as the business downturn at the end of 1995 and the terms of trade shock in 1996. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. This preference has changed little after the crisis. more than half (53 percent) hedged against exchange rate fluctuations.4. Vol. even with a heavy debt burden. some (36 percent) thought that a hedging facility was not available or not working properly.36 percent on average for these companies. According to the survey.128 Corporate Governance and Finance in East Asia. Other factors include. in selecting financing sources. Diversification. and futures and other financial derivatives. II In seeking external financing. maintenance of the existing ownership structure. they survived for two to three . About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. the percentage of foreign currency denominated debt in the portfolio was 14. For these firms. 2. in order of importance. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. many firms (or 42 percent) never considered hedging. Only a few firms sought foreign loans because domestic loans were not available.5 percent at the end of 1997. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21.
The ratios of the top five chaebols were similar to those of the top 6-70 chaebols until 1991 when the top five chaebols’ ratios shot up. but the ratios of independent firms were much lower. 1999). But since 1992. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. They were also higher than those of the top five chaebols until 1992. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. except in 1991.2. (iv) In terms of EBITDA to total assets. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. In order to determine the relationship between financing patterns and corporate performance. as well as lax financial supervision (Nam et al. Nam et al.3. . Among the main findings were the following. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. (i) In terms of total borrowings to total assets.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. except in 19931995 when semiconductor prices were extraordinarily high. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. They were also higher than those of the top five chaebols until 1991. These findings indicate that independent firms have had a lower leverage and performed better financially. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt.13).. the top five chaebols’ ratios were much higher. (ii) In terms of net income to total assets. The extremely high leverage and the ability of chaebols to survive for several years with huge debts are evidence of poor internal governance of both the corporate and financial institutions. the top five chaebols and the top 6-70 chaebols had similar ratios. Table 2. However.
the degree of diversification was highest in the top five chaebols. Meanwhile. The diversification of chaebols under workout was much lower than that of the top 6-30. 2. its profit rate declined. had easier access to credit than the top 31-72 chaebols. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. Their subsidiaries. In terms of the net profit margin (the ratio of net profits to sales revenue). But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992.130 Corporate Governance and Finance in East Asia. and lowest in the top 3172 chaebols. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. except in the recession years of 1996-1997.31). The differences in the degrees of diversification among the three groups are substantial. had a significant role. or outright transfer of resources due to poor corporate governance practices. Indicators such as increasing debt-to-equity ratios. and easier access to cheap credit. Government intervention. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. The more diversified top five chaebols performed better than the less diversified top 6-30 because they were better established in most business areas and have superior personnel and technology. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. larger research and development expenditure. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. too. The degree of diversification of chaebols that fell into default. however. Vol. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. court receivership. second highest in the top 6-30. The diversification of the top five chaebols remained at about the same level within the period. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. rising nonperforming loans (NPLs) and falling . During 1985-1997. debt guarantees for free.
8) 0.8) (3.7 1.6 3.2) (0.5 (0.6 7.2 1.11.3) 0.9 1.1 (3.8 3.8 (0. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.2 1.5) (2.4 0.1) 1.6) (0.9 0.2) (13.9) 2.5 1.7 1.3 1.1 0.Table 2.5 (6.5) (0.1) 0.3 1.1 0.1) — = not available.6 0.6 0.1 1.1) 2.2) 1.8) 0.9 0.4) (1.7 (4.2) (3.9) (9.8 0.3) 0. 1998.6 1. Chung Ang University.8 0.7 (0.2) 2.2) (13.4 (0.6 1.2 (17.8) (1.7 (0.4) (1.4 (1.1 1.9 1.8) (0.7) (1.0) (3.5) (2.4) (1.8 1990 0.4 (0.5) (7.8 0.1 2.0) 0.8) 1997 0.8 1.2 1.4) (6.5 4.1) (5.4 (2.8) (20.6 0.9) 0.2 (0.0) 0. Court Receivership.1 1.3) (0.2) (4.9) 2.7 (1.5 2.8) 0.4 1996 0.8) (37.7) 0.3 0.9 0.4 0.1 4.8 0.1) (6.6) (20.3 0.3 (0.4 0.8) 2.0 4.8) (4.7 1.8 0.5 (0.7 2.3 (3.3) (12.9) (1.4 0. Source: Whan Whang.8) (1. Background and Task of Structural Adjustment.2) 2.7 0.2) (0.1 1.2 1.3 (0.2) 1.7) 0.3 0.0 1992 1994 1.5 (4.2) (4.1 1.6 (0.31 Net Profit Margins of Chaebols.0 1.3) (0.3 3.5 1.3 1.2 1995 3. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.3) 0. Management Research Institute.7 0.0 (7.3 1.3 (0.5 1.5) (1.7 0.3 1.1) 2.0) 0.3 1.1) (1.1 0.0 (0.1) (1.9 0.6 5.8) 0.1 0.5) 0.1 0.3 1.6) (0.5 (0.1 0.3) 1.2) (4.9 1. p.2 4.1) (2.6 0.6) (12.1 (4.3) 0.6 0.2 0.2 (1.6) 0.7 0.4 (0.7 1.3) 1.2 (0.6 1.4) (2.7) (0.4) (0.5 1.2 (0.0 0.8 (0.6) (12.9 8.3) 0.8) 0.7 0.6) 0.6 1.2 1.8 3.0) (0.5 1.8) (11.4 (1.0 1.0 0.3 1.4 2.7 — (0.2) 0.3 0.0) (4.6 (0.1 1.4) (4.6 0.3) (1.5 0.0) (0.0 (2.1 0.6) 0.7) (0.6 0.9 1.1) 0.4 1.1 0.3 0.3 1.1 (9.2 (0.1 1.5 (0. .6 1.9) (8.3 (0.2 1.1 0.3 1.4 1.4 1.6) 0.8 (0.6 (10.6 0.9) 2.3 1.2) 1.3) 12.7 3.1 (1.0 6.7 0.4 (1.8) 1.9 (0.1 (0.8 1.4 1.3) 0.6 1989 1.3) 0.1) 1. Beyond the Limit.0 1987 1.1 (4.
a firm’s board of directors had the power to appoint an external auditor. The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system. 2. and creditors should select (recommend) the external auditor. after the crisis.1 Weaknesses in Corporate Governance Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. the controlling shareholder or CEO generally selects the internal auditor despite a legal provision limiting the votes of the largest shareholder to a maximum of 3 percent. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. and to the development of the market for corporate control. . Moreover. internal auditors cannot be expected to perform their function independently of management. A remote trigger in the Thai crisis was all that took to push the economy over the edge. this has led to entrenched management. They were then almost automatically elected at the general shareholders meeting. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. Until 1997. the independence and objectivity of the external auditor were often questioned. Thus.132 Corporate Governance and Finance in East Asia. Until 1997. Ownership concentration also had ramifications on corporate transparency. outside directors. Meanwhile. Thus. But in 1998. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. Vol. the boards of all listed companies were composed of insiders only. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. the Korea Stock Exchange introduced listing rules requiring that listed firms elect “independent outside directors” to comprise not less than a quarter of the board members. Along with government policies to protect the status quo. Internal and External Control Concentration of ownership has been and will be the major obstacle to the independence of the board of directors from management. a committee composed of internal auditors.5. Now.
The purpose was to increase the size of the stock market by having financially sound private firms go public with an assurance that they would not be taken over. participated in the stock market as short-term traders rather than long-term investors. and some differences in Korea’s generally accepted accounting principles from international standards. regulatory and practical difficulty in implementing proxy voting. profitable firms within a chaebol tended to subsidize unprofitable firms. Traditionally. restrictions of voting rights of shares of institutional investors. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. when a large diversified chaebol. hostile takeovers in Korea will likely be rare in the future. and restrictions on hostile takeovers. individuals. Many of the takeover targets in the past did not have a controlling shareholder. One reason is that the percentage of inside shareholdings for an average listed firm is very high. Representative of the policy was the stipulation under the Securities and Exchange Act that no one other than founders could accumulate more than 10 percent of the voting shares of a listed company unless he or she obtained prior approval of the Securities and Exchange Commission. however. In this situation. Many changes were introduced to promote M&A in the 1990s. These included restrictions of shareholdings of institutional investors. usually a member of the founding family. prevalent window dressing practices. as well as institutions. corporate accounting information was not reliable due to the lack of independence of external auditors. as a whole. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. There were no effective monitoring mechanisms for its management. the Government maintained a policy of protecting the incumbent management of a listed company. However.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. These internal dealings made strong firms weak and helped marginal firms survive. a large issuance of preferred stocks with no voting rights. Diversification can reduce chaebols’ risks through the portfolio effect. Under the direction of the controlling shareholder. has an unsound capital structure and . Meanwhile. Another reason is that firms affiliated with a chaebol are generally regarded as difficult targets as the other members of the group will come to the rescue or act as a white knight.
financing choices of listed firms in order of preference were bank loans. bond issues. and a high degree of inefficiency in the economy. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. Further. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. the typical chaebol firm had an extremely high DER. However. capital.2 The Role of Government Intervention Strong government intervention in the early stages of economic development was useful for overcoming inefficiencies in financial and capital markets and for managing high investment risks. share issues. As mentioned earlier.134 Corporate Governance and Finance in East Asia. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. The new preference ordering is as . Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. Financing preferences changed drastically after the crisis. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. Such problems may eventually cause ripples through the entire economy. 2. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad.5. Vol. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. and internal funds. as the latter are well established in most business areas.5.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. and other individual markets. 2. II strong financial links among its member firms through investments and cross-guarantees. while (non-chaebol) independent firms had much lower borrowing ratios. The Government’s supervision and regulation of financial institutions were poor.
The foremost reason why listed companies preferred debt financing over issues of new shares lies in the largest shareholders’ desire to keep control of the management by preventing dilution of their ownership. However. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. The poor state of corporate governance in the banking and financial sectors was responsible for overlending by banks and NBFIs through perfunctory screening of loan applications. bank loans. the Government and the Bank of Korea defended the currency.Chapter 2: Korea 135 follows: internal funds. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. large-scale bailouts of financially distressed firms. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. The lending practices of banks. Other factors also contributed to this preference. the size of the stock market was not adequate to digest all the potential supply of new shares to finance the rapid growth of corporations. consisted of high proportions of policy loans. 63 percent of which was short-term. which generally required guarantees or collateral. signaling a bearish speculative move on the won. obviously contributed to overlending and aggravated the situation.5 billion. and bond issues. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. won/dollar nondeliverable forward rates increased rapidly. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. After the financial crisis erupted in Indonesia and Thailand. Nonpolicy loans were also considered to be cheap because of interest rate regulations. In November 1997. At the end of 1996. reducing foreign exchange reserves to a dangerous level. The preference for debt finance also led to a relatively large foreign debt. In the international financial market. share issues. the top 30 chaebols showed a DER of 519 percent. This change implies that firms are now more attentive to financial risk and inefficient investment financed by external funds is less likely to recur in the future. Bank loans. which were the most important financing source until 1987. The ratio of external debts to GDP reached 48 percent at the end of 1998. total foreign debt amounted to $157. . Implicit guarantees by the Government on bank loans to large businesses. as evidenced by occasional. As of the end of 1997. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing.
They utilized mutual payment guarantees among their affiliates and believed that they would never fail. the NPL ratio8 of banks and other financial institutions began to increase. However.000 per year starting 1992. The Government could hardly help them because of the number and magnitude of business failures. Financial Sector Vulnerability Because of financial losses in the corporate sector. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. excluding the financial sector. then 20. According to the “six months” definition. Fixed loans are those for which interest is not received for six months or longer.7 percent in 1997. It jumped to 17. Doubtful loans are those for which interest is not received for six months or longer. without strictly evaluating the creditworthiness of businesses and the profitability of projects. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding.1 percent in 1996. has given rise to various types of self-dealings by the controlling shareholder.32). Further. The banks and merchant banks lent to large businesses. Before the crisis. legal and other barriers prevented the exit of financially nonviable firms.6 percent in June 1998.200 in 1997. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. These were the definitions until 30 June 1998. In 1997 they became negative. the ratios of net profits to sales. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. Following the “three months” definition. starting 1 July 1998. The monthly number reached more than 3. The inevitable result of inefficient investment was a fall in corporate profits. Moreover. the NPL ratio reached 7. they are defined as loans for which interest payments are overdue by three months or more.000 during January-September of 1998. total assets. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. and there is no collateral. Vol. and the pursuit of growth through excessive diversification and inefficient investment. nine out of the 30 top chaebols failed. were low in 1996 and 1997. reaching highs of 6 percent in 1997 and 8. . and estimated losses. the NPL ratio of commercial banks increased rapidly from 4. Meanwhile.000 in September 1998 (Table 2. decelerated from March 1998. and returned to about 1.000 from December 1997 to February 1998.136 Corporate Governance and Finance in East Asia. and shareholders’ equity of all industries. especially chaebols. and there is collateral. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans.
238 4.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.859 3.647 8. and continuous and large current account deficits.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.China.855 6. In 1990-1993.553 3. The difference between the Korean and Western definitions of NPLs left foreign investors with suspicions that the size of NPLs in Korea might be much larger than the government-announced magnitude.265 6. Compared to ROAs and ROEs of domestic branches of foreign banks. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.850 3.759 6.255 13.5.890 4.259 2.502 11.754 3.114 811 706 696 866 1. those of domestic banks were lower in the 1990s. This speculation was said to be one of the causes of the financial crisis in Korea. Meanwhile.69 20.985 Services 3. European countries. the ratio reached 7-8 percent.Chapter 2: Korea 137 Table 2. As a result they had largely overvalued currencies.457 2. low efficiency. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US. and Taipei. and large government-directed loans.472 2. 2.244 3.637 6. The current account deficits in terms .133 3.517 2.544 2. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.751 1.769 9.027 Manufacturing 1.131 1.573 3.673 Construction 380 354 242 195 294 585 1.210 1.33).992 11.979 8. Source: Bank of Korea.856 7. and declined to 4-6 percent in 1994-1996 (Table 2.589 171.135 1. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.250 2.657 3. This was mainly due to the high ratios of NPLs.053 5.159 10.107 6.386 5. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.32 Number of Firms with Dishonored Checks.
562 18.475 143.652 29. the ratio of short-term debt to foreign reserves was very high.6 percent (1995).954 9.1 6.0 7.705 160. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.600 10.584 2. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.520 194. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.116 1. Mass layoffs became legally possible only after the economic crisis. although per capita income in Korea was much lower.2 4. even in times of economic slowdown.33 Nonperforming Loans of General Banks.0 7. and 30 percent in 1996.266 10.192 Doubtful (B)b 952 1.077 NPL Ratio (%) 8. because of the rigid labor market. II Table 2. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. Source: Bank of Korea.8 percent (1996).0 8. Businesses served as a social safety net.874 22.390 12. Land prices and real estate rents were also high compared to trading partners. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.484 11.190 9.8 5.1 percent (1995). It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.929 11.138 Corporate Governance and Finance in East Asia.639 1.221 8. Meanwhile large businesses could not legally lay off workers.832 337.649 375.739 241. In addition to the overvaluation of the won. which led to large corporate losses.556 118.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.160 11.430 12. Thailand -8. . of percentage of GDP were as follows: Malaysia -8.537 10.584 Fixed (A)a 5. and Indonesia -3.1 7.6 percent (1995).170 1. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.China. In 1997.736 8. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.310 6.4 5.827 289.997 9. Korea -4. Related to this.910 1.176 7. Vol.China.
Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed.Chapter 2: Korea 139 2. They have also been urged to divest themselves of strategically ill-fitting businesses and sell equity holdings of attractive business units to foreign firms to reduce debts. Downsizing by curtailing employment has been prevalent. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. had been forced into bankruptcy proceedings or merged into healthier entities. Corporations. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. However. and subsidizing money-losing units.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999.6 2. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions.1 Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness.6. . although efforts to lay off thousands of blue-collar employees at Hyundai Motors encountered fierce opposition from labor and ended up in mediation after intervention by politicians from the ruling coalition. They have been pressured to stop such practices as providing loan guarantees. To achieve this. including banks. which were laden with huge amounts of debt and were on the verge of bankruptcy. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. Nonviable firms and financial institutions.
045 in October. On the other hand. Data collected by the Korean Chamber of Commerce and Industry show that the number of potential domestic and foreign buyers in the M&A market increased by about 50 percent over the six-month period from April to October 1998. Noticing this disincentive. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. In many cases. the creditor . This number was at 779 firms in April and grew to 1. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation.281 in April to 2. The reasons are manifold. banks and other creditors were reluctant to absorb losses realized by debt compositions. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. In their first review. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. A debtor whose liquidation value was estimated to be greater than its going concern value was subject to “exit”—meaning the creditors would altogether stop lending and not allow renewal of the existing debt. Locally. Banks did not have the incentive to force financially nonviable firms to liquidate. the number of potential sellers decreased somewhat from 2. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy.138 by the end of October. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. potential foreign buyers waited for the price of acquisition targets to come down further. More than 59 percent of potential buyers were foreign firms. sellers could not find buyers as almost all domestic firms struggled to raise cash for debt reduction and for working capital needs while there was a severe credit crunch following the outbreak of the crisis. The process of voluntary debt recontracting by creditors was prolonged because Korean lending organizations lacked experience and expertise when it involved a multitude of creditors. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. More important. Internationally. Vol.140 Corporate Governance and Finance in East Asia.
A second round of review to select more firms for exit was conducted by the Major Creditors’ Council organized for each of the top five chaebols. two were acquired by newly organized employee stock ownership plans. provided by the World Bank. Among the sell-offs. Corporate Workouts Workouts in the forms of debt rescheduling. . write-offs. By the end of 1998. was allocated to the six largest banks for them to employ outside experts as advisors. and 12 were sold off to other firms. and 16 non-chaebol corporations that had been selected as possible workout candidates. and/or conversion of debt into equity have been applied to those firms that are considered to be viable in the long run and have voluntarily entered into negotiations with creditor banks. but viable. 24 were liquidated. workouts are being applied to non-chaebol firms identified as financially weak. not only for the design of corporate workout programs but also their implementation. The workout plans were completed for most firms by early 1999. FSC has been monitoring the processes from a prudential regulation standpoint. the results thus far have not entirely been as desired. by their creditors. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. These chaebols submitted plans for restructuring to improve their respective capital structures. The plans were put into action immediately following finalization. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. interest reductions. Upon completion of the evaluation. A portion of the Technical Assistance Loan of $33 million. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. three filed for courtsupervised bankruptcy reorganization. 11 were merged into other group members. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. Based on these plans.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. Among the 55 firms selected. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. Also. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks.
chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. Thus. Big deals have been elevated to the status of the most important means of effective corporate restructuring. Foreign investment—in the form of acquisition of controlling interests. In another. it is hoped. some of the acquisition agreements have been discarded for various reasons. the foreign buyer demanded specific protections against adverse developments in the business environment. This figure contrasts sharply with the total of $700 million for all of 1997. uncertainty over the future .5 billion on agreement basis during the 10-month period after December 1997. aircraft.142 Corporate Governance and Finance in East Asia. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Vol. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. enable chaebols to streamline their overly diversified operations and focus on several core business areas. power plant facilities. and petrochemicals. oil refineries. purchase of divested assets. Big deals would. most of the big deals have entered their final stages of negotiation. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. and equity participation—reached about $8. As of April 1999. Big Deals Ever since the outbreak of the economic crisis. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. In the early days after the outbreak of the crisis. In one case. Korea adopted and implemented policies to open its capital market completely. inducement of foreign direct investments was considered to be the most effective means of achieving that end. In the case of automobiles. Restrictions on foreign ownership of land were also abolished. First. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. automobiles. However. labor union demands of the seller were not acceptable to the transacting parties. On 3 September 1998. These deals could eliminate excess capacity in such industries as semiconductors. railroad cars. vessel engines.
(ii) to remove cross-guarantees of loans among group members. Overhaul of Bankruptcy Procedures In February 1998. Seventh.Chapter 2: Korea 143 course of the Korean economy remains high. Fourth. With this in mind. Third. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. Not only does this represent progress in terms of an improved institutional framework for market competition. 2. but it also has important implications with respect to corporate workouts. legal procedures pertaining to corporate rehabilitation and bankruptcy filings were simplified to expedite rulings on the exit of nonviable firms and to ensure better representation of creditor banks in the resolution process for court receivership or court-supervised composition. (iv) to focus on a small number of core businesses.6. (iii) to reduce financial leverage. foreign buyers were concerned with the inflexibility of the labor market. In effect. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. these goals were: (i) to enhance managerial transparency. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. Sixth. The presence of . the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. Fifth. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view.2 Policy Measures for Corporate Reform Goals and Policy Measures for Reform in the Corporate Sector Based on their assessments of what caused the economic crisis in Korea and what needs to be done to overcome it. the widespread practice of cross-guarantees of loans and the lack of corporate transparency could potentially give rise to contingent liabilities to the buyer and this has posed a bottleneck problem to the speedy consummation of deals. and (v) to improve the accountability of controlling shareholders and the board. many of the potential buyers believed that prices asked by sellers were still too high and there would be opportunities to buy assets on fire sales in the future. Second. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. As set forth in the agreement.
Improving Transparency and Corporate Governance9 Transparency and accountability in corporate governance will be promoted by the following measures: (i) consolidated financial statements are required beginning 1999. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. Vol. Fifth. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. Second. (v) all listed companies are required to appoint outside directors beginning 1998 9 This and the following two subsections draw on the Ministry of Finance and Economy. (ii) legal changes have been made so that domestic accounting practices conform to international standards. accounting. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. Korea’s Economic Progress Report.01 percent in May 1998. the new rules made it clear that a court receivership order is available only when the going concern value of the firm under consideration is greater than its liquidation value. and economics professions should be organized to provide for expeditious proceedings in court. First. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. In the past this stage usually extended for as long as two to three years. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. Also. The changes in the reorganization procedures can be summarized as follows. the right to revoke court receivership is allowed to the creditors. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. October 1998.144 Corporate Governance and Finance in East Asia. The purpose of this rule is to shorten the reorganization planning period. number of creditors.” comprised of experts in the legal. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. etc. Fourth. the court may annul its previous decision and force the firm into immediate liquidation. Also. . (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. Third. a “Management Committee. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition.
Chapter 2: Korea 145 (as of the end of May 1998. Korea has rapidly liberalized the capital market by adopting the following measures: (i) the ceiling on foreign equity ownership was completely eliminated in May 1998. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. various supporting measures. Capital Market Liberalization Since 1998. administrative procedures for FDI will be dramatically simplified and made transparent. financial institutions could no longer require cross-debt guarantees. (v) by the end of May 1999.148 industries remain closed. A recent case in point is the penalty imposed by the Fair Trade Commission on chaebol subsidiaries found to be involved in unfair transactions among group members. and (viii) as of 1 April 1998. beginning on 1 April 1999. As for promotion. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. an additional nine industries will be opened or further liberalized. 514 listed companies had appointed 677 outside directors). (iv) during April and May 1998. In addition. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. to FDI). either partially or fully. which was passed in August 1998. 21 industries were further liberalized or newly opened to FDI (now. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. including financial subsidization. (vii) by the end of March 1998. including tax exemptions and reductions. These new standards are and will continue to be strictly enforced. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. and (vi) all current laws related to FDI have been streamlined and incorporated into a single legal framework represented by the Foreign Investment Promotion Act. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. only 31 out of 1. have been instituted for FDI: . According to the law. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998.
Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. Various support measures. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. To minimize potential risks. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. are not risk-free. Vol. Three-year government bonds will be used to establish a benchmark. as well as building an early warning system.146 Corporate Governance and Finance in East Asia. the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. The law allows rental cost exemptions and reductions for FDI. These liberalization measures. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. Also. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). including infrastructure and tax support. It aims to establish a benchmark by consolidating various government bonds. will be provided to foreign firms in the FIZ. however. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market. the Korean Government is strengthening prudent regulations and market monitoring. such as the high-tech industry. These bonds will be issued . The location of the FIZ will be determined at the request of foreign investors. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years.
a primary dealers system will be introduced for healthy financial institutions. and the demand for longerterm bonds increases in the future. but may be extended as required. To ensure transparency and efficiency of the fund operations. This law will not only provide an effective institutional environment for the disposal of NPLs. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. financial institutions . It is now easy for private investors. According to the law. As a pilot program. to establish closed-end investment companies.6 trillion in these funds: W0. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. Related legislation was put into effect in September 1998. and is promoting joint ventures between foreign and domestic agencies. Moody’s signed a joint venture contract with Korea Investors Service. In order to promote a greater market demand for government bonds. The Government established specific qualification criteria and selected the primary dealers in 1999.Chapter 2: Korea 147 monthly. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. invested a total of W1. both domestic and foreign.6 trillion for the debt restructuring fund. including the Korea Development Bank. If interest rates stabilize at a low level. and W1 trillion divided equally between the three balanced funds. These are expected to operate for the next three years. Mutual funds (or open-end investment companies) will be allowed starting 2001. Investment Companies Korea has developed an institutional framework for closed-end investment companies so that they function as a key instrument for long-term financing. they will be managed by foreign investment management companies. It also opened the credit rating service market to foreign competition. but it will also help improve financial institutions’ risk management. Prior to the introduction of this system. In August 1998. with only minor standard exceptions. Twenty-five domestic financial institutions. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more.
As markets become more efficient. A good governance system is essential for the healthy growth of corporations and financial institutions. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. cross-subsidization. For instance. However.g. In principle. unless the limit is tight and binding. On the other hand. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. this regulation may not be effective in curtailing pyramidal structures.148 Corporate Governance and Finance in East Asia. There must be stronger rules to control agency problems. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. is inevitable. greater efforts to improve corporate governance are preferable to regulation of interfirm investment. B investing in C. there is another view that placing a maximum limit on interfirm investments. However. II and qualified public corporations. can utilize ABS. foreign business corporations with good credit standing are now also permitted to issue ABS. Vol. as stipulated by the government measure. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . and other unfair internal transactions among affiliated companies should be stopped primarily by improving rules on corporate governance rather than by boosting the Government’s policing role. However.6..) and the level of interfirm investments is very high. the role of the board of directors as the internal control mechanism must loom large in corporate governance. such as the Korea Asset Management Corporation (KAMCO). Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. and C investing in D. The Government has restored a previously abolished regulation that imposes a ceiling on the total amount that a chaebol company can invest in other firms. then the regulation will inhibit efficient investment of firms. this can only be a temporary measure.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. which is the case for many chaebols. A investing in B. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. Selfdealings. 2. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. More important. when the limit is binding. etc.
and other committees. There has recently been a general shift in individual investor preference from direct personal stock trading to investing in traditional investment trust companies and the newly introduced (closed-end) investment funds. 1997). it will have to include making self-dealings by directors and officers. One way of motivating institutions to do this is to 10 M. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. Since the economic crisis. Latham. The Government has already announced that it intends to amend the Commercial Code to introduce Anglo-American type audit committees as an alternative to the current internal auditor system. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. The Corporate Board. Class action suits are an efficient means for corporate monitoring. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. Companies could also invite nominations from such organizations as the Korea Listed Companies Association or citizens’ coalitions that have been active in monitoring corporate management through proxy solicitations. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. and also negligence of external (independent) auditors actionable. Listing rules may recommend that all or large listed companies adopt an audit committee. governance. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. and requiring that all directors hold shares of their companies.Chapter 2: Korea 149 investors or their trade associations. September/ October 1997. using audit. Institutional investors will play an increasingly important role in corporate governance. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. Further. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. 1997. If and when the law is introduced. 23-26. various measures have been implemented to promote investors’ rights. Proposed: A Governance Monitor. . One action that has yet to be taken is the introduction of an act to facilitate class action suits against corporate directors and internal and external auditors for their wrongdoings. pp.
150 Corporate Governance and Finance in East Asia. Rights of minority shareholders should also be strengthened for these institutions. An efficient means to control problems arising from ownership of financial institutions by industrial capital is to strengthen the accountability and fiduciary duty of the very management of these institutions. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. II provide comprehensive guidelines for their actions in matters related to corporate governance. In the coming years. . and compliance officers. an audit committee. such as the Korea Investment Trust Association. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. The Government can also lower the limits on investments in affiliated companies. Vol. The Government recently proposed the revision of bankruptcy-related laws. securities companies. and impose stronger penalties on violations of the rules on portfolio investments. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. strengthening incentive compensation schemes for executives. Another measure. The institutions’ respective trade associations. important pension funds including public employee funds and teacher funds seem to have their own governance problems because their top management and portfolio management policies are controlled by the Government. Also. and thus cannot be expected to be actively involved in monitoring portfolio firms. Many of the larger investment trust companies. strengthen its supervisory activities. objecting to certain defensive measures proposed by the management. One issue that is being debated is the necessity of the court ordering a firm into bankruptcy once it is found to be nonviable during deliberation on composition or receivership. the Government will have to come up with appropriate policy measures to solve these problems. possibly. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. could prepare such guidelines. by all nonfinancial companies (or “industrial capital”). more drastic in nature. insurance companies. Measures that are being implemented or introduced will require that the management of institutional investors be closely monitored by a board consisting of a majority of independent outside directors. Another concerns whether the court-appointed receiver should be given the power to convene board and shareholder meetings and also to replace directors and officers with court approval. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. etc. reviewing independence and expertise of candidates for outside directors.
Bank boards also need to be made more independent from management. therefore are vulnerable to economic shocks. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. the important issues to be addressed are: (i) improvement of the corporate disclosure system. the banks have great leverage over the management of debtor firms. the limit on ownership of bank shares will have to be eased so that strategic investors (shareholders) can act as true effective monitors of bank management. The Government should substantially reduce the proportion of policy loans from bank loans. bank managers should be made accountable to shareholders but not to the Government. The Government should put more efforts into developing the capital market. Chaebols are overly indebted. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. through them. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date. The public and corporations should be taught or fully informed of the best practices in corporate governance. In turn. private firms. the elimination of implicit guarantees for financial support to chaebols. To facilitate the development of the Korean stock market. excessively diversified into nonrelated business areas. and introducing disincentive schemes for excessive borrowings. lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). (ii) provision of reliable accounting information.Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. and thus full-scale education programs should be developed. which could provide alternative sources of long-term corporate finance. and financial institutions. large firms. and stop unfair internal transactions. to concentrate instead on a small number of core businesses. Many corporations are burdened with excessive debt and. such as application of higher interest rates by banks to chaebols with higher DERs. and (iii) a good corporate governance system to protect investors. This means that the Government can control the banks and. Banks should adopt strong incentive compensation schemes for management. Such measures include providing an effective corporate governance system. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. In order to minimize government intervention in bank and corporate management. The current obligatory system of disclosure that emphasizes “hard” . For this. and consistently show low profit rates. reduction of protection of domestic markets and entry barriers.
Currently.152 Corporate Governance and Finance in East Asia. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. on a real time basis. no economic reforms will be effective. wage rates. . At the same time. the information system of the bond market should be better organized to transmit. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts. especially among business people. In determining optimal exchange rates. politicians. These should be lengthened to make them a source of stable long-term funds. The development of the OTC bond market requires a well-developed dealer system. Without successfully addressing this problem. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. The establishment of a Corruption Prevention Institute will be helpful in this regard. and labor productivity should be considered. penalties on violations of disclosure rules are not effective enough to have a significant impact. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. is considered to be one of the major causes of the economic crisis. and measures to reduce corruption. Policies are needed to help develop more reliable services by bond rating agencies. Future research could include causes of corruption. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates. reasons for different degrees of corruption in various countries. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. One of the significant changes in the bond market after the economic crisis is that most corporate bonds are now issued nonguaranteed and on the basis of credit quality of the issuer. and bureaucrats. Prevalent corruption. Vol. The function of securities companies as dealers of bonds should be improved. The network should cover not only the exchange market but also OTC transactions of investors and dealers. data on quotations and trading volumes.
Korea’s Financial System. 1995. I. 1996. Understanding Flow of Fund Accounts. 1996. K. S. 1989. I. Kim. Korea’s Chaebol. in Korean Managerial Dynamics. various issues. Bank of Korea. 1999. H. Jae Woo. Korea’s Large Conglomerates. Bank of Korea. C. S. D. Survey of Facility Investment Plan. and J. Lee. W. Chung. pp. September 1998. Y. Hong. various issues. S. New York: Praeger. Japanese Zaibatsu and Korean Chaebols. 1998. and 1998 issues. Lee. Is the Fair Trade Policy Fair? Korea Economic Research Institute. 7995. Cho. Kwon. 1997. Bank of Korea. 1996. H. . 1997. Kang. Proposed: A Governance Monitor. Market Concentration and Diversification of Business Groups. Cho. 79-95. various issues. Kim. Center for Free Enterprise. 1994. 1995. Korea Development Bank. K. Korea Economic Research Institute. edited by K. S. Chon. Financial Studies. Hong Moon Sa. S. Lee. C. 1993. Financial Statement Analysis Yearbook. Corporate Restructuring. KERI. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. pp. C.). H. International Financial Statistics. KERI. Hattori. W. T. An Empirical Evidence on Value of a Firm and Ownership Structure. International Monetary Fund. H. H. September 1998. Chung and H. Korean Managerial Dynamics. D. Choi. September 1997. Chon. W. Tomio. The Corporate Board. Korea Economic Research Institute... M. S. 1997. 1989. W. and H. Ju Hyun. New York: Praeger.Chapter 2: Korea 153 References Bank of Korea. and K. Determinants of Diversification of Korean Business Groups. 23-26. N. Financial Studies. September/October 1997. Lee (eds. KERI. pp. Jua. 1998. 1997. Evolutionary Chaebol. Latham.. Kim. Maeil Daily Economic Newspapers. 1992. Economic Statistics Yearbook. Bibong Publishing Co. various issues.
1999. Kim. 1996. 1998. K. A New Trade and Industrial Policy in the Globalization of Korea. Ministry of Finance and Economy. C. C. H. Lee. 1995. Background and Task of Structural Adjustment. Capital Liberalization. Yonsei University. Ungki. Chung Ang University. Corporate Governance in Korea. and J. Joh. S.. I. Wang. Conference on Corporate Governance in Asia: A Comparative Perspective. S. 1996. 1998. October 1998. . Management Research Institute.. Korea Institute for Industrial Economics and Trade.. Korea Finance Institute. II Lee. K. Korea Institute for International Economic Policy. Chicago. Real Exchange Rate and Policy Measures. W. Beyond the Limit. S. 1998. and H. Sohn. Vol. and J. J. September 1998. S. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Korea Institute for International Economics and Trade. Yang. J. March 1999. I. 1999. Kang. Y. K. Whang. U. Ungki. Kim. Korea’s Economic Progress Report.154 Corporate Governance and Finance in East Asia. Seoul. Nam. Lim. 2nd Sangnam Forum. KIET Occasional Paper No. 23. J. 1998. November 1996. Y. KIEP Working Paper 98-05. Lim. Korea Development Institute and World Bank. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Yim. Annual Conference of Financial Management Association. Korea’s Trade and Industrial Policies: 1948-1998. October 1998. Business Groups in Korea: Characteristics and Government Policy. Lee. H. Whan. January 1995. Y.
PSR Consulting. the PSR Consulting.3 The Philippines Cesar G. The Government pursued the privatization of various state-owned corporations as part of its financial rehabilitation programs sponsored by the World Bank and the International Monetary Fund (IMF).. Serrana. for their research assistance. Roble. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. Inc. . after the completion of debt negotiations with the IMF and Paris Club. and government subsidies were tackled during that period. the Philippine economy and corporate sector were in a relatively sound financial position. From 1993 to 1996. staff. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. Companies of other Asian countries were already using these markets to finance investment and growth. The Asian financial crisis revealed that. Saldaña1 3. The lifting of the debt moratorium in 1991. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. 1 Principal. Denise B. When the Asian crisis erupted in 1997. state-sanctioned monopolies. Issues such as State ownership of businesses. the Philippines. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. The author wishes to thank Juzhong Zhuang. healthy profits from the previous five years and new equity raised through successful initial public offerings (IPOs) in a robust stock market allowed the corporate sector to accelerate investments and borrowings. the Philippine Stock Exchange for its help and support in conducting company surveys. overall. both of ADB. about a decade before the recent Asian crisis. in particular Francisco C. and Lea Sumulong and Graham Dwyer for their editorial assistance. David Edwards. Inc.1 Introduction In recent years. and Liza V. Pineda. This has come about following a political and economic upheaval from 1983 to 1987.
yet they did not risk new capital required for modernizing and expanding manufacturing capacity. 3. An industrial elite. It analyzes the impact of corporate governance on company financial performance and financing. and on the financial crisis. Companies finance long-term investments with short-term debt. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. But protectionist policies made labor relatively more expensive and. which leads to their easing of due diligence and monitoring standards when lending to group members. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. composed mostly of families previously in trading businesses. To implement these policies.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. This study reviews the Philippine corporate sector in terms of its historical development. These early industrialists naturally opposed any initiative to reduce tariffs. therefore. their growth could not be sustained. regulatory framework.2. emerged to influence industrial policies. usually with the acquiescence of bank creditors. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. companies were necessarily large and capital-intensive. patterns of ownership.2 3.156 Corporate Governance and Finance in East Asia. Vol. The Board of Investments (BOI) was created to draw up an investment priorities . patterns of financing. control by internal and external governance agents. Corporate financing relies excessively on bank loans. Companies were profitable because of protection from foreign competition. While new manufacturing industries were successfully established. on family-based and controlled conglomerates. the Government overvalued the local currency and imposed high import tariffs. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. Banks have significant presence as members of affiliated business groups. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. and responses to the financial crisis. II Still. The policy was crafted by the martial law regime at that time. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies.
It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. dominance by large companies. including the reduction of tariffs. advance notice of areas where the country disallowed or restricted foreign investment.” No strategic industry could take off without the Government’s participation in its management and operations. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. Starting in 1981. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. the “pioneer” industries identified in the IPP. made less associated with capital investments. Following government initiatives in the control of the infrastructure and utilities sectors. the top three companies accounted for a disproportionately large share of total sales and assets. the State took over the generation and distribution of electricity. quantitative restrictions. i. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. assumed ownership of the largest petroleum refining company. organizing industries into sectors and picking “winners. and orientation toward domestic markets.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives. In 1991. and initiated the development of alternative energy sources in response to the oil crises. the legislative body passed the Foreign Investment Act (FIA). Nevertheless. Exports were not competitive because of the high costs of imported materials. and oriented toward exports. In the early 1990s. The 1980s were marked by a peaceful transition of political power. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration. the Government continuously revised the enabling law of BOI so that incentives were reduced in number. Foreign ownership was allowed only in industries with high technological and market barriers. and import licensing requirements.e. The high industrial concentration led to practices of price leadership and output restrictions and the rise of industry lobby groups—common features of an oligopolistic . The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. In many industries. Reforms in policies.. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. The Government signaled through the IPP its intent to shape the future industrial landscape.
8 4.9 6.000 corporations.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3. only to be unsettled by the crisis of 1997.5 8.2 9.1 5.8 10.7) (10.3 7.8 5.7 (13.2 Thailand 11. however.000 Corporations covers financial and nonfinancial companies.0 (6.9 (1.1 4. only nonfinancial companies were used.7 5.2 During 1988-1997.2 Korea.3 9.5 percent per year (Table 3.0 8.5 9.5 8. Vol.4 Philippines 3.6 7.2).5) 3.8 8.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.000 Philippine companies grew 17.3 8.1). which was taken as a representation of the Philippine corporate sector.4 4.0 (0.2. 3.0 7.9 7. net sales of the top 1.2 7. of 9.7) 10.7 8.9 5. Table 3. This rate of growth was sustained by a comparable 18.8 8.3 2.2 (0.5) 5. II market.5 (7.2) 4. Its growth rate began to catch up with others in 1996.1 8. Key Indicators of Developing Asian and Pacific Countries 2000. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context. .8 5.3 9.158 Corporate Governance and Finance in East Asia.2 7.1 5.2) 0. In this section.0 8. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.1 GDP Growth of Southeast Asian Countries.2 Source: ADB.7 Malaysia 9. Rep. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.2 8. With economic reforms introduced in the 1980s and 1990s.6) 0.
2 378.3 68 7.6 149 12.3 898 1.6 1.4 1.332.4 776.6 5.2 136.7 238. 1988-1997 1989 519.1 Other Indicators No. Source: SEC-BusinessWorld Annual Survey of Top 1.5 51 4.9 78 6.3 941.7 28.341.131. .561.9 3.8 5.1 6.1 51.9 1.4 3.2 Average 146 12.6 1990 1991 1992 1993 1994 1995 1996 1997 1.4 555.4 188.1 5.2 2.0 148.2 4.1 1.2 900.3 306.6 102 16. turnover = net sales/total assets.6 896 0.978.9 896 2.0 1.2 Growth and Financial Performance of the Top 1.4 861.3 862.123.9 2.893.5 887 0.5 1.1 54 11.4 411.3 46.6 144.000 Companies.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.6 426.512.2 Compound Growth (%) 17.317.6 290.0 900 1.1 714.Table 3.3 60 10.7 443.8 77 7.5 1.7 1. return on equity (ROE) = net income/ stockholders’ equity.3 121 12.000 Corporations in the Philippines.6 75 6.7 20.5 570.5 192.8 618.5 4.5 14.697.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464. return on assets (ROA) = net income/total assets.177. of Companies Sales per Company (P billion) 899 0.781.191.1 66 12.9 480.4 898 1.9 617.3 107 13.8 902 1.1 881.394.4 260.5 193.2 338.8 22.1 197 14.1 181 11.160.5 72 7.6 900 1.1 72.8 6.9 898 1.5 446.1 468.1 615.7 1.1 1.209. net profit margin = net income/net sales.1 33.7 218.2 27.1 95.5 119 12.2 2.9 96.9 629.1 4.4 63.4 602.5 64.8 741.6 35.4 8.5 508.7 73 6.647.5 Leverage = total liabilities/stockholders’ equity.8 411.6 954.9 952.6 18.5 1.225.1 73 5.2 1.7 903 0.8 4.6 109 12.8 26.0 1.9 149 6.3 382.2 707.
7 percent.4 24. Total assets grew at an average annual rate of 22.5 Ratio of Estimated Value Addeda to GDP (%) 17.427 13.2 percent. Key Indicators of Developing Asian and Pacific Countries 1999.248 1. Sources: ADB.3 percent.693 1.5 Value-added is assumed to be 30 percent of net sales. Net profit margins for the top 1. 1988-1997 Top 1.1 19.172 2.000 Corporations in the Philippines. .8 17.5 17.697 1. and the SEC-BusinessWorld Annual Survey of Top 1.8 percent per year.979 17. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997. These rates of return are high compared with other Asian countries.1 Net Sales (P billion) 465 519 630 741 862 954 1. various years.4 20.178 1. Return on equity (ROE) and return on assets (ROA) averaged 12. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.160 Corporate Governance and Finance in East Asia. respectively. and by equity that grew at a higher average annual rate of 26.9 percent for the period.6 percent and 5. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. II assets. Vol. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.077 1.474 1.9 23. but the extent of the increase was not as dramatic as in other Asian countries.906 2.3 The Corporate Sector and Gross Domestic Product.394 1. Further. Asset growth was funded by debt that grew at an average of 20.352 1.9 21. leverage increased from 109 percent in 1996 to 149 percent in 1997.5 16. Assuming Table 3. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. for the 10-year period.3). This is high compared with developed countries but compares favorably with other Asian countries.8 19.000 companies averaged 7.
3 42.0 142 22. of Companies 73 Sales per Company (P billion) 2. The premise is that these variables have a direct bearing on corporate performance and growth.9 196 1. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.5 27.7 22.4).1 Financial Ratios (%) Leverage 89 ROE 15.5 23 4.8 22.0 31.4 Stockholders’ Equity 32.8 ForeignOwned 21.3 146 6.5 Retained Earnings 30.4 28. and (iv) privately owned. privately owned companies constituted the largest group (Table 3.0 Turnover 53 Net Profit Margin 15.4 Fixed Assets 19.6 Total Assets 29.2 103 5.8 14.3 11.3 22. corporate control structure.9 158 13.5 Other Indicators Share of Sales (%) 17.7 2.5 GovernmentOwned 4.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.9 26. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.8 3.Chapter 3: Philippines 161 a constant ratio of value added to sales.3 9. various years.8 Growth Indicators (Compound Annual Growth Net Sales 20.0 4.000 Corporations in the Philippines.1 ROA 8.9 17.1 12.1 22 10. %) 17. size. . The foreign-owned companies were the Table 3.8 percent of the corporate sector’s total sales between 1988 and 1997. 1988-1997 Indicators Publicly Listed Privately Owned Rate. A study of company performance by ownership type.8 2.8 606 0. Averaging 42.3 22.0 5. (iii) Government-owned. (ii) foreign-owned.8 No.2 9.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.0 Net Income 19.4 190 5.9 22.0 5. these figures suggest a significant and increasing contribution of the corporate sector to GDP.4 Total Liabilities 26.0 28.3 27.
But by being most efficient in employing assets. . and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration.3 percent. Vol. foreign-owned companies borrowed more than publicly listed ones. Privately-owned and Government-owned companies grew at slower rates.5 percent average growth rate of the entire corporate sector. selling an average of P4. compared with P2. It should also be added that the profit margin of Government-owned companies is distorted by the presence of holding companies such as the Philippine National Oil Company. or 38 percent. and the second lowest asset turnover.2 percent and ROA of 9. the highest net profit margin of 15.9 percent. the asset base is large. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. although small in number. were among the top 1. The government-owned companies had the highest leverage at 190 percent but lowest ROA and ROE because these are primarily public utilities and companies in the energy sector where turnover is low. The compound annual sales growth rate was 21. while there were few of them.000 list. Their ROA and ROE were both more than twice as high as those of government-owned companies. with an average ROE of 22. However. these companies were comparatively large. registered the largest per company sales at about P9 billion in 1997.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997.162 Corporate Governance and Finance in East Asia.000 companies in 1997.5 percent. but lower than those of foreignowned and publicly listed companies. a level high by Western standards but at par with those of other Asian countries.1 billion per company in 1997. exceeding the 17. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. the second best ROE and ROA. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). These were mostly large public utilities. With an average leverage ratio of 142 percent. meaning that the remaining 62 percent were relatively small in sales and assets. The privately-owned companies had a high average leverage ratio of 158 percent. they generated the highest return on investments. Governmentowned companies in the top 1. II second largest at about 27.75 billion per company for foreign-owned companies. Publicly listed companies had the lowest leverage at 89 percent. Bases Conversion Development Authority. and low return on investment is the norm. Publicly listed companies had a minor though steadily increasing share in total sales. followed by publicly listed ones.
7 2.000 Corporations in the Philippines.3 Total Liabilities 30.8 ROA 8.0 55.6 715 0. Performance by Firm Size By firm size.8 6.5).2 Net Income 21.1 Source: SEC-BusinessWorld Annual Survey of Top 1.4 24.0 166 15. and small companies. Sales and resources of the . of Company 159 Sales per Company (P billion) 2.6 26. a company can be a member of a conglomerate or independent.Chapter 3: Philippines 163 Performance by Control Structure By control structure. various years. But the conglomerates were larger measured in sales per company.3 Financial Ratios (%) Leverage 98 ROE 15. had a lower leverage ratio. %) Net Sales 20.7 Total Assets 32.8 Growth Indicators (Compound Annual Growth Rate. Table 3. medium.3 percent for the conglomerates.0 25.1 124 5. and achieved higher returns on invested assets than independent companies (Table 3. compared with 32. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.2 Fixed Assets 25.1 Retained Earnings 32.3 No.0 Turnover 67 Net Profit Margin 12. the corporate sector is divided into large.5 Growth and Financial Performance of the Corporate Sector by Control Structure.2 23.7 Stockholders’ Equity 34. 1988-1997 Indicators Group Member Independent 18. depending on assets and sales. grew faster.0 22.3 Other Indicators Share in Sales (%) 32.
1 No.5 73 6. of Companies 79 Sales per Company (P billion) 7.9 89 1. averaged a far less P3 billion in per company sales. averaged only P920 million in per company sales during the same year.3 Turnover 65 Net Profit Margin 8.2 Stockholders’ Equity 18.1 4.5 128 10.9 32.000 list. various years.5 12.000 list.5 25. referring to the remaining companies in the list. Medium-sized companies also performed better in terms of ROE. 1988-1997 Indicators Large Medium 19.0 156 16.9 Financial Ratios (%) Leverage 158 ROE 13.1 percent of the total sales of the corporate sector.7 44.5 Growth Indicators (Compound Annual Growth Rate. Sales per company in this group averaged P13. Table 3.2 Other Indicators Share in Sales (%) 56.1 ROA 5.5 Total Assets 18.8 percent of the total number of companies in the list (Table 3.164 Corporate Governance and Finance in East Asia.3 Fixed Assets 15.0 730 0. %) Net Sales 15. for this study. II Philippine corporate sector are highly concentrated among the large companies.6 31.2 25.4 billion in 1997. while small companies.1 25.6 49.0 32. Vol.000 Corporations in the Philippines.3 Source: SEC-BusinessWorld Annual Survey of Top 1.4 28. are defined as the largest 100 companies in the top 1.0 7. which. Large companies accounted for 56.6 36. although they comprised only 8.6 Growth and Financial Performance of the Corporate Sector by Firm Size.7 Net Income 1.6 Small 19.9 26. averaging 16 percent.1 81 9.9 Retained Earnings 13. defined in this study as the next 200 largest companies in the top 1.4 Total Liabilities 18. sales of mediumsized companies grew faster than large companies. . However.2 29. indicating that they deployed resources more efficiently than large and small companies.6). Medium-sized companies.6 47.
Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales.7. at 128 percent for the period. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. and utilities and services sectors.7 percent in 1996 to 8. unlike their counterparts in other Asian countries. of net income. net income. The sector showed consistent growth in sales. net income. Leverage was the highest for large companies.4 percent in 1997 from 11. But small companies’ leverage was significantly lower. showed the lowest ROE. i. profits. but suffered its largest decline in net profits in 1997. but lower than that of construction.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997.5 percent for medium-sized companies and 8. especially during the period 1994-1996.7 percent in 1997 for medium-sized companies. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. The growth and financial performance of selected industries. assets. at 156 percent. at 158 percent on average during 1988-1997. reflecting to some extent a “bubble” phenomena in the former two sectors. and construction.7 percent a year earlier.7 billion and P35.Chapter 3: Philippines 165 Small companies. The Asian financial crisis affected large companies most severely. Poor returns appear to have been caused by the low profit margin at 6. and utilities and services sectors. real estate. manufacturing.8 billion in .1 billion in 1996 to P4. ROE dropped to 7. as indicated by the negative annual growth. utilities. and assets was much higher for the real estate and property. Sales revenue and net income declined from P76. and the construction sectors than for the manufacturing. specifically those industries least and most affected by the financial crisis.1 percent.8 percent in 1997.2 percent for large ones.2 billion in 1997 for this sector.. with their ROE dropping to 3. and profitability in 1997 when the crisis started. averaging 10. Growth of sales. Performance by Industry This study also looked at corporate performance by industry. For small companies. are shown in Table 3. compared with 9.6 percent. from 14. The real estate and property sector also suffered significantly in sales. Mediumsized companies’ leverage level was slightly lower. although the largest in number.8 the previous year. Net income declined from P54. Large.e.8 percent. and equity up to 1996. ROE dropped from 10. at -12.
4 Total Assets 19. II Table 3.000 Corporations in the Philippines.7 percent to 10.6 No.8 Stockholders’ Equity 21.9 2.0 23.9 17.6 69 16.3 20.0 21.7 ROA 5.2 12.6 Financial Ratios (%) Leverage 142 181 ROE 13. it does not appear to have been excessively exposed to foreign currency-denominated loans. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.8) 17.3 5.7 billion in 1997. 1996 to P56.9 billion and P24.3 Retained Earnings 17. the sector’s ROE dropped from 15.0 Turnover 112 24 Net Profit Margin 5. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.166 Corporate Governance and Finance in East Asia.7 83 2.9 5.6 Growth Indicators (Compound Annual Growth Rate.4 Source: SEC-BusinessWorld Annual Survey of Top 1.4 16.7 192 9.3 Fixed Assets 20.7 10.6 Total Liabilities 18.7 19.1 24 42. of Company 454 17 Sales per Company (P billion) 1.7 Net Income (12.000 companies’ total sales on average during 19881997.0 31 0.2 45.0 25. and was also much more limited compared with the property sectors in other Asian countries.4 percent.5 Other Indicators Share in Sales (%) 82.7 Growth and Financial Performance of the Corporate Sector by Industry. 1988-1997 Utilities Real Estate and and Services Property 39.5 12.8 48.2 37.7 28.9 23.7 Indicators Manufacturing Construction 27. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis. . various years.2 28 0.8 41. Vol.1 2.2 8.9 2.7 52.1 10.3 55. %) Net Sales 16.4 3. As a result. respectively.4 19. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.
and recognized rules on corporate practices. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. (ii) purpose of the corporation. (vi) names. (vii) number.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. Overall. contains some provisions affecting corporations’ dealings with banks. It specifies the minimum information to be indicated in the articles of incorporation. and residences of original subscribers. and the Insolvency Law. par value. For publicly listed companies. and amount subscribed and paid by each. and dissolution of corporations.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. and amount of authorized capital stock. It provides the basic constitutional structure for the organization. The currency devaluation bloated the foreign currency-denominated loans of these companies. The General Banking Law. the leverage of all four industries was low. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. and restrictions. nationalities. the Corporation Code of 1980 is a compilation of important juridical rulings. unlike in neighboring countries hit by the Asian crisis. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. reaching up to 313 percent in 1997. which was based on American corporate law. One month after registration. (iv) term of existence. . and residences of incorporators and directors.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. The articles of incorporation may also include other matters such as waiver of preemptive right and classes of shares such as founders’ or redeemable shares describing their rights. (v) number of directors (not less than five nor more than 15). nationalities. Under the Code. (iii) principal office. which is also the organic law governing the operations of SEC. and (viii) names. operation. Amendments to the articles of incorporation require approval by a majority of the board of directors and a two-thirds vote of outstanding capital stock.2. privileges. administrative regulations. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. Two other pertinent laws are Presidential Decree (PD) 902-A. which regulates banks and nonbank financial institutions except insurance companies. 3.
and compensation of directors. the bylaws must be consistent with the law. and should not impair vested rights. duties. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. PD 902-A also granted SEC the exclusive jurisdiction to hear and decide cases involving: (i) complaints about devices or schemes employed by the board of directors and officers amounting to fraud and misrepresentation that may be detrimental to the interest of the public or shareholders. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. (iii) controversies in the election or appointments of directors and officers of corporations. To be valid. (iv) time for holding annual election of directors and manner of giving the election notice. (ii) controversies arising out of intra-corporate relations. supervision (regulatory). and public policy. In 1976. between the shareholders and the corporation.168 Corporate Governance and Finance in East Asia. Its mandate is to supervise corporations in order to encourage investments and protect investors. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. However. among shareholders. must be general. directors. manner of voting. (vi) penalties for violation of the bylaws. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. . or officers. uniform. officers. (ii) required quorum in shareholders’ meetings. and reasonable. and forms of proxies and manner of voting them. the corporation’s articles of incorporation. place. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock.4 Philippine corporate law distinguishes between management decisions that require only a majority vote of the board and major decisions that require a two-thirds majority vote of shareholders. (v) manner of election or appointment and term of office of all officers other than directors. and employees. Vol. and (iv) petition of corporations to be declared in a state of suspension of payments in cases when their assets cover all debts but they cannot pay these debts when they fall due. II to adopt a code of bylaws or rules for its internal governance. (iii) qualifications. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. and between the corporation and the State concerning its franchise or right to exist. and manner of calling and conducting regular or special meetings of the directors and shareholders. In addition. and control (adjudicative) of all corporations. and (vii) manner of issuing certificates in the case of stock corporations.
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The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for “suspension of payments” to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors’ properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the country’s facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a “self-regulated” organization. Thus, PSE now
170 Corporate Governance and Finance in East Asia, Vol. II
has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchange’s rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks’ voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks’ voting shares.
Chapter 3: Philippines 171
Regulations on the single borrower limit (SBL) put a ceiling on the maximum amount that a bank can lend to a debtor. SBL rules limit the total liabilities of any borrower of a commercial bank to 15 percent of the bank’s unimpaired capital and surplus, and an additional 15 percent for “adequately secured loans,” to a maximum 30 percent (“unimpaired capital and surplus” refers to the total paid-in capital, surplus, and undivided profits, net of valuation reserves of a bank). SBL limits exclude risk-free loans such as Government-guaranteed loans and loans secured by cash deposits. Total corporate liabilities include all liabilities of the debtors and their majorityowned subsidiaries. The Monetary Board may prescribe the consolidation of the liabilities of subsidiaries with the parent corporation under certain conditions. Central Bank (Bangko Sentral ng Pilipinas [BSP]) regulations do not prohibit loans by the bank to its directors, officers, shareholders, and other related interests, known as DOSRI. However, they are subject to certain prudential requirements under banking laws, as follows: (i) a director or officer of a bank can only borrow or become a guarantor, endorser, or surety for loans from the bank with the written approval of all other directors of the bank (i.e., excluding the director concerned); (ii) the amount of outstanding credit accommodations that a bank extends to its shareholders shall be limited to an amount equal to the sum of their unencumbered deposits and book value of their paid-in capital contributions; and (iii) loans and advances given to officers in the form of fringe benefits shall not form part of liabilities under DOSRI.
Corporate Ownership and Control Patterns of Corporate Ownership
The historical development of Philippine corporate ownership is rooted in the country’s colonial past, the industrial policies of the Government, and the recent emergence of industrialists and an entrepreneurial class. During the Spanish and American period up to World War II, a small number of families acquired land and owned large businesses. These families built and preserved their businesses over several generations. Many of them became controlling shareholders of family-based corporations and business groups that are major players in the present-day Philippine corporate sector. Ownership is a key element in corporate control and governance. Public listing rules of PSE require that a minimum of 10 to 20 percent of
172 Corporate Governance and Finance in East Asia, Vol. II
outstanding shares, depending on the size of the company, be available for trading in the stock exchange. As companies usually only issue the minimum required number of shares, large blocs of controlling shareholders often dominate corporate decision making in publicly listed companies. Public investors and minority shareholders are not in a position to influence management. Moreover, the presence of large controlling shareholders makes takeovers by other companies difficult. For these reasons, the resolution of conflicts between the interests of controlling shareholders, minority shareholders, public investors, and creditors in Philippine companies depends very much on the effectiveness of internal control systems. Ownership Concentration of Listed Companies This study measures ownership concentration in terms of shareholdings by the top one, five, and 20 shareholders.5 Table 3.8 shows that the top shareholder owned 40.8 percent of the market value of an average nonfinancial company. The shareholding of the top shareholder varied across sectors. It was highest for the property sector at 54.8 percent, followed by holding companies (as a sector) at 53 percent. One shareholder held majority control of an average company in these two sectors. The average shareholding of the largest shareholder was less than 25 percent only in sectors with large market capitalization, such as power and energy, and transportation, and in sectors with high risks, such as oil exploration and mining. These figures suggest that for publicly listed companies, a single shareholder often has substantial or even dominant control. Combined, the holding of the top five shareholders in an average company was about 65.3 percent for the nonfinancial sector and 59.2 percent for the financial sector. The five largest shareholders held majority control over an average Philippine publicly listed company, except in three sectors—transportation; food, beverage, and tobacco; and oil exploration. Ownership by the five largest shareholders was on average most concentrated among holding companies (78.4 percent), and in construction (74 percent), property (69.8 percent), manufacturing and trading (68.4 percent), and communications (67.3 percent).
The study derived ownership data for 194 (169 nonfinancial) companies out of 221 (190 nonfinancial) listed on the Philippine Stock Exchange as of 1997. Shareholdings by the top one, five, and 20 shareholders were estimated for each company and averaged by using the market capitalization of each company as a weight.
Chapter 3: Philippines 173
Table 3.8 Ownership Concentration of Philippine Publicly Listed Companies by Sector, 1997
Sector Financial Institution Banks Financial Services Average Shareholdingb Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food, Beverage, and Tobacco Holding Companies Manufacturing, Distribution, and Trading Hotel, Recreation, and Other Services Property Mining Oil Average Shareholdingb
Top 1 26.9 41.3 27.2 35.4 21.5 23.8 47.7 22.7 53.0 37.4 28.9 54.8 23.4 19.9 40.8
Top 5 59.2 63.2 59.2 67.3 55.4 48.4 74.0 44.1 78.4 68.4 55.3 69.8 56.0 45.1 65.3
Top 20a 76.4 65.8 76.2 76.9 72.1 69.2 86.2 69.7 86.0 42.6 68.0 74.5 51.9 64.3 75.9
Information on the top 20 shareholders is not available for five holding companies, 10 manufacturing companies, and two property companies. b Weighted by market capitalization. Source: PSE databank.
The shareholding of the 20 largest shareholders in an average company was 75.9 percent for the nonfinancial sector and 76.2 percent for the financial sector. In 12 out of 13 sectors, the top 20 shareholders owned more than 50 percent of the voting shares of an average company. In 10 out of 13 sectors, the top 20 shareholders held more than a two-thirds majority control of an average company. Ownership Concentration at Critical Levels of Control PSE listing rules require that a minimum of 10 to 20 percent of outstanding shares of a company be issued to the public, depending on its size. An interesting question is whether in reality Philippine publicly listed companies issue enough shares to be truly widely held or whether they barely meet this minimum requirement. The answer to this can be gleaned from an
There are advantages to establishing pure holding companies. In four of 11 nonfinancial sectors. In 76 companies. nonfinancial corporations held majority control. the top five shareholders held more than two-thirds majority control of a company. the top five controlling shareholders were classified into eight groups. the top 20 shareholders collectively owned a majority of a company’s shares. five. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. In 111 companies. In 21 companies. or 80 percent (only nominally publicly listed) of outstanding shares. including pure holding companies. In 116 companies. The largest group is nonfinancial corporations. which are mostly privately owned and controlled by family-based shareholder blocs. II analysis of the number of companies in which the top one. Who are the top one. and 20 shareholders? In Table 3. and share prices are sensitive to movements of foreign funds. Vol. a single owner owned more than 80 percent of outstanding shares. or 14 percent of the total.10. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. controlling an average of 52. large and family-based shareholders pool the family’s ownership over many . the top five shareholders owned more than 50 percent of the voting shares.2 percent of outstanding shares of publicly listed companies. or 78 percent of the total. or 51 percent of the total. or 3 percent of the total. holding only an average of 2.9 shows that in 44 companies. 66 percent (signifying strategic control). Table 3. In four companies.174 Corporate Governance and Finance in East Asia. or 20 shareholders owned more than 50 percent (signifying operating control). Through these. With such high levels of ownership concentration. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. five. a single shareholder held two-thirds majority control.1 percent of publicly listed companies in the Philippines in 1997. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. Individuals did not constitute a significant shareholder group among the top five shareholders. minority shareholders are unlikely to be able to influence the strategic and operating decisions of a company without the support of one or more large shareholders. or almost 75 percent of the total. a single shareholder held operating control of a company. The shares of publicly listed companies are thinly traded and illiquid. or about 30 percent of the total.
Source: PSE databank. Distribution. 1997 % of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 — 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 — — 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 — 13 7 — 2 — — — 3 Top 5 40 33 50 28 27 50 — 28 30 Top 20a 60 67 64 20 47 50 43 36 45 Sector Communication Construction Food.Table 3. and Tobacco Manufacturing.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. . 10 manufacturing companies. Beverage. and two companies in the property sector. a Data for top 20 shareholders were not available for five holding companies. and Trading Holding Power Transportation Property Total — = not available.
3 26.8 21.5 0. and Trading Hotel.9 0.0 5.1 a Weighted by market capitalization. . and Tobacco Holding Companies Manufacturing.0 10.0 0.2 3.3 5.6 9.3 0.3 37.0 0.3 1.2 3.0 1.0 5.7 0.7 67.1 1.6 0.7 3.4 29.3 1. Beverage.0 1.5 4.6 0.0 4.0 1.5 4.8 66.3 0.0 5.4 2.0 0.2 0.0 1.4 0.5 53.6 33.2 1.6 0.7 0. Distribution.3 12.2 59.6 2.5 13.1 0.0 7.6 12.0 0.2 3.0 0.0 0.2 10.9 0.0 45.0 0. Recreation.0 0.4 5. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.1 8.7 1.0 0.4 8.0 0.9 6.7 3.8 0.5 26.0 0.1 9.0 1.9 36.0 2.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.1 0.6 5.2 0.2 0.6 1.6 2.6 0.0 1.8 0.4 1. Source: PSE Databank.7 0.8 0.0 0.0 5. and Other Services Property Mining Oil Average Shareholdinga 33.3 0.7 0.5 12.1 6.3 5.3 0.0 2.0 1.9 52.1 5.Table 3.8 11.0 0.1 7.6 0.3 0.5 0.2 5.2 0.0 0.0 0.4 19.6 0.6 0.7 0.5 2.7 0.6 18.0 1.2 0.2 3.3 2.
1 percent).6 billion or 26. Petron and MERALCO in power and energy. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). Insurance companies were very minor investors in the stock market because prudential regulations prevent them from investing significant amounts even in equities of large companies. and San Miguel Corporation (SMC) in food and beverages.2 percent shareholding by the financial institutions was even inflated to some extent because securities brokers held trading portfolios for their clients rather than long-term investments. Investment trust funds were the most important institutional investors. Privately-owned pure holding companies own a majority of shares and exercise control of publicly listed holding and operating companies through a multilayered pyramid structure. securities brokers (1. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries.6 percent of market capitalization in 1997.7 percent of market capitalization of the nonfinancial publicly listed companies. Holding companies were themselves 66 percent owned by other nonfinancial corporations. As a group. accounting for P258. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications.2 percent in 1997. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies.3 percent). respectively. Such advantages have contributed to the popularity of holding companies among publicly listed companies.1 percent). there was no real market for investment information. The investment funds’ presence in these sectors ranged from 8.7 percent of shareholdings). Because of limited ownership by institutional investors.5 to 12. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. and insurance companies (0. financial institutions did not have a significant ownership in nonfinancial corporations. while still allowing the public to own minority shares. Holding companies as a sector had the largest market capitalization in PSE in 1997. commercial banks (1.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. They can also better manage their income taxes because income from affiliated companies passes through a holding company. with an average of only 7. . The 7. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4.
using data on the Philippines’ top 1.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3.000 Corporations in the Philippines. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. suggesting that most publicly listed companies are parts of business groups. This is significant considering that there were only 31 local commercial banks in the country in 1997. many companies in family-owned groups are not publicly listed. Most family businesses that went public did so because they wanted to raise capital and to gain the prestige associated with being a public company. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks.7 6 7 The study used publicly available shareholder information and published reports.8 percent of total companies in number.000 corporations’ sales. the study put together a list of prominent business groups. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). Vol. about three fourths.11). However. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group.4 percent of the top 1. Prudential regulations. including 16 commercial banks. and tracked the financial performance of each company from 1992 to 1997. remain in force to control excessive lending of banks to insiders. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. For this reason. so far limiting their involvement to selected products. All major industries were represented. of the financial resources in the country. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. A common feature of corporate ownership of a business group is the centrality of a commercial bank.178 Corporate Governance and Finance in East Asia. Still. Large shareholders and their families own these banks directly or through their controlled companies. identified the companies belonging to each of these groups. . To understand the ownership and governance characteristics of family-owned business groups. The Central Bank deregulated interest rates and foreign exchange. including SBL and DOSRI rules. but they comprised only 23. Family-based groups have larger companies since their total sales were about 33.000 companies. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Some 20 financial institutions were affiliated with these groups. and increased the capital requirements for all types of banks. Commercial banks hold the largest share. II Family-Based Ownership and Business Groups The Asian Development Bank (ADB) survey of publicly listed companies conducted for this study reveals that about one third of responding companies started out as family businesses. suggesting that business groups are common in all major markets. Corporate financing depends on intermediation by banks.
and banking. the largest family-based business group was the Ayala Corporation Group. with 27 affiliated companies in the top 1. including business groups and independent companies. a substantial proportion of group profits came from its financial subsidiaries. the biggest private company in the Philippines. or an average of about 12 per group. The main constraint may be the availability of family members that could be drawn for top management positions. construction. the study used the four largest business groups—Ayala. Lopez. and Ayala. For the Ayala group. In terms of sales. Foreign-owned companies mainly serve the export markets.8 percent). Together. Interlocking Relationship between Financial and Nonfinancial Firms Although financial institutions as a whole did not own directly significant proportions of shares of nonfinancal corporations in the Philippines. the three largest entities were family-based groups. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. It is also noteworthy that.2 percent). and more than 20 percent for the Lopez group and Henry Sy group. with the exception of Banco de Oro.12).000. Commercial banks are often affiliated to a particular business group. Cojuangco. Lopez. which was majority-owned by the Henry Sy group. in most . In the meantime. namely. broadcasting (49. the largest was the Eduardo Cojuangco group. Significantly. as discussed in previous sections. the top 10 family-based business groups had only 119 companies in the top 1. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. To show this. retail merchandising (69.4 percent of the group’s 1997 profits). and for the Henry Sy group.6 percent of the total sales of the top 1. for each of these groups.Chapter 3: Philippines 179 Compared with other Asian countries. the two were closely related through their affiliations to business groups. These corporate entities accounted for 53. Also.000 corporations in 1997. an average group in the Philippines has fewer member companies. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. Gokongwei. and Henry Sy—as examples. the nonfinancial sector was real estate (60.1 percent). Family-based business groups are most dominant in sectors such as manufacturing. it was manufacturing (36. ranged according to their sales (Table 3. 25 out of the 50 top corporate entities were familybased groups. real estate. for the Lopez group. the principal owner of SMC.000 companies. In terms of number of companies. In 1997. for the Gokongwei Group.
1 4. of Affiliated Companies Total Sales (P billion) 123. construction.4 6.0 13.2 1. and personal care prods Shipping. food. 4. telecom. 7.5 44.5 26.1 2.4 48. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. 15. real estate. and dairy products Investments.1 4.9 3. 8. power. agriculture.2 1. 11. 5.6 7. beverages.9 2.5 13. 14. and Affiliated Bank of Selected Business Groups.2 16.4 .0 17.6 3. coconut oil. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. food.5 49.7 98. 17.3 2. 13. and mining Management. Consunji 4 3 Food and dairy products Construction and mining 10.5 2. 2.0 Average Sales Per Company (P billion) 6.6 3. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines.0 26.5 47.5 6.8 84. Sector Orientation. and food Food. 6. Beverages. and packaging Power distribution and mass communications Real estate. Flagship Company.5 46. Real estate.3 11.4 10. 10. beverages.0 5. and tourism Credit card 18. 3.3 15. 16.5 17. Eduardo Cojuangco Lopez Family Group Ayala Corp. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M.Table 3.3 3.6 2.11 Total and Per Company Sales. 9.
4 3.3 2. 26. and real estate Department store Mining Construction Telecommunication Shipyard and power 4 7 5 2 4 4 3 2 5 7 5 5 2 3 2 3 2 2 2 2 8.5 8.9 0.0 2.19.2 6.1 0.5 2.9 1.9 7. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 21.6 3. 30.7 3.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. P. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.8 1.8 1.8 1.4 1.0 0. 24. 27. 38. 20.9 6.4 3. 34. Ramos Gaisano Family Group Felipe Yap Felipe F.7 0. 39. 36.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication. 23. . 4 238 1. 31.7 0. 37.6 2. mining.9 0. and various company annual reports.2 1. 33. 22.3 7.7 0. SEC-BusinessWorld Annual Survey of Top 1.7 1.1 1.2 4.6 0. 25.0 5.3 2.6 5.1 1.8 6. 29. 35. 28.0 1.1 2.000 Corporations (1997).9 1. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 32.4 5.7 4.1 805.9 1. distribution.
14. Consunji Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Large Large Medium Medium Medium Large Large Large Medium Large Medium Medium Medium Medium Medium Medium Medium Medium Medium Small Small San Miguel Corporation MERALCO Ayala Corporation Toyota Motors Robinson Shoe Mart Philippine Airlines Phil. 11. Alaska Milk Corporation DM Consunji. 8. 7. 17. 2. 21. Uytengsu/General Milling Group David M. and Affiliated Bank of Selected Business Groups. 16. 12. Inc. 15. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. Eduardo Cojuangco Lopez Family Group Ayala Corp. 3. 18. Flagship Company. 5. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 19. 10. 20. 1997 Business Group Size Classa Flagship Company Affiliate Bankb UCPB PCIBank BPI Metrobank/Global Bank PCIBank Banco de Oro Allied Bank Bank of Commerce Asian Bank PDCP Bank Union Bank Consumer Bank (Savings Bank) RCBC Asian Bank Equitable Banking Corp.Table 3. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go W. 6.11 (continuation) Total and Per Company Sales. Sector Orientation. 9. 4. 13. 1.
Fil-Estate Development Inc. 34. 39.65 billion. 25. medium = P1.000 Corporations (1997). 24. 33. 23. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.48 billion. 22. Ramos Gaisano Family Group Felipe Yap Felipe F. Inc. 32. F. 30. Refers to commercial banks. 27. 26. unless otherwise indicated. P. PT&T Corp. Cruz & Co. 38. 28. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. Kepphil Shipyard Inc.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. and various company annual reports. 29. 35.48 billion. 36. Sources: PSE Databank. a b Size class is measured in terms of sales: Large = greater than P4.65 billion to P4. SEC-BusinessWorld Annual Survey of Top 1. 31.. small = less than P1. 37. .
5 77. Texas Instruments (Phils. car manufacturing. 7. Fujitsu Computer Products Corp. banking. Inc. bank. 14. 24. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. and mining Gold and other precious metal refining . and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate. beverages. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. 6. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. 19.8 53.). 18. and personal care products Shipping. and food Food.Table 3. 5. and car manufacturing Power Refined petroleum products Refined petroleum products Banking.4 48.6 26.3 15. 4.and Foreign Jointly Owned Business Group Business Group Business Group Government-Owned Publicly Listed/Foreign-Owned Foreign-owned Business Group Business Group Business Group Business Group Business Group Foreign-Owned Foreign-Owned Business Group Business Group Foreign-Owned Privately-Owned Publicly Listed/Foreign-Owned Privately-Owned Business Group Corporate Entity 1.5 46.0 37. mass communications. food. 15.5 17. food.0 38.6 18. of the Phils. 2.5 44. beverages. power. First Pacific/Metro Pacific Group 21. Inc. and real estate Banking. 3.7 98.5 26. agriculture.8 84.5 15. 10. and packaging Power distribution. construction. and bank Real estate.).8 22. 9.2 16. Philippine National Bank Mercury Drug Corp. 8. 16.0 24. 20. coconut oil. 13.4 19.2 Business Group Business Group Business Group Government.1 60. and telecommunications Department store and banking Airlines. food. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. telecommunication. and dairy products Investments. 12. 11.2 49.12 Control Structure of the Top 50 Corporate Entities.1 17.5 47. 17. 23. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 22. Beverages.
14.3 8. Amusement and Gaming Corporation Mitsubishi Motors Phils. 34.5 8. 42. Inc.9 14. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. corn (unmilled).6 Foreign-Owned Foreign-Owned Foreign-Owned Business Group Foreign-Owned Business Group Privately-Owned Government-Owned Business Group Business Group Business Group Business Group Business Group La Suerte Cigar and Cigarette Factory Land Bank of the Philippines Procter and Gamble Philippines Andres Soriano Family Group George Go Hitachi Computer Products (Asia) Corp. 40. EAC Distributors Inc. Jollibee Foods Citibank N.290 53. Consunji Uniden Philippines Laguna. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. 9. Corp.1 9. 48.4 10.3 13.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. 45.A.2 7. Inc. PSE Databank. 29.4 8. 49.0 13. National Steel Corporation National Food Authority Phil. 27. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. Luis Lorenzo Family Group United Laboratories Development Bank of the Philippines Alcantara Family Group Bienvenido Tantoco Elena Lim Brimo Family Group Andrew Tan Total Share in Top 1. real estate. 36.. Philip Morris Philippines. 37.0 12.25. 50.6 1.8 Privately-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned Government-Owned Government-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned 38.9 7. 35.8 6.7 13. 43. W. 26. Inc. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 30.6 9. 33. 47. and various company annual reports. 41.5 10. . 39. Uytengsu/General Milling Group David M. 31.000 Corporations (1997).0 11. 44.7 10.9 7.5 8. 28.7 10.6 12. 46. 32.9 6.8 9. Philips Semiconductors Phils.0 5. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters.
A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). issuance of corporate bonds. amendments in the bylaws. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. sale or disposition of a substantial portion of corporate assets. these were dispersed shareholdings. 8 The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank. the board of directors plays a crucial role in corporate governance. Actual control of the banks was still held by the groups. . 3. appointment and compensation of senior executives. voluntary dissolution. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies.3. accounting and auditing. Of course. corporate mergers or consolidations. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. jointly and individually. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. II publicly listed commercial banks affiliated to these groups. investments of corporate funds in other companies or purposes. and declaration of cash dividends. and financial disclosure. Shareholders have the right under the Code to file derivative suits against directors and officers and other third parties to redress any wrongdoing committed against the corporation for which the board refuses to sue or to remedy. Vol. although public investors held a majority of shares. approval of management contracts. issuance of stocks. determination of compensation to board members. However.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. business groups had only minority ownership.8 The Board of Directors As the representative of shareholders in a company. The Corporation Code holds members of the board of directors liable.186 Corporate Governance and Finance in East Asia. shareholder voting in general meetings and legal protection of their rights. removal of directors. such as amendments of the articles of incorporation. They are likewise liable if they pursue financial interests that conflict with their duty as directors.
in a descending order. appointed by the Government. protecting shareholder interests.7 percent). But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. In practice. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. In a few cases.5 for board members. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies.6 for board chairpersons and 7. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. But professional expertise is also an important criterion (28. More than half of respondents indicated that board directors were elected during the shareholder general meetings. a fixed fee plus performance-related bonuses (30 percent).7 percent). Making day-to-day management decisions was not regarded as an important board responsibility. the average number of years of holding office was 6. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents).9 percent).Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. or representatives of creditors. or a per diem for meetings (18 percent). According to the ADB survey. . ensuring that a company follows legal and regulatory requirements. appointing senior management. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. or the Government without approval by shareholder general meetings. or percentages of shareholdings (28. board directors were the founder of a company. and determining remuneration for board directors and senior management. with a maximum of 36 percent. The longest was 27 years for board chairpersons and 14 years for board directors.
by tenure and compensation. however. The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board.9 In practice. Unlike in Western corporate models. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management.188 Corporate Governance and Finance in East Asia. negotiates the audit fees and scope of audits. The nomination committee searches and reviews candidates for key management positions. In the ADB survey. These committees were established only recently. This suggests that large shareholders control CEOs by means other than shareholdings. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. and nomination committees. owners brought prominent political or civic leaders into their boards with the intention of improving the visibility of the corporation rather than improving the quality of board decisions. audit. But the independence of these outside directors is often doubtful. the CEO 9 The three most common board subcommittees are the compensation. A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). only 35 percent of responding companies have set up board committees. Vol. II Compensation for the chairperson was determined either by the board (54 percent of respondents). When the CEO was not the chairperson. the parent company or company bylaws (21 percent). large shareholder-dominated companies often view such committees as unnecessary formalities. Companies may set up special board committees to strengthen due diligence procedures. About half of the active committees were audit committees and the other half nomination committees. or amount of shareholding (15 percent). the chairperson of the board was also the chief executive officer (CEO). and reviews the findings of external audits. The audit committee selects external auditors. or management (15 percent). The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. In some companies. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. namely. Ninetythree percent of the respondents had one or more outside directors. . The ADB survey shows that in 41 percent of the responding companies. It is also not clear whether the outside directors were elected before or after the financial crisis. relationship with controlling shareholders (35 percent).
if the CEO’s contract was preterminated. (iii) invests in another company for a purpose different from that of the corporation. the Corporation Code allows cumulative voting for directors. . the Corporation Code requires that the following types of transactions involving potential conflict of interest between shareholders and management be reviewed and approved by the board: (i) dealings of a company with directors or officers. The longest service rendered was 27 years. the rights to demand payment for shares of those who do not agree with the board’s decisions when a company (i) amends the articles of incorporation. Fourth. or (iv) enters into a merger or consolidation with another corporate entity. to help ensure the representation of minority interests in the board. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company..2 years. equal to three years’ pay. i. shareholders may exercise appraisal rights. An overwhelming 70 percent of respondents said a CEO who was not the chairperson of the board could make key decisions only after consulting the chairperson or the entire board. They can vote through proxy. Among others. (ii) contracts with companies linked through interlocking directorship. Second. of directors representing minority shareholders. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. including electronic means.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. The average service length of CEOs was 5. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. A substantial number of respondents also considered looking after interests of other stakeholders and the general public as among the important responsibilities of the CEO. Third. Shareholder Rights and Protection Under the Corporation Code. and (iii) involvement of directors in businesses that compete with the company. Companies are not allowed to issue shares with different voting rights. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus.e. without cause. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. But about 27 percent viewed it to be ensuring steady growth of the company. Fifth. shareholders enjoy a number of rights and protection. and prohibits the removal. first.
hostile takeovers are not common because in most companies ownership is concentrated . In the case of preemptive rights. potential buyers are required to make a tender offer to minority shareholders at a price equal to the offer it is making to controlling shareholders. However. no one has been successfully prosecuted for insider trading. There was only one case. because of the dominance of large controlling shareholders. In practice. that of Interport Resources Corporation. Being appointees of controlling shareholders. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. in cases of corporate takeovers.190 Corporate Governance and Finance in East Asia. There was little chance that a proposal from minority shareholders could ever get approved. Vol. In the past. In cases of derivative suits against directors for wrongdoings or actions against insider trading. because of poor compliance and enforcement as well as some loopholes in corporate laws. Few minority shareholders actually exercised their appraisal rights. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. where SEC made substantial progress in investigation. Consequently. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. Sixth. the Revised Securities Act has strict provisions designed to deter insider trading. SEC proceedings were costly and time-consuming. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. Those who did were usually offered below-market values for their shares. Last. Regardless of the amount of shares held. a shareholder could file a derivative suit against a director to redress a wrongdoing. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. there were often no real discussions of board proposals or actions. During annual general meetings where minority shareholders could exercise their rights. II shareholders are allowed to inspect a company’s stock and transfer books. The company was dissolved before indictment. in the Philippines. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management.
An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.4 percent of shareholders but 58 percent of outstanding shares. About 93 percent of the respondents contracted . representing about 24 percent of outstanding shares.900 shareholders per company did not vote during the last annual general meeting. a company that is widely held but has a large shareholder. representing 3.2 7. followed by management and banks. 1999.0 36.0 51. the successful hostile takeover by First Pacific Group of PLDT.8 30. appointed either by the board or shareholders during the annual general meetings.8 92.3 56.2 69.6 30.8 56. Nominees held about 45 percent of the outstanding shares. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.4 70. An average of about 4.Chapter 3: Philippines 191 in a few controlling shareholders and families.522 shareholders each. Nevertheless. The responding companies had on average 43. Yes 100. About 333 shareholders per company voted by proxy. and their activism in the corporate sector. Table 3.7 43.4 No 0. Table 3.2 43.13 summarizes rights that the shareholders of the responding companies enjoyed.0 48. protection. The ADB survey provides further evidence on shareholder rights.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. The brokers or securities companies were the most important proxy voters.0 63.13 ADB Survey Results on Shareholder Rights Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings Source: ADB Survey of Philippines Publicly Listed Companies.
II their annual audit to an international auditing firm. the US GAAP). vary in their evaluation of some major accounts such as securities and other liquid assets. long-term leases. These different versions of GAAP. namely. and an analysis of financial statements. revaluation of fixed assets. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. financial reporting standards allow room for interpretation by independent auditors. the agency also requires reports on important details about their operations and management. In two celebrated cases.. From publicly listed companies. a hostile takeover case). intangible assets.e. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. independent audits do not guarantee the absence of questionable accounting practices. or the accounting standard of a specific developed country (for example. with the longest being 50 years. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. as practiced in the Philippines). The Code grants a shareholder the right to inspect business records and minutes of board meetings.192 Corporate Governance and Finance in East Asia. Because of such long relationships. Nevertheless. . a management discussion of the business. there are many cases of poor financial reporting by large companies. Disclosure and Transparency The disclosures required by the Corporation Code are achieved through shareholders’ inspection of a company’s books and an “information statement” that companies should regularly issue to shareholders. the local standard (i. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. In practice. the responding companies have been associated with their present auditors for 13 years. investments in subsidiaries. the information statement transmitted to every shareholder should contain the audited financial statements. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. the international accounting standard. Vol. and consolidation policy. foreign currency-denominated liabilities.. On average. although closely related. An auditor can choose among three alternative sets of GAAP. Most major international auditing firms operate in the Philippines. intra-company receivables and payables. Nevertheless. Meanwhile. imposing penalties on violators. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency.
Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. marketing. the authorities. and publicly listed. because of the highly concentrated ownership of Philippine corporations. which are controlled by large shareholders with public investors in a minority position. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. Family-based controlling shareholders use them as vehicles for controlling business groups. they formed the largest group of corporate entities in the Philippine stock market in 1997. and financing.Chapter 3: Philippines 193 Many small. Corporate Control by Controlling Shareholders As in many other Asian countries.g. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management. from a minority-controlled to a majority-owned subsidiary. which are closely held by large shareholders and family members. accounting for 27 percent of the total stock market capitalization that year. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. However. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). Controlling shareholders usually select member companies that require large . They allow risk pooling and can achieve economies of scale in management. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. large shareholders can use their control to transfer wealth from a company in a business group where they have low cash flow rights to another where they have high cash flow rights.. sometimes did not penalize independent auditors for poorly prepared audited financial statements. When control rights exceed cash flow rights. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA). controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. Pure holding companies can be privately owned. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies.and medium-sized businesses did not have quality financial statements.6 billion. Even for widely held public companies. arguably. e. Publicly available financial information was often of low quality. which are usually controlled by holding companies.
2 percent. active minority or passive minority holdings.1 percent of Ayala Land. Public investors collectively hold a minority of 41 percent. They are operating companies but at the same time have majority or minority share ownership in other operating companies. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. Minority-owned companies may also need access to resources of the group. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. Inc. a family-owned pure holding company. namely. with 59 percent of shares. Ayala Corporation then holds a sufficient number of shares to achieve various degrees of control in two types of holding companies and two types of operating companies. Ayala Corporation. . and a passive minority investment at 15 percent in Honda Cars (Philippines). is privately owned. Controlling shareholders gain additional leverage in management control over minority-owed companies. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. It has a majority control at 71. Vol.. In a passive minority-owned operating company. The first three companies are publicly listed while the fourth. and customers. They may have a representative in the board. the parent company plays an active role in management. minority control at 42. financing.4 percent of Bank of the Philippine Islands.1).6 percent of Globe Telecom. Ayala Corporation is a publicly listed pure holding company. of Cebu Holdings (a publicly listed government-owned company). II equity investment for public listing. It is majority-owned by Mermac. an active minority share at 44. Some holding companies are not pure holding companies. Honda Cars (Philippines). controlling shareholders of the parent company do not participate in management. In cases of minority ownership. as an example (Figure 3.and minority-controlled operating companies are also holding companies. Ayala Land fully owns Makati Development Corporation and holds a minority stake. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. Ayala Corporation’s majority. at 47. Depending on the performance of the company. controlling shareholders of the parent company may eventually increase their shares to a majority position. especially its management. In an active minority-owned operating company.194 Corporate Governance and Finance in East Asia.
04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. .6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. (58.. (47.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.96%) Privately-Held Pure Holding Company Public Investors (41. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. Inc.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. Inc.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.Figure 3. Inc.
5%] / [(88.98% x 42. Vol. defined as control by large shareholders of an operating company through minority ownership by several companies.10 The Ayala family’s control rights over BPI was 1.3% x 5. and Larry H. Simeon Djankov. is illustrated in the Lopez Group (Figure 3. 1999b. Lang. and a minority-controlled holding company. The situation offers large shareholders tremendous incentive to move resources 10 For details. Joseph P. Benpres Holdings. 1998. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Simeon Djankov.3% x 1. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. See also Stijn Claessens. Who Owns and Controls East Asian Corporations? 11 Ibid.64%) + (37. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1.44%] / [25%] = 1.44%] / [58.7 times 12 . First Philippine Holdings Corporation.5% x 14. see the World Bank research papers by Stijn Claessens.14%] / [6. Diversification and Efficiency of Investment by East Asian Corporations.11 The Lopez family’s control rights over MERALCO was 5.2). a privately owned company.76%)] [39. however.5%] [39.44%] = [42. Expropriation of Minority Shareholders: Evidence from East Asia.196 Corporate Governance and Finance in East Asia. H. companies in the Lopez Group are large and minority-controlled.7 times Ibid.8%] 5. P. Fan. MERALCO. The Lopez Family owns a significant portion of shares of these companies if these indirect shareholdings are summed up and attributed to the beneficial owners.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. The control of companies through indirect corporate shareholdings. The Separation of Ownership and Control in East Asian Corporations. and 1999c. P.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights.14%] / [1. Being in the public utilities sector.12 These examples show that even when large shareholder groups are minority shareholders. Rockwell Land.64% +37. and Larry H. Lang: 1999a. Generally.
64% MinorityControlled 14.Figure 3.7% 62.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24. Inc.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.76% Operating Company MinorityControlled 24. Privately-Held Pure Holding Company 88.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1. .3% 11.
while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. The average company. the data suggest. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. 3. The survey results also revealed that creditors did not intervene in the management of borrowing companies and wanted to maintain business relationships with corporate borrowers even when they were in trouble. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. Control by Creditors According to the ADB survey. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . However. whether for working capital or capital expenditure.198 Corporate Governance and Finance in East Asia. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral.3 The Role of Creditors in Corporate Control This study examines the role of creditors in corporate control by looking at (i) how corporate borrowers perceive the control power of their creditors. Vol. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. and (ii) how the legal framework protects creditor interests and rights.3. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. Suspension of Payments of Debts Under PD 902-A.
This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. Commercial banks hold about three fourths of the resources of the financial system. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. bank credit is the main source of corporate financing.. wait for 14 years from the time the company petitioned for suspension of payments in 1984. under which.Chapter 3: Philippines 199 agreement. Under such circumstances. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. SEC could intervene to avoid asset dissipation. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. The corporation continued to be under rehabilitation receivership as of June 1999. There are two modes of suspension of payments under PD 902A. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. a real estate-based business group. including the rehabilitation of the corporation. a company’s assets are of sufficient value to cover all of its debts. The borrower will propose a rehabilitation plan to SEC.4 3. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. Under this mode. For example. could take an indefinite period. An impending conflict between the two parties could result in dissipation of assets of the company due to creditors’ action to liquidate the company’s assets they hold as collateral. SEC and the court required that the creditors of BF Homes.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. profitable companies from going public. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. The first mode is for simple suspension of payments. Publicly listed companies do not represent a cross section of the Philippine corporate . There are no legal or practical limits to the time period of suspension of payments. the litigation process. 3. Inc. In practice. Consequently.4.
this is because. Interest rates.000 companies. Foreign portfolio investments also remained small. the country experienced double-digit inflation. the collapse of the stock market during the Asian financial crisis suggested that the earlier stock price surge in part reflected the “bubbles” common to other stock markets in the region. II sector. Table 3. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. As a result. most listed companies are controlled by their five largest shareholders. about the size of Thailand’s.. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e. especially short-term debt. The stock market was depressed up to the early 1990s. Rising stock prices during the Ramos administration reflected to some extent the business optimism. Korea and Thailand). compared with other economies. inflation. However. Most publicly listed companies issue only up to 20 percent of total shares to the public. The crisis affected the Philippine corporate sector. In part. companies expanded only at a moderate pace.5 billion). compared with Malaysia ($186 billion). Vol.7 billion. but not to the same extent as it did in other Asian economies. From the 1970s up to the early 1990s.g.200 Corporate Governance and Finance in East Asia. Of the 221 companies listed in the Philippine Stock Exchange in 1997. Korea) ($143 billion). only 84 had sales large enough to be placed in the top 1. The corporate sector raised a substantial amount of .4 billion (or $59 million using the average exchange rate). The period 1993-1997 was one of lower inflation and declining lending rates. was one of the smallest in the region at $47. Equity instruments include common stocks. Philippine companies were less leveraged. however. the Republic of Korea (henceforth. preferred stocks. Foreign funds were wary of the Philippine stock market because of its limited liquidity. is far ahead of the flock. and less engaged in risky investments. less exposed to foreign debt.14 shows that the average volume of daily trading in 1997 stood at P2. The market capitalization of the Philippine stock market in August 1997. They invested in only a few large companies whose shares were relatively liquid. Equity financing through IPOs was active. the minimum required to qualify as a public corporation. while interest rates were at high levels and volatile. Even in the real estate sector. Malaysia. The Philippine stock market is not a liquid market. and convertible securities. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. and Indonesia ($61.
5 1.7 391.2 3.692.2 1.0 0.5 12.2 0.8 0.2 61.6 1.1 0.2 297.2 ($ million) — — — — 6.7 1.5 571.121.9 2.1 0.8 799.1 524.7 41.4 1.5 1.248.7 0.0 1.2 1.3 158.3 0.2 59. 1983-1997 Daily Trading Volume (P million) — — — — 129.8 102.5 26.1 5.1 0.1 88.6 261.5 Year 369.3 — = not available.686.4 Ratio of Market Capitalization to GDP 0.445.3 314.7 2. . P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.5 16.3 59.351.088.0 0.8 1.2 925.7 207.421.14 Philippine Stock Market Performance.545. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.077.386.Table 3.1 0. P billion) Gross Domestic Product (current prices.373.9 1. Source: PSE databank.474.5 72.515.8 1.6 1.9 114.3 0.0 161.9 608.3 Market Capitalization (year end.9 2.8 1.4 9.906.0 0.2 0.9 682.0 2.3 2.3 4.2 57.251.4 728.9 12.171.
Negotiated credits. discounting of receivables. a strong regulatory system for bank supervision is imperative. Under SEC regulations. which ultimately influences the pricing of commercial paper issues. Only a few large companies floated commercial papers because of the limited market. The corporate bond market was stunted. moreover.6 billion. because business groups often own large commercial banks. corporate bond issuing was even more limited. However. are in a position to provide such discipline. by virtue of their large stakes in the financial system. lack of competition among financial institutions. leases. The largest buyers have been commercial banks. Vol. The measures used in the analysis are: . issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. Debt instruments include negotiated credits and debt securities.. and inventory financing. and the dominance of large commercial banks. 3. of which 85 percent was raised from 1993 to the first half of 1997. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. the rights issue was a popular way of raising equity capital. which in most cases is an affiliate of the issuing company. Only the commercial banks. new equity. asset-backed credits. sells these commercial papers through brokers. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. which were the principal source of corporate financing in the Philippines. which buy commercial papers either for their own account or for their clients.2 Patterns of Corporate Financing The study looked at retained earnings. and high transaction costs. tight regulations. Corporate bonds are another type of debt securities. and debt as sources of corporate financing by using flow of funds analysis. The picture of the financial system that emerges is thus one of limited capital markets. The underwriter. about 127 companies went public with a total value of offerings of about P134. Capital markets cannot provide the market discipline that corporate investors need. by volatile interest rates and the absence of a secondary market. Debt securities include commercial papers and corporate bonds. From 1988 to 1997.4. However.202 Corporate Governance and Finance in East Asia. include bank credits. Because existing shareholders wanted to retain their proportionate control over their companies. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks.
9 0.3 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.5 0.5 0.4 0.0 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.2 0. .4 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.15 Financing Patterns of the Corporate Sector. It measures a company’s capacity to finance asset growth by equity capital.2 0.000 Corporations in the Philippines from 1988 to 1997.3 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.8 0.1 0.6 0.15. it is one minus IDFR.1 0.9 0.3 0.7 0. It measures a company’s capacity to finance asset growth by internally generated funds.1 Average 1.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.1 0.5 0.0 0.4 0. On the other hand.1 0. 1988-1997.4 0.4 0. As shown in Table 3.6 0.4 1.5 0.5 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.5 0.8 0.4 0.5 0.6 0.5 0.9 0.2 0.8 0.000 Corporations in the Philippines. By definition.2 0. the average SFRF was high at 109 percent.5 2.1 0.3 0. It measures a company’s reliance on borrowings in financing asset growth. during this period.5 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.4 0.3 0.9 0. the SFRT was low at Table 3.3 0.3 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.2 0.
16.0) 0. 1991.2 0. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. Corporate Financing by Ownership Type As shown in Table 3.3 0.5 Foreign-Owned 1.204 Corporate Governance and Finance in East Asia. There were significant year-to-year variations. Companies financed fixed assets from internal sources in hard times. when it financed 45 percent of it. II only 19 percent.5 Privately-Owned 0. reflecting the capital flight caused by political instability in the early 1990s.3 0.1 a Excludes negative balances.8 0. with debt providing 93 percent of the financing requirements. On Table 3.3 0. for all three types of companies—publicly listed. Total assets grew by 23 percent that year. Vol. In all the years. Source: SEC-BusinessWorld Annual Survey of Top 1.3 0. the SFRF was higher. This was mainly caused by the declining contribution from retained earnings. As a result.6 0. retained earnings declined and few new equity investments flowed into the corporate sector.7 0. 1988-1997.16 Corporate Financing Patterns by Ownership Type.and foreign-owned.5 0. implying that internal funds were far from sufficient to finance growth in total assets. It can also be observed that the relative importance of stockholders’ equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997. privately.9 0.2 (0. . debts were the most important source of financing. In 1997.000 Corporations in the Philippines. except in 1991. In periods of an economic crunch such as in 1989. Retained earnings were the least important. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. except for foreignowned companies that had a negative new equity financing ratio. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. internal funds were not a significant source of financing growth in total assets. and 1997. the level of corporate leverage increased.
0 12.4 100.9 24.0 1993 14.1 10.1 9.4 12.7 23.3 12.0 Source: SEC-BusinessWorld Annual Survey of Top 1. 1992-1996 (percent) 1992 Assets Cash and Temporary Investment Accounts Receivable Inventory Other Current Assets Total Current Assets Investment Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Debt Other Long-Term Debt Other Long-Term Liabilities Total Liabilities Stockholders’ Equity Total Liabilities and Stockholders’ Equity 14.9 12.9 16.1 49.9 0. contributing 90 percent of growth in total assets. publicly listed companies relied more on new equity financing than privately.3 10.7 100.7 2.6 0.6 43. The sector built up its short-term debts.8 38.0 8.8 17.7 13.1 50. .3 12. 1988-1997.and foreign-owned companies.8 100. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.5 9.4 43.4 100.3 10.8 4.3 13.4 41.0 10.2 12.2 42.8 0.6 48.8 3. It presents a composition analysis of assets and financing sources for the period 1992-1996.1 13.7 7.1 7.8 3.6 26.5 12.8 0.0 13.4 3.6 37. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.3 51.1 15.2 100.Chapter 3: Philippines 205 average.8 46.0 1994 19.2 100.17.8 26.2 51.9 3.8 39.5 16.4 10.2 3.9 16.0 53.000 Corporations in the Philippines.0 9.0 100.8 16.9 16. Foreign-owned companies relied more heavily on debt financing.9 100.0 6.6 48.9 38. especially bank loans.3 48.3 4.5 27.3 11.7 2.4 2.4 100.0 38.5 41.7 13.17 Composition of Assets and Financing of the Publicly Listed Sector.4 100.3 12.4 2.8 51.0 9. significantly Table 3.9 4.0 10.0 9.2 3.5 0.7 4.0 1995 1996 13.0 9.
Further. Group companies were generally more profitable than independent companies.1 0. and economies of scale in fund raising.13 was at 1. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. The traditional measure of liquidity. On average. Vol. group companies usually financed their investment in member companies by equity rather than debt. retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups. as opposed to 94 and 30 percent. the average SFRF of business groups was higher compared with that of independent companies.000 Corporations in the Philippines. 1988-1997. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. For these two reasons. As shown in Table 3. the current ratio.2 0.5 0.206 Corporate Governance and Finance in East Asia. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. Table 3. The normal standard liquid position is a current ratio of 2 or higher.45 in 1996. II in 1996 and became more vulnerable to the financial crisis in 1997.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. Group companies financed an average of 45 percent of growth in total assets by debt.3 0.5 0.18 Financing Patterns by Control Structure. their inherent ability to pool risks. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.9 0. respectively.6 Independent Company 0.18. compared with an average of 54 percent for independent companies.3 0. . the easier access to external credit. indicating that many publicly listed companies were likely to be in a tight liquidity position.3 0. for independent companies.
Corporate Financing by Firm Size SFRF was highest for medium-sized companies.Chapter 3: Philippines 207 independent companies.2 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.55 was substantially higher than the small companies’ 0.5 Medium 3. On average.08 and SFRT of 0.4 Small 0.000 Corporations in the Philippines.1 0. averaging 61 percent of growth in total assets. With assets growing at a fast pace during this period.19).5 Excludes negative balances. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.06. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.88 for large companies (Table 3.76 for small companies and 0.47. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. and 1997 with 131 percent. The corresponding ratio was 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.9 0. Source: SEC-BusinessWorld Annual Survey of Top 1.6 0. Table 3. Large firms consistently increased their reliance on debts from 1994 to 1997.2 0.3 0.8 0. with an average of 3.50 (Table 3. Excluding .3 0. equity financed 42 percent of incremental asset growth.19 Financing Patterns by Firm Size. Large companies’ IDFR of 0.2 0. compared with 55 percent for large companies and 47 percent for small ones. 1988-1997. These years were 1991 with 110 percent. medium-sized companies used more debts.20).3 0. 1993 with 96 percent.5 0. There was also increased reliance on debt financing.6 0.
While this level is considered prudent.6 0.6 a Excludes negative balances. .000 Corporations in the Philippines.5 0. Source: SEC-BusinessWorld Annual Survey of Top 1.58 and SFRT of 0. Equity financed an average of 62 percent of total asset growth.3 0. SFRF for the sector averaged 0. achieving an average SFRF of 3. Since the real estate boom coincided with that of the stock market.47 two years later. In the eight years preceding the crisis.79 and in 1997 at 0.4 3.04. debt financed about 78 percent of asset growth in real estate.2) 0.4 0.6 0.27. Vol. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. The sector had the highest leverage among all industries that year.5 0. The situation improved beginning 1994.3 0.3 0. the incremental equity ratios of the industry were high. II 1991. with an SFRF as low as 0.1 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. During the crisis year.29. The construction sector was a heavy user of debt financing. Up to 1997.91. The real estate industry financed its growth by substantial equity funds. Excluding 1997 when fixed assets declined. increasing to 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. many of the leading real estate companies successfully went public during that time. Incremental equity financing amounted to an average of 44 percent of total asset growth. when debts declined.3 0. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.5 Utilities and Real Estate Services and Property 0. 1988-1997.6 0. ranging from 41 to 118 percent. the total debt ratio was much higher in 1996 at 0.7 0. the manufacturing industry financed 57 percent of its total asset growth by debt. The effects of the crisis of 1997 were adverse.5 (0.4 Construction 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994. the industry generated internal funds.208 Corporate Governance and Finance in East Asia.20 Financing Patterns by Industry. while SFRT averaged only 0.32. Table 3.4 0.4 0.
as the dependent variable. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. 1992-1996. was regressed against measures of profitability and of financial leverage. Profitability.009 5. while if it fails. and the Failure of Internal Control Systems.00036 2.421 0. ownership concentration = the total shareholdings of the top five shareholders.860 Leverage = the ratio of total assets to total equity.287 0.14 Large shareholders may borrow excessively to undertake risky projects.4. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. knowing that if an investment turns out to be successful they could capture most of the gain. ROE. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. As shown in Table 3. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. The Modern Industrial Revolution. ROA. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. the degree of ownership concentration. ROE. more profitable. ROE = return on equity.130 ROA 0.00056 1.769 0. . alternatively. 14 See for example Michael Jensen (1993). ROA = return on assets. at the same time. Table 3.21 Ownership Concentration. Financial Leverage.21. Journal of Finance 48: 831-880.230 Leverage 0. and leverage.Chapter 3: Philippines 209 3. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. Source: Author’s estimates based on the PSE databank.008 5.00125 2. measured by the percentage of shareholdings of the largest five shareholders.004 3. and financial leverage are all positively and significantly related to the degree of ownership concentration.3 Ownership Concentration. Using the PSE database. Exit. creditors bear the consequences.
After a . The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). Vol. The country experienced balance of payments surpluses but these were due to transfers. with commodities accounting for the balance. In sum.5. foreign investments in the country have been low.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. which averaged 4.5 percent per year from 1992 to 1997. the country’s GDP growth pace indicated that it did not have a “bubble economy. industry at 34 percent. the economy still showed vestiges of its import-dependent and substituting character.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. The largest contributors to GDP were services at 43 percent. Net investment inflows were $3. The export sector had a very narrow breadth. an overexpansion of capacities. Commercial and industrial activities in the country were largely oriented to domestic markets. Exports were growing at about 20 percent per year in the three years preceding the crisis.1 The Corporate Sector in the Financial Crisis The Financial Crisis: Causes and Manifestations A devaluation of the local currency signaled the arrival of the financial crisis in 1997. raw materials. with a narrow exporting industry base. notably remittances of overseas workers. Although much lower than those of other Asian countries. their growth gathering momentum only beginning in 1992. and agriculture at 21 percent. In 1997. Compared to other East Asian crisis-affected countries.210 Corporate Governance and Finance in East Asia.8 percent of GDP from 1995 to 1997. Garments was the second largest export sector at about 9 percent. Because of limited local capital. II 3. Manufactures accounted for about 85 percent of exports.5 3. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. Net trades in goods and services averaged a deficit of 4. and intermediate goods. the country was less dependent on foreign private capital. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. more than half (52 percent) of exports were semiconductors. Historically. The costs of an economic correction brought about by the regional financial crisis were thought probably to be low due to the sound structure of the real economy and the strong position of the financial sector.” that is. but its share had been declining by 4 percent per year since 1995.
assets grew at a compound annual rate of about 31 percent. The corporate sector was in a relatively stable financial condition around the time of the crisis. The lessons from debt restructuring became the basis for the Government’s economic policies. From 1988 to 1996. Closer analysis. Profitable operations since 1992 had allowed it to build equity. Total debts were only 52 percent of assets or 108 percent of equity. . The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. an average inflation rate of 7. the discipline of the loan moratorium and the restructuring of the country’s loans to long-term maturity kept this ratio below 100 percent up to September 1997. which. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors.5 percent. fueled also by successful IPOs during the stock market boom of 1993-1996. while sales grew by only 20 percent per year. In the Philippines. unlike their counterparts in the region. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991.1 percent. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. During this time. After hovering in the range of 100 to 127 percent. resulting in stability in the short-term debt to reserves ratio. in turn.3 percent. the Government restructured its debts into longer tenors with a maximum of 25 years.8 percent.6 billion as of March 1997. the country and the corporate sector had no access to foreign currency debts from the international financial market. a government fiscal surplus from 1994 to 1997. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. a positive balance of payments from 1992 to 1996. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. From 1993 to 1997. adjustments were focused on the quantity and quality of the banking system’s corporate loans. an average Treasury bill rate of 13. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. depended on the quality of the corporate sector’s investments. the Government sought stability and achieved this in 19921997. however. and a relatively healthy banking system. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. Eventually. average ROE was 13.
300 1.303 23.101 92. growing by about 34 percent per year from 1994 to 1997.0 1996 3.47.650 32. Sources: Bangko Sentral ng Pilipinas and SEC. Table 3. 1997 = 29. These patterns in investment and financing are similar to those of other countries in the region. It rose to $2. It financed 26 percent of corporate capital growth. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. Net foreign portfolio investment amounted to $1.749 26. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region.718 30. . But portfolio investment amounting to $406 million flew out of the Philippines. Debts financed a large part of this expansion.517 1.71. the other immediate impact of the crisis was that on foreign investment flows.485 145. the country’s economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive “contagion” effect of optimism by investors and creditors about the region. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. net FDI remained stable at more than $1 billion. 1996 = 26. or 114 percent of net foreign direct investment (FDI). Data for 1998 cover only January-August.5 billion in 1995.101 billion or 196 percent of net FDI in 1996.073 (406) 121.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.22).5. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. Vol.212 Corporate Governance and Finance in East Asia. 1995-1998 Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1.609 1.4 1997 762 1.7 Note: Peso-dollar exchange rates used are: 1995 = 25. In 1997. 1998 = 41. In sum. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.06.22 Foreign Investment Flows. but to a lesser degree.074 2.” 3.22.0 1998 739 555 328 69. Most of this leverage happened during the boom years in the region. precisely. mitigated the effects of the pullout and liquidation of investments in the aftermath.
The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. new borrowings financed asset growth. lending rates also came down. Although corporate borrowers were not highly leveraged.9 percent. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation.7 percent in January 1998. By March 1988. Because of weak internal fund generation. which held about 75 percent of the assets of the financial system in 1997. The resources of the financial system that year totaled P3.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. meanwhile. The real problem of the corporate sector during the crisis was the rise in interest rates. then rose to a high of 22. Lending rates were well above the 20 percent level from July 1997 to March 1998. and the wholesale and . ranged from 11 to 13 percent from 1993 to July 1997. ROE at 6.2 percent in November 1997. The interest rates on Treasury bills. the sectors with the highest outstanding loans had reduced their credit exposures. in varying degrees for each sector. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past.369 billion. they were willing to restructure and renegotiate existing loans by corporate borrowers. the corporate sector became vulnerable to loan calls and high interest rates.3 percent of assets. Loan calls. Net profit margins were at a 10-year low at 4. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets.2 to 28. the commercial banking sector’s capital remained strong at 17. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. albeit at current market interest rates. By October 1998. Companies deferred investments in new fixed assets. depended on the liquidity and capital position of commercial banks. Loans outstanding of commercial banks declined by the first quarter of 1998. Because commercial banks were strongly capitalized. When the Treasury bill rates eased in March 1998. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. sparking a rise in interest rates on corporate loans. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. With the increase in borrowings and reduced liquidity. in turn. Average bank lending rates climbed to their peak of 25. and leverage increased to 149 percent compared with 109 percent in 1996.2 percent was barely above inflation rate.513 billion. with commercial banks holding P2.
set limits on overbought/oversold foreign exchange positions of banks.5-6 percent. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts.5 percent by September 1998. through the Bankers’ Association of the Philippines. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. and its experience of low. But the Philippine banking system had gone through worse crises in the past. single-digit NPL ratios began only since 1989. In March 1997. Still.6 percent in June 1998. the ratio increased to a high of 11. thereby reducing overall intermediation costs. and the financial system. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. including (i) a regulatory limit of 20 percent on banks’ loans to the . These figures show that adjustment problems were industry-specific and that the real estate industry. As for nonperforming loans (NPLs). as with its counterparts in other Asian countries. was a problem sector.214 Corporate Governance and Finance in East Asia.9 percent of bank loan portfolios. by 12 percent. These peaked at 14. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. and subsequently went down to 13. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. Vol. The Central Bank adopted other measures to strengthen the financial system. real estate loans averaged 11. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986. The Central Bank also moved to control inflation and bring down domestic interest rates by reducing the statutory reserve requirement by 3 percentage points and raising the liquidity reserve ratio by the same amount. II retail trade sector. 3. The move retained the liquidity position of banks but lowered their cost of reserves. and set up a hedging facility for borrowers with foreign currency-denominated loans. However. the fiscal position.3 percent in December 1997.5. This allowed the Central Bank to convince the banks.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues.
Responses of the Corporate Sector The corporate sector’s financial position. (PAL). A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. the largest telecommunications setup in the Philippines. was known to have a policy . In the case of PLDT. First Pacific Corporation. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. In response to calls for lower bank intermediation costs. subcontracting and outsourcing.6 percent growth in 1999. The economy avoided a recession in 1998 and achieved 3. PAL. the country’s flag carrier. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. The policy directions and actions taken by the Government appear to have ushered in recovery. its accessibility to foreign capital. With prudent monetary management. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. (v) improving disclosure requirements on the financial position of banks.Chapter 3: Philippines 215 real estate sector. the Government kept inflation below 10 percent. Large companies with heavy loan exposures such as Philippine Airlines Inc. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. changing technologies. consolidating business units. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. With its weakened financial position. the corporate sector dealt with the crisis as any company facing a recession and drying up of credit would—companies cut costs by reducing staff. the Asian crisis opened a unique opportunity for foreign investors. Financially strong companies were able to survive the crisis by effecting such internal restructuring. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. The acquiring company. Average Treasury bill rates have cooled since mid-1998. and giving up noncore businesses. took more action. bank loan rates have also come down. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. and the legal framework for reorganization and liquidation conditioned its response to the crisis. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors.
the Cojuangcos. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies.216 Corporate Governance and Finance in East Asia. One mode was the outright purchase of shares in the open market. SMC is another widely-held company managed by a minority shareholder. eventually took over PLDT and announced a restructuring plan for the entire group of companies. By itself. When Cojuangco took over. PLDT’s large minority shareholders such as the SSS and First Philippine Fund publicly announced their willingness to offer their entire holdings in a block sale at a premium. Corporate governance is conditioned by the high ownership concentration of these large companies. II of investing to control companies that are dominant players in their industries. In a legal process that ended in his takeover of management. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. Ownership is highly concentrated and a few dominant players control major industries. is whether there are sufficient safeguards to prevent controlling shareholders from . Conclusions. It may even solve agency problems that a separation of control and ownership could precipitate because large shareholders have an incentive to closely oversee management. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. at a premium over the market price to reflect the value of management control. The question. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. Consequently. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. concentrated ownership of companies is not equivalent to weakness in corporate governance.6.1 Summary. Vol. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. the stock price of PLDT was buoyant during the takeover period. controlling shareholders can capture these profits by excluding public investors from ownership. Although considered the prime industrial company in the Philippines. First Pacific.6 3. When companies are highly profitable. however. using some or all of these means. A second method was to purchase the shares of other large minority shareholders. the Soriano family. 3. Its stock price and returns to shareholders had stagnated.
medium companies showed higher profitability than large and small ones. to some extent. By size. By control structure. and the lack of market for corporate control. The result is that corporate governance depends only on internal controls. the most numerous in the corporate sector. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. an underdeveloped capital market. The five largest shareholders have majority control of an average publicly listed company. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. an ineffective insolvency system. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. foreign companies were the most profitable but highly leveraged. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. ownership of banks by business groups. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. Performance was. minority shareholders need to be protected by external control mechanisms. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings. Ownership of publicly listed companies is highly concentrated. Forming business groups appears to be a viable means of competing because this allows for more efficient organization and utilization of resources of large controlling shareholders. influenced by industry characteristics. By ownership structure. Analysis of corporate financing by ownership . This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. were the least profitable. Leverage was within Asian norms but above developed country standards. With large shareholders in control. while the largest 20 shareholders control more than 75 percent of shares. Returns to capital exceeded inflation rates. Financial institutions are not significant shareholders. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. Privately-owned companies. passive independent auditing. oligopolistic market structures.
Large companies owned or controlled by business groups tend to dominate their industries. The difference between management control and ownership rights is usually substantial. Vol. A business group is an effective business organizational model for achieving leadership in industries. Ownership concentration was positively related to both returns and leverage. as typified by the Ayala Group. Even in cases where the group owned only a minority share of a commercial bank. Larger disparities in control over cash flow rights imply higher incentives for large shareholders to (i) expropriate wealth of shareholders not belonging to the controlling group and (ii) invest in empirebuilding and high-risk projects. II type gave similar results. the bank usually accounted for a large share of each group’s net profits. The positive relationship between financial leverage and ownership concentration is consistent with the hypothesis that controlling shareholders prefer to use debt financing in order to avoid ownership dilution. family-based shareholders gain control by such means as the setting up of holding companies. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. A commercial bank is an important part of most business groups. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. with the foreign-owned companies found to rely more on borrowed funds. selective public listing of companies in the group. ROA. Large. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). The extent of governance problems depends on internal control policies of the controlling shareholders. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. ROE. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. The pyramid model is useful for centrally managing smaller companies. After controlling for industry effects. . Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. and sustained growth. and the extent of supervision of outside institutions such as independent auditors and SEC. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. and leverage were all positively related to the degree of ownership concentration.218 Corporate Governance and Finance in East Asia. Business groups with pyramiding structures heighten the issue of corporate governance. and centralized management and financing. superior profitability.
decide on the financial future of a troubled debtor. adversely affecting companies’ operations and financial position. rather than the banks that lent millions of pesos. As the crisis wore on in 1998. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. decisions by large sharehold- . and sound overall creditworthiness. Specific actions recommended are described below. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years. low inflation. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. including suspension of payments. resulting in the banks’ accelerated restructuring of troubled debts in this sector. The Central Bank imposed strict limits on real estate lending. For example. strong capital position built on IPOs in a buoyant stock market. there were sharp rises in the number of bankruptcies and petitions for debt relief. There are systemic risks involved in highly concentrated ownership. Promoting a Broader Ownership of the Corporate Sector The highly concentrated ownership of the publicly listed corporate sector should be a concern of SEC and PSE. That is. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. and a market-oriented policy environment. a strong international reserves position. SEC’s quasijudicial functions. This law is flawed in concept because it supplants a market-based credit agreement with a political process. with recently restructured public debt. there was a sharp rise in borrowings and decreasing productivity of investments a few years before the crisis in a pattern similar to that of Asian crisis countries. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A.6. SEC officials. the government budget in surplus. Under the new Securities Regulation Code enacted in 2000.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position.2 Policy Recommendations The Government should address weaknesses in corporate governance identified in this study by introducing reforms in the policy and regulatory framework and promoting the development of markets. 3. Still. mostly by highly leveraged companies and speculative investors in real estate. are to be removed and transferred to courts.
SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. to 25 percent. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. To strengthen the board. inadequate disclosures. Clear legal accountability is a precondition for successful shareholder activism.220 Corporate Governance and Finance in East Asia. II ers often cause wide volatility in stock prices and invite reaction from creditors. Another measure would be to impose a statutory limit on the number of directorships that one can accept. The adjustment should be made over a fixed period of time. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. To help ensure this. depending on the size of the company. they serve to curb the powers of controlling shareholders. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. and self-dealing. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. The following recommendations involve amendments to the Corporation Code that will improve transparency of ownership and address the current high level of ownership concentration in Philippine business: (i) require disclosures of underlying ownership of shares held by nominees and holding companies. It has suffi- . Vol. (ii) require disclosure of material changes in ownership. insider information. Strengthening Minority Shareholder Rights An issue that concerns minority shareholders is whether they have instruments—legal or ethical—that can prevent controlling shareholders from expropriating their wealth through risky investment and financing. PSE Listing Rules should specify criteria and a selection process that will help ensure that the nominees for the position are truly independent and qualified. This may limit current practices of appointing prominent individuals and family members as directors.
Impose severe penalties for any attempt by banks to circumvent this regulation. e. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. and related interests. reporting. raising the current two-thirds majority to a three-fourths majority. directors. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. (iv) require banks to follow international financial accounting. Because ownership is generally concentrated in five shareholders. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. officers. and (v) closely monitor. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. prudential measures and regulations. the board will be compelled to initiate a thorough discussion of the merits of the proposed related-party deals that will require the participation of minority shareholders.Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks. in particular. or prohibit cross-guarantees by companies belonging to affiliated groups. limit. Finally. For example. fit and . (ii) set strict limits on lending by banks to affiliated companies. in areas of supervisory functions of the central bank. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority.. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. They need legal empowerment such as higher majority voting requirements. and disclosure standards. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. the board can easily muster the needed majority to approve the deal. and of banks in nonfinancial companies in order to avoid connected lending.g.
Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. an active financial analyst community can begin to form. This investor profile has a “missing middle”—long-term investors who intend to participate in longterm growth of a company and who also trade shares depending on company performance. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. and external auditors. The current law should expand class action suits to include management and . Investment and venture capital funds meet this description. In developed capital markets. Vol. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. foreign ownership of banks. Presently. Reforming the Legal and Regulatory Framework for Investment Funds and Venture Capital Owners of Philippine publicly listed companies consist of controlling shareholders and investors that hold trading portfolios. By supporting the establishment and operation of institutional investors. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. This way. Its priority is to protect prospective fund investors from unscrupulous fund managers. Promoting Shareholder Activism Promoting shareholder activism to encourage small shareholders to actively monitor management is an approach that has not been tried out in the Philippines. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. management. and lending to DOSRI.222 Corporate Governance and Finance in East Asia. transparency. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. institutional investors lead public investors in providing market signals to companies. Two measures should be adopted to promote shareholder activism. If institutional investors are present. Institutional investors impose market discipline by voting on strategic corporate decisions. II proper rule. institutional investors can be a driving force in providing market discipline to management.
guarantees. SEC should take steps to simplify the process of class action suits and provide an avenue for out-of-court settlements similar to practices in the US. the Government could develop the market for future issues of corporate bonds. and the external auditors. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations.Chapter 3: Philippines 223 auditors. information disclosures. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. their directors and management. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. And by issuing Government Treasury securities in longer tenors. entry . The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. SEC should allow minority shareholders to be represented by activist groups. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. and Credit Information Bureau that can be the starting point of this effort. Securities market development efforts should coincide with strict regulation of the commercial banking sector. Legal provisions for class action suits should cover self-dealing by directors. These groups have an incentive to gather technical expertise. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. Expanding Debt Securities Financing The Philippine corporate sector relies on bank loans because controlling shareholders do not want to dilute their control by issuing equities. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. and dividend decisions. leadership. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. There are existing institutions such as Dun and Bradsreet. compensation contracts.
Vol. Efforts to reduce graft and corruption. Penalties for poor conduct of auditing by independent . Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. II and exit barriers. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. Current disclosure requirements of SEC are not rigorous enough for public investors. PSE and SEC need to build a liquid and efficient market. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. Lack of liquidity deters institutional investors. so that small. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. Many large companies remain privately owned. The Government should also continue to improve infrastructure. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. and various other forms of protection. Audited financial statements contain basic information about a company’s financial position and performance.and medium-scale companies can become more competitive relative to large companies. improve enforcement of the rule of law.224 Corporate Governance and Finance in East Asia. and publicly listed companies trade barely the minimum number of shares required for public listing. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. and provide quality basic services should also be heightened. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. PSE should campaign for top-tier companies to go public and work with SEC in encouraging publicly listed companies to expand their share offerings to the public. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. Many of the problems associated with auditing and disclosure stem from the tendency of SEC and PICPA to be satisfied with replicating what their counterparts in the US require by way of audit standards and disclosures.
and Liquidation. the new law needs to be effectively implemented and enforced. and liquidation of troubled companies should be made a priority of the Government. SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. Improving the Legal Framework for Suspension of Payments. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. Reorganization. reorganization. The law on suspension of payments replaces a market-oriented solution with a political process. and transferred these to courts. and implement those standards and penalties rigorously. suspension of payments and private damage actions. . The law is obviously not in line with the Government’s policy of allowing market mechanisms to work and not intervening in private sector business.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. review the system of penalties on professionals involved in a company’s violation of disclosure rules. including the resolution of intracorporate disputes. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. Instead. Reforming the legal framework for suspension of payments. it creates a moral hazard problem. SEC and PICPA need to formulate more specific disclosure standards. For that matter. violators were made to pay only nominal penalties.
Manila: Asian Development Bank. Working Paper. Stijn. and Fausto Panunzi. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. The Structure of Corporate Ownership: Causes and Consequences. Large Shareholders. Stijn. Stijn Claessens. P. 1999. Dennis. Claessens. Fan. Fan. P. H. 1999. Claessens. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Harold. Emilio. 1998c. May. 1998. Lang. Diversification and Efficiency of Investment by East Asian Corporations. Denis. Lang. Michael. 1998a. and Clifford Holderness. Simeon Djankov. Tokyo: Institute of Developing Economies. Dennis Gromb. Joseph P.. Stijn. Stijn. Philippine Macroeconomic Prospects: The Next Ten Years. and Larry H. edited by Toida Mitusuru and Daisuke Hiratsuka. 693-728. P. 1988. Thailand: From Financial Crisis to Economic Renewal. Simeon Djankov. H. Monitoring and the Value of the Firm. World Bank. 1989. World Bank. Equity Ownership. M. 1997.. Fan. Simeon Djankov. II References Abonyi. October. Alba. and Larry H. Simeon Djankov. David J. Joseph P. Barclay. . Lang. The Philippines: Onward to Recovery. H. 1994.226 Corporate Governance and Finance in East Asia. Asian Industrializing Region in 2005. and Atulya Sarin. Lang. Jr. Institute of Southeast Asian Studies. The Separation of Ownership and Control in East Asian Corporations. Working Paper 2088. Journal of Political Economy 93 (6). and Simeon Djankov. Stijn. and Larry H. Working Paper. Agency Problems. and Corporate Diversification. Bangko Sentral ng Pilipinas. Simeon Djankov. 1997. Private Benefits from Control of Public Corporations. Claessens. 1998. World Bank. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Vol. 1999. 1998b. Joseph P. March. World Bank. World Bank. July. Ownership Structure and Corporate Performance in East Asia. Antonio. Claessens. and Larry H. Diane K. Expropriation of Minority Shareholders in East Asia. XXIX. 1985. P. Quarterly Journal of Economics. Vol. Key Indicators of Developing Asian and Pacific Countries 1998. Journal of Finance 2 (1). Claessens. Joseph Fan. P. and Larry H. and Kenneth Lehn. George. Journal of Financial Economics 25: 371-395. Pedro. Lang. Demsetz. Discussion Paper. Burkart. Asian Development Bank.
1990. American Economic Review 85: 567-85. Journal of Financial Economics 11: 5-50. 1983. 1986. Stephen. Modigliani. Corporate Governance: Emerging Issues and Lessons from East Asia. and William Meckling. International Corporate Governance. Philippine Stock Exchange Fact Book 1997. and Jeremy C. and Merton Miller. 1994 and Investment Guide 1997. Scharfstein. 1995. 1993. 1998. Stephen. The Cost of Capital. Michael. Myers. Joseph C. and David Scharfstein. . Exit. and the Failure of Internal Control Systems. and Artur Raviv. Takeo. Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. World Bank. Lufkin. Review of Economic Studies 51: 393-414. Liquidity and Investment: Evidence from Japanese Industrial Groups. and the Theory of Investment. Jensen. Michael. The Market for Corporate Control: A Scientific Evidence. Jensen. Corporate Finance and Takeovers. Jensen. Journal of Finance 45: 321-350.. American Economic Review 76: 323-29. Stein. 1977. Hoshi. and David Gallagher (eds. Oliver. Jensen. Journal of Financial Economics 27: 4366. Quarterly Journal of Economics 106: 33-60. 1976. 1984. Robert H. and Richard Ruback. Euromoney Books. Douglas. F. Stuart.). 1958. Anil Kashyap. and John Moore. 1995. Agency Costs of Free Cash Flow.Chapter 3: Philippines 227 Diamond. The Modern Industrial Revolution. Journal of Financial Economics 3: 305-360. Harris.. Michael. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. Agency Costs and Ownership Structure. Hart. Capital Structure and the Information Role of Debt. Theory of the Firm: Managerial Behavior. Michael. Prowse. Journal of Financial Economics 5: 147-175. Corporate Structure. 1990. Corporation Finance. American Economic Review 48 (3): 261297. Prowse. Internal versus External Capital Markets. The Quarterly Journal of Economics. Franco. Determinants of Corporate Borrowing. Financial Intermediation and Delegated Monitoring. 1990. 1991. November. Milton. Journal of Finance 48: 831-80. 1994. Gestner. David S.
Large Shareholders and Corporate Control. Journal of Money. DC. 1998. Vishny. No. Journal of Finance LII. Andrei. Journal of Finance 91: 1121-1139. 1997. No. 1991. Stein. Stiglitz. Internal Capital Markets and the Competition for Corporate Resources. Washington. 1992. . Andrei. Singh. and Banking Lecture 17. Vol. East Asia: The Road to Recovery. II Prowse. and Robert W. November. Vishny. Credit Markets and the Control of Capital. Journal of Political Economy 94: 461-88. DC. 1. The Structure of Ownership in Japan. Webb. 2. IFC/WB. World Bank. Shleifer. Asian Development Bank. Some Conceptual Issues in Corporate Governance and Finance. May. March. Technical paper No. Washington. David. Credit. 1996. and Robert W. 1985. 1998. A Survey of Corporate Governance. Ajit. Stephen. Journal of Finance L11: 737-783. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. Jeremy C. 1997.228 Corporate Governance and Finance in East Asia. Joseph E. Shleifer. Mimeograph. 1.
For the period 1994-1996.1 Introduction In May to July 1997. Faculty of Business. the Stock Exchange of Thailand for its help and support in conducting company surveys. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. with Thai corporations overutilizing short-term foreign currency-denominated loans. with the currencies of Indonesia. The banking system. But it also laid bare weaknesses in both the financial and corporate sectors. Malaysia. Thai corporations were collectively overexposed to exchange rate risks. short-term private debt obligations grew to about 60 percent of total private sector debts. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. It was inefficient in financial intermediation. As a result. Chonburi. . the Thai Government conceded and adopted a floating exchange rate regime.4 Thailand Piman Limpaphayom1 4. but also the stalling of East Asia’s “economic miracle. 1 Associate Professor. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. Thailand. and Philippines all depreciating significantly. poorly regulated and sheltered from competition. and Lea Sumulong and Graham Dwyer for their editorial assistance. had been plagued with prudential problems for a long time. magnified the impact of these problems on the economy when the crisis hit.” After mounting an aggressive defense of the currency. heralding not only a financial crisis in the country. The fixed exchange rate policy. The corporate sector also contributed significantly to the crisis. The majority of these debts were not properly hedged. Republic of Korea (henceforth. Asian University of Science and Technology. the Thai baht came under pressure from speculative attacks. the banking system merely validated the financial risks. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. David Edwards. The author wishes to thank Juzhong Zhuang. both of ADB. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. In the prelude to the 1997 crisis. Korea).
The country initiated national economic development planning in 1961 when the economy was growing rapidly.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. Section 4. the Government increased tariffs on products that could be produced locally.2 4. The study then considers policy recommendations with emphasis on corporate governance improvement. Vol. and a family-based corporate ownership structure. Section 4.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.4 provides an overview of Thailand’s financial markets and examines patterns of corporate financing and investment in the years prior to the 1997 crisis. 4. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings.2. its growth and financial performance. The National Economic and Social Development Board was created to plan the country’s economic and social development. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. Import tariffs on machinery and heavy equipment were removed. as well as its legal and regulatory framework. Section 4. while new industries were encouraged to reduce the need for imports. with government policy providing support but avoiding direct interference. To protect domestic industries. Section 4. .1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. lack of transparency and adequate disclosure.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. This study examines these and other factors that might have weakened corporate sector governance in Thailand. The First and Second Plans (1961-1971) Under the first two plans.230 Corporate Governance and Finance in East Asia. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).
To close the fiscal gap. Budget deficits also increased throughout the Fourth Plan.4 billion from overseas and increased taxes on numerous items. the current account registered a surplus in 1986. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. the value of the baht remained stable. the government’s debt burden escalated. The Government had to shift emphasis to restoration of economic stability. however. it proceeded with its development plan for the industrial sector. resulted in increases in the current account deficit. chemicals. leaving the Government no choice but to resort to overseas borrowings. The average budget deficit reached an all-time high of $2. Budget deficits remained a major problem during the Fifth Plan. lower than anticipated due to a worldwide economic recession. Fourth.6 percent per year. Thus. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. However. processed steel. with the agricultural sector the major contributor. averaging 1. helped offset these deficits. and automobile assembly) emerged. gross national product grew by about 7 percent per year.3 percent in 1974. Inflation levels were low.Chapter 4: Thailand 231 During this period. The focus shifted to export promotion. Unemployment. Consequently. . remaining high until 1981. At the same time. The results were increased exports. especially foreign aid from the United States. the industrial sector grew at a faster rate than the agricultural sector. however. canned foods. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. became a major problem as domestic investment declined. including luxury goods.5 percent in 1973 and 24. The decline in imports was steady.4 percent of GDP.15 billion per year or 4. As a result. and increases in world food and oil prices. textiles. and reduced current account deficits. Inflation reached 15. the Government borrowed $6. External factors. Industrial sector growth was also rapid and many industries (tires. an improved trade balance. Average growth for the period was 4 percent per year. The Third. with the devaluation of the baht in 1984 a major step in this direction. including a weakening of the dollar. capital inflows. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry.
the bulk of domestic investments went to speculative ventures such as real estate. Most of the FDIs—originating mainly from Japan. Europe. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. The exchange rate was steady at around B25 to the dollar.2 and 13. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments.5 to 13. Inflation was 4. from only $31 billion in 1992.8 percent. reaching an annual inflow of $2 billion in 1991. On top of its predominantly “borrowed” nature. From 1989.4 percent targets. Growth of exports and imports averaged 14. respectively. The country also attracted a large amount of foreign direct investments (FDIs). the property sector began to collapse in 1996. property development. United States.6 percent.6 percent target of the Seventh Plan. while exports expanded considerably. compared with the 8. Average annual growth in real GDP was 8 percent. lower than the target of 8. better than the 5. and Hong Kong. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. The country’s high ratings in the international capital market. compared with the 14.7 and 11.2 percent target. invited a deluge of capital seeking profitable investments. averaging 10.2 percent per year. Private sector investment grew at an average annual rate of 7 percent. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. rather than to productive activities. . II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. combined with its liberal financial policies. The manufacturing sector became a dominant force in the economy. increasing its share in total export value from 42 to 76 percent. Growth rates during 1987-1991 ranged from 9. Singapore.232 Corporate Governance and Finance in East Asia. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due.5 percent. China—went to export-oriented manufacturing industries. compounded by a slump in property sales.8 percent. Thailand became a debtor’s market. and the stock market. an oversupply of housing emerged. with private foreign debt reaching $92 billion by the end of 1996. By 1995. Vol.
the signs of an economy about to falter were there.Chapter 4: Thailand 233 Toward the end of the Plan period. Before the capital market emerged.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. In 1969. the corporate sector’s main source of funding was the banks. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. the Government amended the “Announcement of the Executive Council No. Robbins. which raised the debt service ratio. which was amended in 1979 and 1985. the Government passed the Public Limited Company Act. However. In 1978. The deficits caused the Government to rely on even more external borrowing. 4.3 percent in 1996. many companies considered the Act too restrictive and a hindrance to growth.2. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. SET officially became “the Stock Exchange of Thailand” in 1991. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. a former Chief Economist from the US Securities and Exchange Commission. a policy that held throughout the first six economic development plans.” which later became the master plan for the development of the Thai capital market. In May 1974. Sidney M. In his report. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. the capital markets didn’t play a significant role until 1975. prepared a comprehensive report entitled “A Capital Market in Thailand. its policy had always been to protect domestic banks. In 1972. on account of an overvalued baht that weakened export competitiveness. placing all publicly listed companies under regulation. Under the 1962 Commercial Banking Act. Exports went into a tailspin. Foreign banks were barred from competing directly with domestic banks. with growth shrinking from 23. the Bank of Thailand and .8 percent in 1995 to 1.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. And because the Government considered the banking system vital to the development of the economy. Robbins recommended an overhaul of the existing informal stock market established earlier by a group of local brokers in favor of a centrally regulated institution. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996.
A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. Thailand’s capital market entered a new era with improved legislation and regulation. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. While the Bank of Thailand had the regulatory power to influence business practices. However. the Government was under international pressure to deregulate the financial sector. The introduction of these two laws came just after the Government’s signing of Article VIII of an Agreement with the International Monetary Fund (IMF) in May 1990 to deregulate and liberalize financial markets. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. increased financial market activities.234 Corporate Governance and Finance in East Asia. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. In the 1990s. Thai banks gained access to a variety of funding sources from around the world. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. to cater specifically to its . Earlier. Externally. Vol. II the Ministry of Finance had full authority to supervise all commercial banks. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. the financial and banking laws were generally ineffective. and new financial instruments. the World Bank had recommended such a move. At the end of the Sixth Plan.” The Government also granted financial institutions overly generous bailouts. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. With the liberalization of financial markets. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. The regulatory measures were inadequately designed and poorly enforced. it usually relied on “moral suasion. Laws were enacted to stimulate growth of the corporate sector.
9 1. however.0 19.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. and Restaurants and Hotel Transport.9 16.0 110.9 34.1 trillion and paid-up capital of B1. Gas. about 661 companies with total registered capital of B2.9 261. and Communication Financing. The majority of the companies are in manufacturing.0 21. in that order.6 23. 4.2.1 Public Companies Registered.394. Forestry.Chapter 4: Thailand 235 fast-growing neighbors. Social and Personal Service Total Note: The data for 2000 is as of October 2000.5 50. Financial deregulation and liberalization were key to realizing that vision. Real Estate.6 1.3 trillion have been registered with the authority (Table 4.2 Type of Business Agriculture. Worldwide. The Bangkok International Banking Facility (BIBF) was thus established to facilitate international borrowings and encourage capital flows as a means of financing the current account deficit.1 78. . In terms of capital. Hunting.101.1 30.1). The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. the financial sector is the largest. The result was a corresponding growth and development in Thailand’s capital markets.3 83. Ministry of Commerce.0 Paid-up Capital (B billion) 1. Thailand. and wholesale/ retail trade and restaurant/hotel sectors. with B1. finance. Insurance.6 350. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. and Business Service Community.2 11.6 2.5 111. and Fishing Mining and Quarrying Manufacturing Electricity. and Water Construction Wholesale and Retail Trade.291. Storage.4 trillion in registered capital and B791 billion in paid-up capital. Source: Department of Commercial Registration.5 791. the country became recognized as an economic development model for other emerging economies.
this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together. The number of listed companies and securities steadily increased until 1996 (Table 4.9 1998 1999 15.7 5.7 136. reached .5 39.3 31.9 37.8 201. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. from only B20.4 51.7 9.8 — 26.7 billion in 1996.5 1.6 8.0 0.2 40. Vol.7 7. allowed Thai financial institutions and corporations to obtain funds overseas.236 Corporate Governance and Finance in East Asia.3 194.7 27.2 5. moreover.2).8 billion. Domestic and offshore debt issues reached B54.5 1.1 54. Table 4. The 1997 crisis battered the primary market for securities. the value of public offerings rose steadily.6 174. The development of the corporate sector closely followed the development of capital markets.0 20. Source: Key Capital Market Statistics. These peaked at B89. the year before the crisis struck.1 — — — 6.3).4 34. Securities and Exchange Commission of Thailand. meanwhile.8 1995 64.3 22.1 286.6 — = not available.7 billion and B27. reaching a precrisis peak in 1996 (Table 4.2 Public Offerings of Securities. After the passage of the SEA of 1992. The stock market also became an invaluable source of funds for corporations.6 7.2 25. respectively.9 31.5 — — 56.3 1996 1997 65. The signing of Article VIII with the IMF.8 151. reducing the value of offerings to a little more than a quarter of the previous year’s level. Market capitalization.1 599.6 39. 1992-1999 (B billion) Type of Securities Equity Debt Instrument Domestic Offering Offshore Offering Hybrid Instrument Domestic Offering Offshore Offering Total Funds Raised 1992 1993 1. II B261 billion.5 billion and B1 billion the previous year. While a rebound was apparent beginning in 1998.4 277.2 12. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.1 2. the capital market became instrumental in the rapid growth and development of the corporate sector.4 96.3 6.0 1994 82.
The financial leverage of all companies declined until 1994. But instead of shifting to a low gear.281 832 373 356 482 Due to listing requirements and other reasons. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3.6 trillion.5 at its peak in 1987. its high point in 1995 at B3.303 930 855 1.268 2.301 3. Foreigners accounted for an increasing proportion of SET’s turnover value. ROE similarly fell from 21. the companies could not generate enough net returns from their assets and equity. was the ominous deterioration in the key financial ratios of publicly listed companies. and gross profit margin.560 1. in the end. By the early 1990s. gross profit margin rose until 1991 before falling in 1992. not all public companies are listed on the SET. their share rising from 17 percent in 1993 to 43 percent in 1997.683 1.4). the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. The key financial ratios of all companies listed on SET bear this out (Table 4. corporate profitability had been declining. While the decline in gross profit margin was not as sharp.535 1. had been on the rise throughout the 1980s. The upward trends for ROE and ROA continued through 1989.565 2. Corporate profitability. resulting in their inability to fulfill debt obligations. return on equity (ROE).4 percent in 1996. The trend reversed in 1995.193 2.610 1. Meanwhile. then stalled in 1990.8 percent.325 3. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . however. ROA dipped from 10. however.114 1. the averages for all three profitability ratios took a downswing all the way until 1996.133 1.3 percent in 1989 to 3. Throughout the 1990s.201 2. when long-term debt grew as Thai corporations began to borrow heavily to finance growth.Chapter 4: Thailand 237 Table 4. Source: Securities and Exchange Commission of Thailand. From 10. as measured by return on assets (ROA).360 1.1 by 1996. pulled down by active public offering activities. the average times interest earned (TIE) was down to 5.3 Statistical Highlights of the Stock Exchange of Thailand.4 percent to 5. Side by side with this surge of financing for corporate growth.
7 54.4 12. which fell from 16 percent in 1991 to just under 6 percent in 1996.4 51.0 139.4 5.7 80.6 125.0 117.5 52.8 151.9 77.4 18.5 38.5 30.9 140. Severely affected by global competition throughout the decade. II Table 4.2 27.7 4.4 26.0 3.8 88.7 27.4 34.1 52.4 3.9 66.4 7.7 27.1 242.3 4.8 54.4 24. these companies opted for debt. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.5 50. and footwear industries also experienced losses.7 21.2 35.9 39.2 27.2 6.7 5. US. Thailand’s ROE.8 5. practice of heavy borrowing.8 25.5 9.5).1 16.0 29.2 215.6 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.2 10.7 15.3 12.4 12.4 Key Financial Ratios of Publicly Listed Companies.7 59.9 144.6 36. The downtrend in corporate profitability.6 12.4 9.4 7.7 20.6 138.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.7 35.4 119.0 63.4 4. A major reason for this was the rapid rise in asset prices.7 34.7 5.4 139.8 11.3 8. Among the crisis-hit countries.8 8.0 145. clothing.1 60.9 7. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. which was particularly significant in the two years preceding the crisis.1 44.6 168.0 7.3 10.1 9. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations. Korea and Thailand had the highest debt-to-equity ratios. Despite the availability of the equity market.2 161.4 44.8 5.7 5.9 7.7 12.5 63. was also distinct in the region.9 8.7 12. resulting in higher collateral values for borrowers.238 Corporate Governance and Finance in East Asia.6 27.3 91. the textiles.9 51. Hotels and travel showed the highest ROE of 15 percent while textiles.2 10.9 14.2 49.1 16.9 27.6 41. They were generally more efficient in managing their assets and .2 10. Overall.4 47.1 120. Vol.0 125.8 14.4 28.5 51. and footwear had the lowest at 11 percent. was felt across industries.7 12.6 7.8 51.7 12.5 15.2 64. clothing. 1985-1996 LongTotal Term Total Return Return Gross Debt Debt Debt on on Profit Times to to to Assets Equity Margin Interest Equity Equity Assets (%) (%) (%) Earned (%) (%) (%) 3.1 114.
8 6.7 6.7 14.3 23.9 13.1 29.5 7. Cumulative voting.1 6.5 87.8 47. which would be disruptive to company management.4 116. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.2 10.6 5.4 52.5 94.3 49. the law disallowed cumulative voting.2 134. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. In sum. also deteriorated.6 12.8 142. weaknesses became evident. measured by total asset turnover.0 83. the overall activities of listed companies.3 164.1 5.6 7.2 18.6 6.1 13. 4. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.3 15. However. could lead to a high turnover in the board. capital despite the higher gross margins of small companies.2.Chapter 4: Thailand 239 Table 4.4 8.4 Legal and Regulatory Framework Before 1992.6 30.6 10.8 26.8 10.3 49.3 135.1 Small Medium Large 5.6 30.0 20. US. by the 1990s.2 121.9 20. . For instance.3 43.0 48.2 12. Although stable in the 1980s. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate. 1985-1996 Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6.6 31. total asset turnover declined after 1989.8 62.7 10. They also tended to use more financial leverage than small companies as their total DERs show.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 61.1 25.3 25.3 52. During the 1990s. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.5 6.3 88. it was thought. although the performance of listed companies in the late 1980s was strong.8 6.5 Average Key Financial Ratios by Company Size.3 176.
2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. and external monitoring and control of corporations were also weak. relaxed the contentious provisions of the 1978 Public Limited Company Act. Cumulative voting was made optional.5. The law prohibited the largest shareholders. As the succeeding sections point out. coupled with weak corporate governance. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. Fortysix companies responded. As it turned out. but not all questions were answered. . This will be discussed in Section 4. Vol.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. for instance. However. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. and the punishment for management misconduct was also lightened considerably. An Asian Development Bank (ADB) survey conducted for this study shows. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. as a group. that creditors had generally little influence on the management of corporations. The Public Company Act of 1992. concentrated ownership. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. the exit of these provisions appears to have contributed to the 1997 financial crisis.240 Corporate Governance and Finance in East Asia. adopted to promote the development of publicly listed companies. II Another issue was the proportion of shareholding by top shareholders. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. The provision discouraged original family owners from registering their companies. played an important role in bringing about the financial crisis. The protection of minority shareholders was inadequate under the Public Company Act of 1992. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. 4.
1 4.2 56.9 26.4 6.5 9.0 53. Ownership Concentration Between 1990 and 1998.1 7.9 4.China have the least concentrated ownership.7 12.9 55.4 4.0 5. 56.2 4.1 11.4 percent of outstanding shares.4 6.2 11.0 3.1 5. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.3 7. respectively.6 57. and 28.9 3. with the largest shareholder on average controlling 10.4 26.6 68.3 11. the top five shareholders of each of publicly listed Thai companies held.9 52.9 6.9 52. this was not the case. 33. Stock Exchange of Thailand.3. these companies obtained funding solely from banks or from their own retained earnings.9 52.0 7.2 4. But with their increased reliance on new varieties of equity and debt instruments. with the top three shareholders accounting for almost 50 percent (Table 4.2 4.4 5.1 5.9 54. Indonesian. there were only slight variations in the pattern. Unfortunately. Most large Thai corporations listed on SET started out as family businesses.1 3.0 3. creditors. The Public Company Act of 1992 allowed ownership and control of these companies to remain with the founding families even as they became increasingly dependent on nonfamily resources.3 percent.7 7.Chapter 4: Thailand 241 4. Table 4.3 percent and 18. . one would expect the public. China firms have the highest single shareholder ownership concentration at 35.1 12.4 26. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28.3 16.5 Average for 1990-1998 period. In the past.3 7.3 28.6 27.7 percent.4 10.4 26.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.8 5.6 28.9 percent of shares of a company.1 percent of control rights. Thai. on average.5 28.0 7. Across industries.3 5.1 5.0 56.9 11.6 4. In contrast.7 6.6).8 11.7 11.9 3. and minority shareholders to stake their claim in the control and regulation of these companies. Source: Comprehensive Listed Company Information Database.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. Ownership was most concentrated in the packaging.8 32. and Hong Kong.
These are consistent with the hypothesis that companies with more concentrated ownership tend to engage in higher debt financing because their controlling owners do not want to dilute their control by bringing in new equity holders. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.647 Note: The regression included dummy variables for industry.115 9. Through these holding companies. Based on a regression analysis. results show a significant positive relationship between ownership concentration and financial leverage.034*** 0. ** at the 5 percent level.005** 0. founding families maintain effective control of entire groups.022*** 0.533)*** Debt-to-Assets (0. Company size is significantly related to ROE and leverage.090 0. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. Leverage. II agribusiness.080 6.242 Corporate Governance and Finance in East Asia.800 0. there is no statistically significant relationship between ownership concentration (measured by percentage of shares owned by the top five shareholders) and profitability of Thai publicly listed companies (Table 4. as measured by debt-to-equity and debt-to-asset ratios.8). with a top-five ownership concentration of at least 60 percent. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. including those that are publicly listed .031 3.029 3. US. and ownership types.037 0.7). year.116) Debt-to-Equity (1. Table 4.7 percent of outstanding shares on average (Table 4.169*** 0.058* ROE (0. * Denotes significance at the 10 percent level. owning 26.072) (0. *** at the 1 percent level.001*** 0. and building and furnishing industries. Ownership Concentration.7 Statistical Relationships between Corporate Profitability. On the other hand. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.001) 0.003 0. Vol.001 0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.
the company. In 1994.5 percent.7 5.6 5.4 22.2 1.3 percent of outstanding shares.9 6.0 3. Stock Exchange of Thailand. This practice is illustrated by Central Pattana. with 29.5 0. including finance and investment companies.6 1.5 26.1 0.3 1. unlike in Japan where crossshareholding is common.3 20.1 4.3 0.4 1.5 Individuals 13. owned by the Chirathivat family.8 1. a company listed in the real estate sector of SET. Source: Comprehensive Listed Company Information Database. averaging about 18. Although holding companies set up affiliate firms.8 28.2 18.4 1.8 0. operates five of the most successful shopping malls in Thailand.3 27. the affiliate firms rarely hold shares of their parent companies.5 2.5 5.0 18. Established in 1980 with a registered capital of B300 million. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.1 1.9 18.5 Government Other 0. The ADB survey indicated that listed companies held shares in an average of 11 companies. In addition.3 27.0 17.5 1.3 1. .9 0. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.9 15. one of the founding members.7 — 1.6 25.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.4 1.5 NBFIsa 6.5 1.7 1.4 20. The largest shareholder is Central Holdings Company.Chapter 4: Thailand 243 Table 4.6 28.5 0.8 23. Typically. a NBFIs denotes nonbank financial institutions.2 1. the company increased its registered capital and became a public company listed in SET. Individual family members also hold a significant amount of outstanding shares. in SET.5 0.2 5.9 7. individual members of the Chirathivat family aggregately hold 25.6 percent of outstanding shares.3 27. These individuals usually hold important management positions in concerned companies.7 0.2 7.1 1.9 19.0 19.3 1.7 Bank 2. The top 10 shareholders include a holding company owned by the Tejapaibul family.3 — = not available.6 1.6 1. a joint venture among three families. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.
3 Discussions in this section are based on results of company surveys by SET and ADB. Except in the hotel and travel service sector. qualification. For example. 1. Vol. Nonbank financial institutions hold an aggregate 5. has the Ministry of Finance as its only large shareholder with 92. and a state bank.9 percent of outstanding shares. Moreover. By owning 62 percent of voting shares. only one tenth of listed companies have commercial banks on their top-five shareholder list.5 percent of total outstanding shares of listed companies. the top 10 shareholders consist predominantly of members of founding families and their holding companies. both conducted in 1999. the Government owns the majority of the shares. There was a trend of rising government shareholdings throughout the period 1990 to 1998. Another example is Bangchak Petroleum Plc. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. II another of the company’s founding members. Only a handful of companies have the Government among their large shareholders. where the top three shareholders are the Ministry of Finance. . Together. commercial banks account for only 1.5 percent of total outstanding shares. they account for 80 percent of total outstanding shares. roles. the Government’s role in public companies is expected to decline. In effect.3.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. and responsibilities of directors of public companies. The Government holds. the predominance of individual family members and holding companies in the top shareholder list remains valid. these shareholders are able to control the company. they exercise limited influence in operations because of the restricted size of their shareholdings. duties. Although the list of top shareholders of publicly listed companies includes financial institutions. with the envisioned privatization master plan. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. on average.. Thai Airways International Plc. In such cases. the Petroleum Authority of Thailand. On average.244 Corporate Governance and Finance in East Asia. 4. Across industries.1 percent of total outstanding shares of listed companies. However.
while 30 percent of respondent companies held board meetings monthly. an executive board consists of senior management and some main board members. Meanwhile. Unless stipulated in public companies’ articles of association. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. directors shall be elected at the annual general shareholders’ meetings (AGSMs). directors are required to act with care and honesty for the company’s best interest. The ADB survey indicated. while 15 percent of respondents went beyond the requirement. and to comply with the laws and articles of association. In their business conduct. directors may be imprisoned or fined. Although 28 percent of the chairpersons came from the ranks of independent outside directors. Nineteen companies stated that selection was based on professional qualifications.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. but not in 22 others. In five other companies. In addition. selection was based on relationships with controlling shareholders. Some companies (36 percent) had five to six main board members holding seats in their executive boards. Three companies indicated that the CEO and the chair were close relatives. directors could be compelled to compensate the company for damages arising from their misconduct. Many companies have a formal policy on corporate governance and business ethics. Chair of the Board and Chief Executive Officer The SET survey showed that about 73 percent of listed companies had a separate executive (management) board. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. Generally. the majority (71 percent) had board chairs who were also members of top management teams. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. meanwhile. If found in violation of these provisions. .
Vol. Also. the remuneration packages had to be approved during AGSMs. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. while 19 companies observed only some of them. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. Where different. with 41 firms admitting the use of services of international auditing firms. the auditor is not . however. the work of this committee was often considered part of the executive board’s responsibilities. Audit Committees and Accounting Standards Since January 1999. Chair. The directors’ compensation was determined largely by the Board of Directors except in 19 percent of the companies surveyed where a remuneration committee was in charge. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. These committees were mainly responsible for determining compensation for senior and regular staff. not an independent assignment. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. In one company. Half of the companies in the SET survey had a separate remuneration committee. In 25 companies. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards.246 Corporate Governance and Finance in East Asia. SET’s attempts to bring accounting practices to international standards have included requiring listed companies to consolidate all liabilities— including those on off-balance sheets—in their financial statements beginning June 1998. II Compensation of Directors. However. Companies already with audit committees did not have independent outside directors as audit committee members. All respondents confirmed the use of external auditors. Three companies allowed their management to determine the chair’s compensation package.
(i) No standards are enforced in the content and timing of notices for shareholder meetings.Chapter 4: Thailand 247 independent from the company. However. there are also significant gaps in the system of shareholder protection. For instance. Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. and the Bank of Thailand— are not clearly defined. SET. As a result. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. According to the ADB survey. Forty-four companies indicated that they had proxy voting in place. most responding companies have rules and regulations intended to protect shareholders. shareholders can claim compensation in cases of negligence or dishonesty by management. remuneration. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. there is the danger that top management may be capable of unduly influencing the board’s decisions. (iii) Because the chair is frequently also part of the top management team. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. debentures. or other financial instruments. In the majority of these companies (38 out of 46 respondents). as well as the registration and holding of shares. SEC. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. At least 28 responding companies had the following . Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. The Act also holds directors liable for any damage to shareholders. Relationships between firms and external auditors are generally long-term. and executive committees. SET’s rules and regulations closely follow this Act. stipulates the proper conduct of shareholder meetings. While safeguards are in place. although recently. (ii) The prudential role of outside directors is limited by the noncompulsory character of their participation in key decision-making bodies such as the audit. The Act. averaging about 14 years. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. likewise. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. shareholders have access to reliable information at no cost. with 13 companies allowing proxy voting through mail.
These problems appear to be partly a result of the relaxation of the rules and regulations in the original Public Limited Company Act of 1978.248 Corporate Governance and Finance in East Asia. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. . 66 percent of total outstanding shares. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. Written law and its enforcement diverge partly because of a provision that shareholders who take action against erring directors must have at least 5 percent of the total number of shares. 4. did not vote in previous AGSMs. But the exercise of these rights requires even higher shareholding levels. on average. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. In practice. While stimulating the growth of the sector.3. Although the attendees held. given their importance in providing finance and their stake in companies. the only group of shareholders that can exercise rights is the top five shareholders. minority shareholders are assured adequate legal protection. Only a small number of shareholders attended the latest AGSMs. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. and mandatory disclosure of related interests and significant shareholders’ transactions. Banks would be obvious candidates to implement these mechanisms. takeover of the company. But with the ownership concentration of Thai companies. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. Almost 82 percent of shareholders.3 External Control Control by Creditors The fact that insider control in Thai companies is very strong should compel a search for alternative external control and monitoring mechanisms. such protection has been insufficient. Vol. it would be difficult for minority shareholders to gather the shares needed to take action. In theory. and insider trading. On paper. however. representing only about 28 percent of shareholdings. and call an extraordinary session. they comprised only 8 percent of total shareholders. In effect. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings.
Under a weak bankruptcy system. other than losing control. Normally. the majority believed that creditors had little influence on company management and decision making. to solve debt repayment problems. such as that seen in Thailand before the crisis. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. There were many options. 17 indicated that only some of their creditors had such a requirement. Actual bankruptcy proceedings took more than five years on average. However. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. a company’s reputation and its long-term relationship with creditors sufficed in many instances. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. which could cause a delay by at least a year. Apparently. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. as the ADB survey confirmed. however. while 18 said none of their creditors required collateral. creditors do not always require project feasibility studies or business plans in granting loans. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. borrowers seldom lose control to creditors even when they default and become insolvent. For 20 of the 46 responding companies. Leverage allows the assets and operations of the company to grow without diluting corporate control. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. 11 experienced rejection after the crisis started. they resort to borrowing. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. including procedural disputes. .Chapter 4: Thailand 249 Historically. while loans for fixed investment were also more likely to be supported by collateral. creditors’ collateral requirements were tightened after the crisis. In the end. Most companies reported that banks were more likely to require collateral. when insiders want to expand their company’s operations without losing control. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. Only three companies thought otherwise. Debtors had many handles to stall the bankruptcy process.
before the extent to which the bankruptcy framework has been strengthened becomes clear. Since the introduction of the Public Limited Company Act of 1978. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. its main role is to ensure transparency and fairness. Although merger and acquisi- . The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. The first category is the acquisition of shares in the open market. Such efforts would serve to strengthen external discipline on controlling owners. whether directly or indirectly. SEC has no authority to either approve or reject tender offers.3 billion (Table 4. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. however. The second category is the tender offer. only a limited number of successful mergers of public companies have taken place. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. In 1994 and 1995. with a significantly lower total tender offer value of B8. and failed to provide managers with strong incentives to perform efficiently.3 billion. The market for corporate control has not been active in Thailand.9). In 1996. of shareholders: (i) all shareholders must receive tender offers. there are two categories of merger and acquisition activities with associated regulatory measures. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. There are detailed requirements regarding such notification. According to the SEA of 1992. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. SEC was later made responsible for regulating corporate takeovers. Recently.250 Corporate Governance and Finance in East Asia. It will take years. with a total tender offer value of B42. if the purchase of shares implies a change in the directors or business activities. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. Vol. there were only six tender offers. In this case. there were 41 cases of tender offers.
9 3.1 19.7 Purchase Value Number of % of Tender Offer Value Companies 84.1 58.2 7. But instead of opting for an active role in the market for corporate control. trading by mutual funds in SET represented less than 10 percent of total trading. Source: Securities and Exchange Commission of Thailand. employees are even less willing to accept common shares as a form of compensation or benefit. . Eleven of the 46 responding companies in the ADB survey offer ESOPs. but the average shareholding is smaller than 1 percent of total outstanding shares.3 6. While the Thai mutual fund industry compares well to those in other developing countries in the region. Few companies offer employee stock option plans (ESOPs). The number of domestic institutional investors rose after the mutual fund industry was established in 1991.2 6.4 23.1 84.2 6.0 55. employee participation in corporate governance in Thailand.6 17. employees regard the plans as monetary incentives. Twenty-nine firms indicated that employees held shares of their companies.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.8 81. Pension funds are perhaps even weaker in Thailand.7 11.9 Merger and Acquisition Activities.3 60. not with a view to becoming involved in actual management. Provident funds for government workers and workers in public enterprises have been established only recently.0 B billion 4. Employee Participation in Corporate Governance There has been little.Chapter 4: Thailand 251 Table 4. Because of the current crisis.3 11. most of these were forced mergers or related to rescue packages. Since 1994. they have mostly been concerned with short-term gains. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.1 75. it remains small.5 6. but employees have never been represented in the board of directors since their shareholdings are minimal. if any. Even when companies offer ESOPs.2 8. tion activities increased after 1997.
6 6.360.3 5.912.2 262.372. The bond market played only a marginal role in corporate financing.669.4 4.1 5.663. total assets of commercial banks amounted to B5. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. Bangkok Bank Ltd.10 Size and Composition of the Thai Financial Sector.1 7.825.1 6.979.1 Domestic Debt Securities Outstanding 215. Vol.564. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.0 SET Market Capitalization 1.0 8.9 2.10) shows that Thailand is a highly bank-dependent economy.5 6.0 3.5 Outstanding Loans from Commercial Banks 2. .037.559.1 3.906.6 1.775.268.390.252 Corporate Governance and Finance in East Asia.325.193.119. Thai Bond Dealing Centre.430.4 519.6 2.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand. The country’s largest bank.230. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4. accounted for 28 percent of the banking sector’s total assets.5 trillion. The share of domestic banks in the banking system’s total assets was 80 percent. Table 4.4 3. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2. the banking sector was highly concentrated.5 5.4 4.1 3. In 1996.485. although its role increased in the wake of the crisis. there were 29 commercial banks.4.3 1.3 546.0 339.4 1.161.477.300..8 3.8 941. The Banking System Until recently.5 4. and Bank of Thailand.5 4. 15 of which were domestic banks. II 4.0 424.171.2 2. the next four largest banks accounted for 63 percent.133.
also made it unattractive to raise capital from the equity market.8 in 1998. Licenses were granted to 15 Thai banks. BIBF banks also enjoyed tax incentives on their operations and profits. In the following years. owning 70 percent of the country’s second largest bank. The number of listed companies also quadrupled between 1981 and 1993. In 1993. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. was set up by 74 members with an initial capital of B500 million. Benefiting from rapid economic and industrial growth. The Equity Market During the first few years of its operations. Some 347 companies were listed in the same year with a total market capitalization of B3. After that. SET was not very active. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. the Bangkok Stock Dealing Center (BSDC). In 1995. reaching 355. an over-the-counter market. and 20 new foreign banks. the SET index declined. SET is organized into 32 major industries. Despite the worldwide market crash in 1987. the stock market entered its first boom period in 1986. SET immediately recovered due to the strength of the Thai economy.3 trillion. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. and almost all capital account transactions were deregulated. finance. Turnover value reached B2. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. The lack of supply of quality shares was a big problem for SET at that time. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. BSDC is a nonprofit. The Government removed controls on capital and dividend repatriation in 1991.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. Banking activity peaked in the mid-1990s.2 trillion. self-regulatory organization under the . 12 existing foreign banks. In contrast. Because borrowers carried the exchange rate risk. due to their close ties. the market rose steadily and reached a record high in the fourth quarter of 1993. banking. Through the years. Easy access to commercial bank loans by family business groups. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. and property have accounted for the bulk of trading volumes.
the two classifications were merged. If the issue is oversubscribed. which consist of SET and BSDC. among other functions approved by SEC. SET’s primary functions are to serve as a center for the trading of listed securities and to provide the essential systems needed to facilitate securities trading. It separated the primary and secondary markets to promote more flexible and effective supervision of both.8 billion in 1996. Before 1993. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. Listed companies were those that had (i) paid-up capital of at least B20 million. After initial public offerings. The listing application should be submitted concurrently to SEC and SET. Turnover value was B1. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. also acts as a clearinghouse. If approved by SEC and the SET Board of Governors. Only one security was listed in BSDC in 1995 and two more in 1996.5 percent and collectively owning at least 30 percent of paidup capital. stock trading can commence within five days. lottery drawing must be used to ensure fairness. approved by SET. however.254 Corporate Governance and Finance in East Asia. each holding no more than 0. SET established new requirements for initial public offerings. and (ii) a minimum of 300 shareholders. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. SET. The company should then appoint a financial adviser. In 1998. securities can be traded in the secondary markets. In July 1990. securities deposit center. The primary market is supervised by SEC. the BSDC was dissolved in 1999. The allocation procedure is nondiscretionary. Consequently. there were two kinds of companies in SET—“listed” and “authorized” companies. Company applicants must have an established history of operating under substantially the same management. and securities registrar. According to the SEA of 1992. to assist in the public offering process. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. and pro forma balance sheet and income statements. II jurisdiction of SEC. . Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. but dropped the following year to B122 million. with each facing different listing requirements. Vol. turnover value was negligible and the BSDC Index remained flat throughout 19961998. financial projections. In 1996. so now only listed companies are traded in SET. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets.
the Government issued more bonds to finance industrial development projects and perennial deficits. it represented only 9 percent of GDP. Beginning 1961. which encouraged limited companies and public companies to issue debt instruments. The proportion of domestic convertible debt instruments increased until 1995. The bond market in Thailand started in 1933. in 1994. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. the size of the corporate debt market rose to B132. however. the market for these bonds has been slow owing to the change in the Government’s original policy of requiring the use of state-guaranteed bonds as legal reserves. In 1996. the Bank of Thailand assumed responsibility for regulating the bond market. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. the first bond rating agency in Thailand. Upon its founding in 1942. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. The corporate sector played a limited role in the bond market in the early years because of the complicated rules and regulations in effect at that time. and the Government did not issue new bonds during 1990-1997. To gain some perspective of the size of the bond market in Thailand. compared to 110 percent in the US and 74 percent in Japan in the same year. Companies generally issued short-term debt instruments like promissory notes or bills of exchange.11).Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. Investors had limited knowledge of debt instruments. However. The recent financial crisis. it accounted for a small share of the entire financial sector. The budget surpluses of the 1990s eliminated the need for new bond issuance. while secured debt instruments accounted for just above 10 percent.9 billion. was also instrumental to the growth of the corporate debt market. A turning point of the corporate debt market was the enactment of the SEA of 1992. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. The Thai Rating Information Services. . Four years after the passage of the SEA.
2 2.2 89.1 289.0 60.1 121.4 110.2 43.8 31.7 132.5 10.7 28.7 95.4 — — — 1.4 — 9.1 61.1 — — — 29.6 billion.9 0.4 — 26.3 6.0 86.9 40.1 6.1 8.1 55.8 55.0 — 5.0 17.3 3.7 0.7 — — — — — — — 77.5 — 39.7 821.9 329.0 27.9 37.0 33. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts. then declined substantially in 1996 and 1997.2 28.9 5.5 55.256 Corporate Governance and Finance in East Asia.3 13.7 5.1 141.7 7.0 7. Total offshore debt offerings peaked in the run-up to the financial crisis.5 — — 32. total offshore debt offerings had plunged by 68 percent to a mere B28.5 138. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.1 41.0 26.3 140. The following year.3 — — 3.4 billion.9 20.0 333.9 30.1 10.2 57.1 315. By 1995.5 billion.3 — 14.11 Offerings of Debt Securities.1 12.1 — — 6.7 5.8 2.5 — — — — 1. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.3 50.6 — — 0.0 281.8 191. this had climbed to B200.1 21.1 59. turnover value had reached B51. by the end of 1997.8 167.2 39.4 49.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.8 47.7 538.7 0.5 37.3 22. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.5 — 0.1 107.7 — — — — — 4.2 — — 50.9 37.0 0. .2 45.4 7. the year the crisis unraveled and the baht was floated. II Table 4. a surge attributed to capital inflows encouraged by high returns on Thai bonds.3 46.3 8. However.0 5.6 19.3 29. Vol.7 90.0 — 26.5 5.5 — — — 3.6 — 0.3 46.5 43.0 — 5.7 — — 40.4 57. 1992-1999 (B billion) Item Government Bonds Treasury Bills State Enterprise Bonds Guaranteed Nonguaranteed Other Government Bonds Corporate Bonds Domestic Secured Unsecured With Warrant Convertible Short-Term Offshore Secured Unsecured With Warrant Convertible Total 1992 1993 1994 1995 1996 1997 1998 1999 — — — — — — 400.
Companies in construction and property development seemed unable to generate internal funds. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996.Chapter 4: Thailand 257 compared with investment in equities. In the same year.12). The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. short-term loans accounted for more than 40 percent of total liabilities. while for the property development industry. these accounted for 33 percent of total liabilities. significant variations can be noted. Turnover fell further to B72. 4. steadily easing up between 1990 and 1996. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. and marketable securities holdings. For the construction industry. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange.4. a trend most apparent in the leap between 1991 and 1992. Construction and property development industries tended to have high proportions of long-term loans and debentures. cash balances. In any case.2 billion as a result of the default of debentures due to the Asian crisis. At lower than 5 percent of total liabilities. Retained earnings accounted for about 30 percent of total equity financing. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. with equity levels remaining high despite an increase in debt. turnover value plummeted to B106. There was also little change in the trend in retained earnings within the seven-year period. judging by their relatively low levels of retained earnings. The proportion of accounts receivable also declined steadily. these comprised 31 percent. From 1990 to 1996.1 billion in 1998. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. Longterm loans accounted for about 20 percent of total liabilities.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. In 1997. In addition. they also had a relatively small proportion of equity and . Equity financing remains an important part of listed companies’ long-term financing. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. The average for all industries was only 22 percent. Across industries.
2 42.2 2.5 9.8 1.9 18.6 2.2 12.6 22.2 43.5 9.0 100.2 17.0 Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.2 1.0 10.9 14.8 21.0 10.9 14.3 25.5 1. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.2 35.6 36.3 17.9 15. compared with the 44 percent general average.6 11. II Table 4.0 100.9 20.1 13.1 49.8 6.0 100.2 22.5 11.0 100.8 9.3 18.3 1.0 51.4 17.8 7.9 49.2 3. US.7 7.0 100.6 50.8 46.0 100.3 48.0 100.8 35.2 16.9 40.8 10.8 25.8 14.6 38.0 12.4 17.9 38.6 21.6 0.0 100.3 2.8 34.1 18.3 34. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.3 34.6 0.13).5 1.0 100.3 18.1 36.8 37.3 38. were highly leveraged.6 100.7 16.9 14.9 2.3 12.6 15.1 5.6 0.258 Corporate Governance and Finance in East Asia.1 50. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.6 13.6 12.6 6.4 2.2 16.1 7.3 14.7 14.3 14.7 16.3 49.9 50.8 9.1 2.0 13.4 7.4 43.0 2.9 14.6 14.2 2. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.2 2.6 51.9 43.8 3.9 16.0 100.4 21. Vol.0 14.2 2.3 1.8 37.9 0.7 1.5 0.2 1.6 0. medium.8 8.4 14.5 1.2 15.2 17.7 0.7 52.7 17.5 14.8 17.0 100.0 100.2 17.0 15.0 7. Printing and publishing companies had lower financial leverage than companies in other industries.9 17. The level of total liabilities for the group characterized by high ownership concentration .7 15.9 6.0 48.9 6.2 34.2 1.4 48.0 100.7 9.4 49.0 1.8 19.9 17.3 21.4 6.3 50.9 12.4 49.4 8.12 Common-Size Statements for Companies Listed in SET.6 8.2 17.3 6.8 20.2 43.5 43.7 36.0 100.7 18.6 18.9 10.2 45.6 10.9 14.9 3.6 100.5 37.1 17.7 50.0 6.
1990-1996 Degree of Ownership Concentration Item Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity High 2. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.8 37.0 14.1 18.6 14.3 35.1 36.4 18.3 16.4 7.3 1.4 50.8 13.7 17.4 1.Chapter 4: Thailand 259 Table 4.2 0.0 6.0 6.7 12.5 13.2 8.0 100.1 53.6 15.6 22. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.5 percent for low ownership concentration companies.9 2.9 7. was 53 percent of total assets compared with 49.9 0.4 35.4 49. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.4 13.0 Low 1.6 0.9 36.8 13.6 100.3 8. For the high ownership concentration group.6 9.0 100.0 Medium 2.7 19.2 45.1 49.9 100. US.0 7.8 12.3 100.1 44.9 16.3 1.7 percent for medium ownership concentration companies and 49.4 37.2 11.0 19.2 22.4 3.6 47.0 41.13 Common-Size Statements of Public Companies by Ownership Concentration.9 50.5 11.0 16.9 21.2 14.5 21.5 18. .5 100.6 2.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.
Vol.7 28.7 34.4 139. The TIE ratio declined from its peak of 7. Short-term debt accounted for most of the increase.0 28.14 Financial Ratios of All Listed Firms. the choice of financing is determined by the company’s liquidity considerations.9 63.7 5.9 7.3 61. followed by bank loans. An overall picture of SET-listed companies’ financing and investment patterns in the 1990s shows a steady rise in the use of financial leverage (Table 4.1 52.15. bond issues overtook loans from commercial banks as the second preference.9 14.6 7.4 5. was the headlong deterioration of firms’ ability to meet their interest payment obligations. As a result.14). however. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.7 in 1994 to 5.1 44.7 12.6 138. After the crisis.8 65. minimization of transaction and interest costs.8 151. Table 4. these firms more easily increased their leverage.260 Corporate Governance and Finance in East Asia.4 12.1 31.2 68.0 145. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.1 23.8 5.9 51. thus rendering them more vulnerable. however.5 52.1 144.4 7.0 50.4 51. Generally.6 41.8 percent in 1990 to 52.2 49. 1990-1996 Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) 1990 1991 1992 1993 1994 1995 1996 8. .7 66. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.1 64. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.6 125. US.4 44.8 65.1 31. bond issues.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.3 31.2 35.7 12.7 34. The ratio of total debt to total assets increased from 50. More important.0 25. While further detailed investigations are necessary.7 11.1 in 1996.1 16.7 percent in 1996. and rights issues. especially from 1994 to 1996.1 16.8 51. Such deterioration of financial positions during the period was a common feature of listed companies. Public companies relied more on short-term debt financing in the period before the financial crisis.5 38.9 140. and maintenance of the existing ownership structure.
5 4. private debt accounted for 84. the proportion of short-term debt increased from 15. The proportion of nondebt-creating capital flows.5 34. The proportion of external debt as a percentage of GDP consequently increased from 42.2 percent in 1986 to 251. From only 34 percent in 1986. Nonbank private debt increased from 27. 4.0 64.4 63. The composition and term-structure of this debt. unhedged foreign exchange liabilities.16).Chapter 4: Thailand 261 Table 4.15 Financial Ratios of Listed Companies by Ownership Concentration.9 percent in 1997.5.5 148. Their average annual growth rate declined from 28.4 13. is even more telling. such as direct equity and portfolio investment.4 27.2 49.4 52.5 percent between 1985 and 1990 to 8.8 49.7 percent from 1991 to 1996.6 30.5 126.4 percent to 46 percent during the same period.8 14. 1990-1996 Degree of Ownership Concentration Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) Low 6.3 42.6 11. however.5 percent of external debt in 1996 (Table 4.1 High 6.8 29. continued to slide from 1985 to 1997. US.8 Medium 7. Additionally.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. . This decline was accompanied.2 124. From 45 percent of total net capital movements in 1985.8 28.8 66. peaking in 1994 at 84 percent. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF. debt-creating capital inflows rose to 65 percent in 1990. and a preponderance of short-term debt liabilities. on the other hand.8 percent in 1986 to 52 percent in 1995.1 The Corporate Sector during the Financial Crisis Impact of the Financial Crisis on the Corporate Sector The financial crisis came after a period of rapid growth in the Thai economy.
3 — — — — — — — 6.9 4.3 16.9 11.2 2.7 10.8 3.7 0.2 32.1 22.Table 4.9 5.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.2 10.5 14.7 1.1 95.3 37.3 12.5 12.4 3.4 2.3 0.0 8. .3 10.2 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.2 0.0 4.9 100.0 3.5 4.0 13.8 0.9 0.9 35.3 0.4 15.3 0.5 16.3 3.7 20.3 0.0 0.0 6.1 64.9 10.1 30.1 0.5 12.1 5.8 12.5 4.7 23.2 14.3 0.3 0.6 Total 18.3 20.6 52.9 7. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.9 3.6 — 0.3 2.9 6.16 External Debt.9 1.3 0.2 2.9 29.7 2.6 18.1 34.4 5.3 105.2 15.7 24.9 1.0 11.1 23.3 0.9 13.1 2.3 7.7 109.8 13.9 10.0 11.9 3.8 108.5 1.8 10.5 19.4 — — — — — — — 1.4 18.0 21.9 43.9 6.9 31.7 13.2 2.8 31.1 0.1 12.1 0.1 Source: Bank of Thailand.3 3.2 0.4 10.6 1.1 0.8 3.6 7.
suggesting that serious investors have not returned to the market. If lending rates remained high. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. On average. The value of public offerings sank in 1997 to B56. exposing the companies to disaster when the baht started tumbling on 2 July 1997. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998.281 in December 1995 and to 831. and drastic decline in the number and capital of newly registered companies.6 in December 1996. reaching 45 percent of total outstanding credit in December. the SET Index stood at 1. The effects of the crisis were felt across all industry sectors. Similarly. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. the index declined to 1. the number of newly registered companies dropped to a 10-year low in 1998.360. Even before the crisis. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. At the end of 1994.17). After that. and (iii) bankruptcies. the liquidity problems faced by the corporate sector are likely to continue for some time. Most of these foreign debts were not properly hedged. trading activity at SET had been on the downturn. With easy access to foreign funds. based on the three-month past due definition. from its peak in 1995. Due in part to liquidity problems on the one hand. outstanding credit also declined throughout the second half of 1998. leaving domestic investors with large capital losses. Aside from the problem of NPLs. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. and poor business confidence on the other.6 billion from the 1996 level of B201 billion. The ADB survey conducted for this study confirms this: 35 of the 46 respondents indicated that they took out foreign-denominated loans mostly from foreign banks. Meanwhile. Foreign investors retreated from the market. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. according to the Bank of Thailand. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. Trading volume has since been thin. banks would be recording more of such NPLs. closures. It hit a 10-year low in the second quarter of 1998. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. .
224 4.105 4. 4.066 19.080 9.925 12. .777 11.410 37.904 20.264 Corporate Governance and Finance in East Asia.334 4.17 Number of Newly Registered and Bankrupted/Closed Companies.695 3. The price-to-earnings (P/E) ratio deteriorated from 19.218 3.677 Bankrupted/Closed 2. the Government was left with no choice.095 14.112 9.2 billion for balance of payments support and buildup of the country’s reserves.307 4.288 35.792 7.902 3.201 24.096 22. II Table 4. But when assistance from other sources did not materialize. A steady price decline over the past few years has dragged down the ratio of market price to book value. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.797 4. Vol.6 in 1997.5 at the end of 1994 to 12 in 1996 and further to 6.410 5.134 31. As part of the assistance package.977 Source: Department of Commercial Registration.409 6. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.915 37.407 28. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.312 25. It also explains the higher dividend yield ratio. Ministry of Commerce.2 Responses to the Crisis Initially.5.933 25.052 36. Thailand. The IMF financial package was a credit facility of $17. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.
only two companies emerged intact from the suspension. Many believed that the process was inefficient. and Credit Foncier Businesses. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. These include repeal of the Commercial Bank Act.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. There were many options for solving debt repayment problems. debtors could drag out the process for many years. and worked on revisions to the Secured Transaction Law. and did not recognize debtor-initiated bankruptcy declarations. and the Act Regulating the Finance. and restore solvency. also aimed at institutionalizing legal and regulatory reforms. While no definition for “insolvency” could be found in the bankruptcy law. and if necessary. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. secured creditors had to obtain the court’s approval before starting proceedings . By invoking procedural loopholes. follow through with a civil or bankruptcy suit. For example. Strict loan classifications. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. Creditors could negotiate to reschedule debt repayments. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. the Civil and Commercial Code. loan provisioning. it was widely interpreted as “having debts more than assets. IMF relaxed these key conditions. drawn up with World Bank and ADB assistance. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies. and income recognition were implemented. Regulatory Response by the Government The IMF program. Under the old bankruptcy laws. As it turned out. Securities. increase profitability. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. The old law allowed only creditors to file bankruptcy suits. The assets of the other companies were liquidated by auctions. creditors seldom succeeded in obtaining payment against bankrupt borrowers. however. In early 1998. The Bank of Thailand also improved banking standards.
a remedy beneficial to borrowers and creditors is made possible through a business reorganization that should improve the borrower’s debt position and ensure its continued operations. In 1999. II for the recovery of debt through the realization of any collateral. the judges and court officers have yet to learn and master the new bankruptcy procedure. In effect. To make matters worse for creditors. The reorganization process is successful if (i) the debts shall have been discharged. But more important. and expensive process. the amended law limits the rights of secured creditors. Enforcement of the new law is bound to be ponderous and lengthy. time consuming. The new law is designed to prevent bankruptcy due to temporary liquidity problems by allowing an insolvent debtor to file a reorganization plan with the court. it covers only the court-supervised reorganization of distressed companies. (ii) management of the company reverts to the borrower. If the process fails to revive the business. For one. (iii) shareholders regain their legal rights. thereby allowing court-supervised corporate restructuring. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time.266 Corporate Governance and Finance in East Asia. which means that a debtor could continue in business while the reorganization program was being implemented. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. There are other potential problems. In Thailand. The amended legislation also includes voluntary bankruptcy as a new feature. Under the old Bankruptcy Act. The amended law also introduced the concept of automatic stay. the main purpose of which is to assist in the rehabilitation process so that a company can repay its debt and still retain its assets while remaining in business. The amendment added reorganization provisions to the Bankruptcy Act of 1940. Chapter 11 is the main tool in restructuring bankrupted companies in the US. and (iv) the debts shall have been settled within a five-year period. The original Bankruptcy Act dealt only with liquidation and composition. Vol. the company shall be declared bankrupt and liquidation of assets shall follow. but it is a complicated. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. Companies need . The model for Thailand’s amended bankruptcy law was the US Chapter 11. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment.
In case the board of directors does not comply. corporate governance) that caused the bankruptcy in the first place. The result. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. and (ii) processing of default cases within four to six months of filing of a court claim. only tangible assets were the norm.g. namely “liabilities exceed assets. Replacing the Public Limited Company Act of 1978. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. Under the new law. . the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting. has not been satisfactory. In the past. Still pending Parliament approval is the amendment to the Secured Transaction Law. shall have the power to call the extraordinary general meeting.” The Foreclosure Act Amendment was likewise passed in 2000. SEC also examined the possibility of an amendment to the Public Company Act of 1992. after determining the legitimacy of the request. Minority shareholders also have to absorb the costs related to their actions because the 1992 Act does not allow them to be reimbursed by the company. questions have been raised regarding the appropriateness of the 1992 Act. the test for insolvency still uses the balance sheet criterion. however. Without the necessary corporate restructuring. minority shareholders’ rights are not adequately protected. Consequently. Most important. The amendment also remedies the slow process of executing or disposing of assets in a public auction..” as opposed to the more appropriate criterion of “ability to pay when the debt falls due. the court. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. The new foreclosure law cuts short the procedures required under the Civil and Commercial Code for petty or simple cases dealing with mortgage defaults: (i) submission by the drafting committee of a default judgment bill within a week. There have been proposals to lower the minimum shareholdings required for a minority group to request the board of directors to call an extraordinary general meeting at any time. The proposed new law seeks to expand the type of assets that a borrower can use as collateral.Chapter 4: Thailand 267 to solve the problems (e.
to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. it permits directors. In addition. However. Otherwise. Vol. Consequently. This may be true in countries where publicly traded companies are widely held. The radically changed circumstances after 1997 offer the possibility that firms and their controlling shareholders will be under greater pressure to concede to the exercise of minority rights. Because of high ownership concentration. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. The only reason Thai investors placed their money in stock issues despite these legal cracks was the rapid increase in stock prices in the 1990s. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. But as demonstrated. minority shareholders have no chance of being represented in the board. disrupts the company’s management and decision making. i. The regulators are drafting a proposal to amend the provisions on related transactions. who are also the managers. The proposal for the amendment of the Public . The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. which.. and determine voting results on virtually any matter. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. In the absence of such a stock market boom now. they face the prospect of being unable to compete for the scarce funds available in the equities market. the dominance of controlling shareholders. the controlling shareholders have the exclusive domain to appoint or exercise management. with the approval of the board.268 Corporate Governance and Finance in East Asia. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. in turn. vis-a-vis the minority shareholders. Where equity will come forward. The proposal clearly delineates duties of care and loyalty for directors of public companies. the main problem is overlooked.e. subject only to approval by the board of directors. without cumulative voting. this is not so in publicly traded companies in Thailand. But because this is the assumption embedded in the regulation. Directors enjoy unusual protection under the 1992 Act in that they can be pardoned by shareholders in the annual general shareholders’ meeting for any violation of fiduciary duties. claiming that it creates fragmentation in the board of directors. Most companies decide against cumulative voting. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure.
In particular.767 cases involving outstanding credit of B2.1 trillion of outstanding credit. as well as those that did not cooperate with CDRAC’s restructuring process.8 trillion had been completed. Some 82 percent of these cases have been successfully restructured. Commercial banks initiated 74 percent of these cases. will be settled by the courts. In response. only 7.764 debt restructuring cases involving B1. and manufacturing sectors. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. In addition. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. 322. personal consumption.6 trillion) have agreed to cooperate with CDRAC’s restructuring process.1 trillion in outstanding credit.068 cases involving B475 billion are undergoing restructuring. the court had more than 80 cases for disposition. accounting for B1. CDRAC’s target debtors comprised 10. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. The first bankruptcy court in Thailand opened on 18 June 1999. with the majority of the debtors coming from the commerce. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. As of November 2000.6 trillion. Another 77. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. Cases for which negotiations were unsuccessful. and procedures for debt restructuring. Considerable progress has been achieved on this front. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. By October 2000. although since then.Chapter 4: Thailand 269 Company Act of 1992 includes a recommendation to require all public companies to use cumulative voting to ensure that the board of directors consists of representatives from all groups of shareholders. Within three months. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. a Corporate Debt Restructuring Advisory Committee (CDRAC) was established in 1998 to map out debt restructuring measures in support of efficient negotiations between the private sector and financial institutions.147 cases (B1. methods. accounting for B1. contributing to the unprecedented rise in the corporate sector’s bad debt. However. This point is crucial because compared with . the Government introduced debt restructuring-related measures to help resolve bad debts. where bankruptcy procedures are swift and effective. the number of cases has abated.
to push companies to harmonize their accounting with international standards.6 4. Conclusions. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. II Malaysia. and promoted key industries through incentives. despite the weakness of their disciplinary powers. The economic development of Thailand took off with the implementation of a series of National Economic and Social Development Plans beginning with the first medium-term plan for 1961 to 1966. Financial information from listed companies will also soon be required to conform to International Accounting Standards. It required listed companies to establish their own audit committees by the end of 1999. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation.6. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. The study covers the period 1985 to 1996. Thailand is coming from a situation where excessively high leverage became the norm because firms could obtain finance without having to concede a measure of control to outsiders. a time span that includes the onset of financial liberalization—the turning point of Thai economic development in the last decade—and represents the decade preceding the Asian financial crisis of 1997. behavior. Vol. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. 4. For this reason. Examination of corporate ownership. In the next three decades.1 Summary. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. Such improvements in disclosure standards are part of the efforts of SET and SEC. The . and even Indonesia. Philippines. and performance during this period helps understand the causes of the crisis. the Thai Government managed its economy with the corporate sector as the main engine of growth and development.270 Corporate Governance and Finance in East Asia. the Government protected certain corporate sectors through tariffs and regulation. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand.
Nonbank private corporations accounted for most of the increase. the profitability of publicly listed companies abruptly declined and their financial leverage increased. The impact of the crisis was felt across all industries. Thai companies were vulnerable to exchange rate risks. there was a marked increase in the number of public corporations. the number and value of public offerings of securities accelerated. The SEA of 1992 also marked the beginning of an active bond market in Thailand. the corporate sector entered a new era with the enactment of two major pieces of legislation. the increase in long-term debt more than compensated for the drop. the top five largest shareholders hold about 56 percent of total outstanding shares. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. During 1992-1997.000 from the previous year’s level. This implies that the control of an average Thai company is typically in the hands of a few persons (founders or their associates) who own a majority of total outstanding shares. The number of newly registered companies in 1997 dropped by almost 10. foreign debt in the Thai corporate sector increased continuously. even after the development of capital markets. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. At the onset of the 1997 financial crisis. the overall pattern of ownership concentration seems to have been stable for the past 10 years. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. the numbers of bankruptcy cases and company closures reached alltime highs. at a time when most of them were already experiencing declining profits and high leverage. Subsequently. . In 1992. In 1995 and 1996. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. After 1992. At the same time. the Public Company Act of 1992 and the SEA of 1992. Meanwhile. the overall corporate sector was seriously affected. Although there are some variations across industries. Minority shareholders. Because most of these debts were not hedged. reaching its peak in 1996. Although there was a decline in short-term foreign debt. Consequently. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. The study examined the impact of ownership structure on corporate governance and financing patterns. On average. One of the major findings is the high ownership concentration among Thai companies listed on SET.
holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. Consequently. are not active. Individuals and insiders hold the second largest proportion at about 19 percent. The highly concentrated ownership structure weakens the protection of minority shareholder rights. Vol. through the use of holding and affiliated companies. the existing legal and regulatory framework suggests otherwise. II although larger in number. protect the interests of all shareholders of public companies. averaging 46 percent. In the past. Institutional investors in Thailand. hold only a small portion of total outstanding shares. Nominally. Among the five largest shareholders of Thai companies listed on SET. With financial institutions playing limited roles in the capital market. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. The implications of ownership structures that are concentrated to such a high degree are serious. foreign and domestic. Thus. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. The investing public holds the rest of the outstanding shares. Financial institutions hold a very small proportion. there is a clear lack of outside monitors for these publicly listed but family-controlled companies. These laws stipulate rules and regulations concerning the activities of all public companies.272 Corporate Governance and Finance in East Asia. the government pension fund was the only major institutional investor. The key laws. the mutual fund industry has entered the picture but with limited roles and activities. the Public Company Act of 1992 and the SEA of 1992. All these. The rules in both Acts governing . The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. contribute to the lack of external controls on the corporate sector through the capital markets. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. along with a highly concentrated ownership structure. Recently. they have little influence over management decision making and control. It remains to be seen how reforms in bankruptcy procedures—including the increased threat of creditor control—could shift the incentives of controlling shareholders toward greater acceptance of equity finance and its consequent accession of control to new shareholders. The absence of external market controls on the management of publicly listed corporations is dangerous.
the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. For instance. because there is no separation between ownership and management. but is significantly related to financing patterns. these companies tend to become overleveraged. Consequently. because there are shared interests between the controlling shareholders and key management personnel.6. Ownership concentration appears to have little impact on corporate profit performance. Specifically. The ownership structure of Thai listed companies also significantly affects company behavior.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. moreover. In view of this. Rather. key reforms that will strengthen the regulation of financial institutions. In this third area. posed formidable barriers in the minority shareholders’ exercise of their rights. The second issue involves the protection of shareholder rights. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. The third issue involves creating external market controls through better regulation and development of the capital markets. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. an aim that can be achieved mostly through legal reforms. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. making them vulnerable to economic shocks. For example. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. . Certain provisions. the main challenge is not how the board can control management to maximize shareholder value. before the crisis.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. 4. However.
he/she often has the decisive vote. SET. Vol. Under the current system. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. If this were the situation. In this setting. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. If the principal shareholder is in fact chair of the board. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. SEC was established as another supervisory agency. In reality. SET was mandated to supervise listed companies. Only then will these agencies be able to act promptly and effectively. with control delegated to professional managers.274 Corporate Governance and Finance in East Asia. There is also supposed to be separation of ownership and control. and increase the participation of institutional investors are imperative. . This is due to the historical development of the Thai corporate sector: before 1975. and after the enactment of the SEA in 1992. activate the market for corporate control. the supervisory system is fragmented and not as effective as it should be. voting only on major decisions. As in other crisis economies in the region. in most of Thailand’s publicly traded firms. the Ministry of Commerce had the sole supervisory responsibility. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. this is a problem in Thailand. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. The board therefore plays a pivotal role. It is important that the roles and responsibilities of each agency are clearly defined to the public. Consequently. and SEC) are involved in corporate supervision. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. Once the roles and responsibilities are clearly defined. the supervisory agencies also need to be empowered to enforce the laws. II encourage market competition. The owners of a firm rely on a board of directors to supervise the managers. The best approach may entail establishing a single. three major government organizations (the Ministry of Commerce. in 1975.
Chapter 4: Thailand 275 There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. The slow improvement in the legal framework has likewise obstructed progress in this area. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. The second recommendation is to dilute ownership concentration through the use of regulatory power. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. Through an amendment in the Public Company Act. and a prohibition of connected transactions by directors or management. The Government does not have an effective way of monitoring the financial activities of these companies even as it is widely believed that a large amount of funds is being channeled through them. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. This move is expected to be unpopular among founding family members and original owners. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. and . Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. they should be monitored and regulated. There is also a need for legislation dealing with nominee or holding companies because they are the institutional means that founding family members use to maintain control. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. the Government can change the shareholding limit for controlling shareholders. increasing penalties for directors engaged in misconduct. Because these holding companies control a number of large public companies in Thailand. there has been much progress in this area. regulators must increase transparency and step up enforcement. The situation prompts two specific recommendations. accountability. Since the Asian financial crisis. SEC is exploring the possibility of amending the law toward this direction. transparency. requiring cumulative voting for the election of directors. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. To ensure a level playing field.
The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. Capital Market Development and Regulation Another important issue concerns the development of capital markets. it will be difficult to improve corporate governance in Thailand. However. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. especially in the area of connected lending. This may not be possible without reforms in the banking sector itself. aimed at ensuring that banks finance only creditworthy projects. In the stock market. while a strong domestic debt market will also offer protection from foreign exchange risk. will lead to the emergence of a reference yield curve. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. II responsibility among companies. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. Without a strong and efficient capital market. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. in turn. which. for instance. Accounting standards have also been under review. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. .276 Corporate Governance and Finance in East Asia. the power of the capital market to discipline inefficient management is almost nonexistent. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. there is a need to increase market disciplinary power through market competition. A well-developed domestic debt market will provide corporations with an alternative to bank financing. Vol. One way the Government can improve the current situation is to require publicly listed companies to trade a higher proportion of outstanding shares in the secondary market. In an environment of highly concentrated ownership. The same goes for improvements in the bankruptcy system. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. The first step is to establish an active secondary Government bond market. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. Further.
The Stock Exchange of Thailand. The Securities and Exchange Commission of Thailand. Ministry of Commerce. The Thai Bond Dealing Centre. US. The Stock Exchange of Thailand. Bank of Thailand Quarterly Bulletin. The University of Rhode Island. The Securities and Exchange Commission of Thailand. Kingston.Chapter 4: Thailand 277 References Annual Report. The Stock Exchange of Thailand. 1997-1999. Department of Commercial Registration Database. 1995-1999. 1995. Bond Market Development in Thailand. 1998. 1995-1999. Pacific-Basin Capital Markets Research Center. 1997. Fact Book. Bank of Thailand Monthly Bulletin. Key Capital Market Statistics. . 1995-1999. Thailand. Bank of Thailand. Bank of Thailand. PACAP-Thailand Database. Thai Accounting Standards. The Stock Market in Thailand. 1997.
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