Corporate Governance and Finance in East Asia

A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand

Country Studies

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. ThispublicationwaspreparedundertheAsianDevelopmentBank’sregionalTechnical 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

1990-1997 Table 1.4 Growth Performance of Publicly Listed Companies by Sector.5 Financial Performance of Publicly Listed Companies by Sector.19 DER and ROE of Publicly Listed Companies by Sector.11 CharacteristicsoftheBoardofCommissioners Table 1. Indonesia Table 1. 1992-1999 Table 1. 1996-1998 2.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.1 Listed Firms with Positive Economic V alueAdded.21 Nonperforming Loans by Type of Bank. 1992-1997 Table 1. 1993-1997 Table 1. 1992-1999 Table List of Tables 1. 1993-1999 Table 1. 1992-1997 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates.8 OwnershipConcentrationofPubliclyListedCompanies.3 Subsidiaries of the 30 Largest Chaebols Table 2. 1988-1996 Table 1.14 Banking Sector Outstanding Loans. 1992-1997 Table 1.7 Growth Performance of the Top 300 Conglomerates.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1992-1997 Table 1.4 Development of the Stock Market.20 ROE of the Banking Sector.2 Foreign Capital Flows.12 CharacteristicsoftheBoardofDirectors Table 1.1 Growth of the Banking Sector. 1990-1998 Table 1. 1996-1999 Table 1.2 KeyMacroeconomicIndicators Table 2.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 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 .9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1997 Table 1. 1986-1996 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization. 1992-1998 Table 2.13 Presence of Board Committees in Listed Companies Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies. 1992-1995 Table 1. 1996-1998 Table 1.18 GDP Growth by Sector. Republic of Korea Table 2.

12 Table 2.25 Table 2.14 Table 2.11 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.28 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.30 Private Capital Flows to Korea. 1994-1998 Financing Patterns of the Top 30 Chaebols.18 Table 2.23 Table 2.22 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.20 Table 2.15 Table 2.16 Table 2.13 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.17 Table 2. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 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 . 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.21 Table 2.19 Table 2.27 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols.10 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.29 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies.24 Table 2.8 Table 2.9 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.vii Table 2. 1997 Ownership Concentration ofAll Listed Firms. 1995-1997 Ownership Composition of Listed Companies. 1997 Ownership Composition of Listed Firms in Selected Countries. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.6 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.5 Table 2.26 Table 2.7 Table 2.

The Philippines Table 3. 1995-1998 4.1989-1997 Table 3.17 Composition ofAssets and Financing of the Publicly Listed Sector. 1986-1998 Nonperforming Loans of General Banks. 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. 1988-1997 Table 3. 1989-1997 Table 3.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1990-1999 Table 3.11 TotalandPerCompanySales. 1988-1997 Table 3.2 Growth and Financial Performance of the Top 1. 1988-1997 Table 3.14 Philippine Stock Market Performance.21 OwnershipConcentration. 1997 Table 3. 1989-1997 Table 3. 1978-2000 Table 4. 1997 Table 3. 1989-1997 Table 3. 1997 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. Flagship Company.000 Companies.15 Financing Patterns of the Corporate Sector.Profitability andFinancial .16 CorporateFinancing PatternsbyOwnershipType. 1992-1996 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. 1985-1997 Number of Firms with Dishonored Checks.SectorOrientation.viii Table 2. 1988-1997 Table 3. 1988-1997 Table 3.33 Net Profit Margins of Chaebols.32 Table 2. 1988-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. 1989-1997 Table 3. Thailand Table 4.19 Financing Patterns by Firm Size. 1997 Table 3. 1983-1997 Table 3.31 Table 2.3 TheCorporateSectorandGrossDomesticProduct.20 Financing Patterns by Industry.18 Financing Patterns by Control Structure.2 Public Offerings of Securities. andAffiliated Banks of Selected Business Groups. 1992-1999 . 1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.1 GDP Growth of SoutheastAsian Countries.1 Public Companies Registered.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.12 Control Structure of the Top 50 Corporate Entities.22 Foreign Investment Flows. Leverage Table 3.

17 StatisticalHighlightsoftheStockExchangeofThailand.10 Table 4. 1990-1998 Merger and Acquisition Activities.4 Table 4.13 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.3 Table 4. 1990-1996 External Debt. 1992-1999 Offerings of Debt Securities. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . Ownership Concentration. 1993-1999 Size and Composition of the Thai Financial Sector.15 Table 4.1 Figure 3.1 Figure 1.16 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.7 Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1.11 Table 4.9 Table 4.5 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1990-1996 Financial Ratios of All Listed Firms.2 Figure 3.6 Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies. 1985-1996 Average Key Financial Ratios by Company Size.14 Table 4.8 Table 4. 1992-1999 Common-Size Statements for Companies Listed in SET.12 Table 4. Leverage.ix 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 supportADB’s 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 theeightADBmembercountriesthatparticipatedinthestudy’sfinalizationworkshop 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 annualgeneralshareholders’meeting 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 Tobin’s Q won UnitedStates

Note: In this volume, “$” refers to US dollars, unless otherwise stated.

1 Indonesia
Saud Husnan1



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.

Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels.6 percent) and trade (-18 percent). The scale of the financial crisis exposed weaknesses of the country’s corporate sector. However. followed by finance (-26. short-term loans were used to finance long-term investments. contracting by 36. except utilities. patterns of ownership and control. 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. All sectors. Foreign debt reached more than $100 billion. It analyzes the weaknesses of corporate governance in Indonesia.5 percent. were the ones most affected. On the other hand. and how it contributed to the crisis. the Indonesian economy seemed to be in generally good shape. In many instances. particularly those with large foreign loans. The study also identifies family-based companies and corporate groups. how it has affected corporate financial performance and financing. Malaysia. highly leveraged companies. 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. Foreign creditors. no doubt. the currency composition and term structure of corporate foreign indebtedness were causes for concern. and responses to the financial crisis. Section 1. posted negative growth. This study reviews the Indonesian corporate sector’s historical development. patterns of financing. this left the Indonesian economy extremely vulnerable. and analyzes their importance to the corporate sector in Indonesia. these controlling families had political connections that allowed their companies to enjoy special privileges. When the crisis hit the country.3 looks at patterns of corporate ownership and control. prior to the financial crisis. placed a high premium on these political connections in assessing the chances of being repaid. 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. and .5 percent. Vol. These banks were allowed to operate even if they violated minimum capital adequacy requirements. In this setup. Section 1. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted.2 Corporate Governance and Finance in East Asia. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies.2 presents an overview of the Indonesian corporate sector. or Thailand. II rate reached 58. regulatory framework. The construction sector was the worst hit.

Despite the oil revenues.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics.4 analyzes corporate financing patterns. The industries that emerged were highly import-dependent and reliant on tariff protection. Not all items in the questionnaires were answered by the respondents. Up until the mid-1960s. medium. and tobacco industries.2. how it was affected by the crisis. while Chinese and indigenous entrepreneurs ran some large businesses in trading. in the course of the fight for nationhood from 1942 to 1950. and its response. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). . It also examines the statistical relationship between corporate performance and corporate governance characteristics. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. a gradual shift in public investment away from manufacturing took place. In the early 1970s.and large-scale companies were dominated by state-run industrial concerns.2 1. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. substantial volumes of private investment entered the scene. textiles.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. Section 1.1 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. Subsequently.5 examines the corporate sector during the financial crisis in terms of its role. Section 1. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. However. 1.2 Section 1.

A number of underwriters emerged. the value of manufactured exports overtook the value of oil and gas exports for the first time. . Third. the number of firms quoted in the stock market was only 24. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. potentially subjects companies to greater regulatory scrutiny. even when new shareholders do not threaten the control exercised by the original owners. These were families with strong links to the political elite of the New Order. First.2 The Capital Market The Government reactivated the stock exchange in 1977. Partly as a result of various government policies. Vol. Second. there were also many rapidly growing large-scale companies and business groups or conglomerates. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. In 1992. produced consumer goods. 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. Last. and related products) had shares in total exports that were rapidly increasing. But these proved counterproductive because they limited the potential for capital gains to prospective investors. 1. The equity market remained largely unappealing due to a number of factors. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates.2. the Government shifted its industrial policy toward the promotion of labor-intensive exports. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. During this period. In the 1980s. many founding owners of companies were reluctant to go public and dilute their corporate ownership.4 Corporate Governance and Finance in East Asia. wood. 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). exports of nonoil products (particularly textiles and footwear. mostly nonbank financial institutions and stockbrokers. But until the end of 1988. which dominated their respective sectoral outputs and markets. a distinct industrial elite started to emerge. the dilution of corporate ownership. the Indonesian industrial sector was quite diverse. While most of the companies were small. Generally speaking. and employed the bulk of the industrial labor force. By 1987.

the number of private domestic banks increased. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. Interest rate regulations on state banks and credit ceilings in general were removed. But in terms of assets per bank. the number of listed companies in the stock exchange increased substantially. Conglomerates carried out 210 out of 257 IPOs.Chapter 1: Indonesia 5 At the end of 1988. Table 1. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. private domestic banks dominated the sector in terms of number and total assets. and increased access of domestic banks to international financial markets. more significant reforms were introduced.1 shows that from 1994 to 1998. These included the opening of the banking industry to new entrants. the capital market played an increasing role in raising long-term funds needed by the corporate sector. the banking sector has been and still is the major source of credit for the corporate sector. The initial banking sector reform was introduced in 1983. state-owned banks were still among the biggest. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. companies could no longer enjoy low-interest credit from state banks. the banking sector has undergone many reforms. Since 1977. six SOCs had issued equities in the market. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. began to face competition. with a total value of more than Rp8 trillion. In 1988. which were previously constrained to 4 percent per day. the controlling shareholder of these SOCs is still the State. . Partly as a result of these reforms. However. The Government also allowed foreign investors to buy up to 49 percent of listed shares. with a total value of Rp16. The dominance of state banks started to erode. However. The banking sector.5 trillion. Thus. which up to then was channeling oil revenues to priority sectors. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. 1. Through the years.2. However.3 The Banking Sector Despite the development of the stock market. to date. Consequently. from 24 in 1988 to more than 300 in 1997. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). During this period. reduced restrictions on foreign exchange transactions.

4 34 12.6 34 14. BCA.6 164 144 130 92 387.5 27 88.8 29 6. 1993 100.3 201. Of these. II Table 1.9 27 113. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).2 10 14.5 528.8 27 200. 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.9 31 9.9 39 18.7 27 37.4 789. Because regulation was weak. But the banking system proved incapable of performing its intermediation function.6 7 12.8 31 10. banks could earn profits even when they did not gather and process information about risk.9 762. Both BCA and BUN have shareholders linked to the former President Suharto.8 166 248.9 248.5 27 66.5 7 9. Vol.8 10 19.7 351.6 7 7.6 Corporate Governance and Finance in East Asia.1 240 1995 122. the 10 largest were all affiliated with major business groups.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.3 30 7. 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. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group). .3 27 51.8 27 147. and Bank International Indonesia (ranked 9th). The other banks among the top 10 were state banks.0 234 1994 104.5 165 308. In terms of assets.3 10 17.6 240 1996 1997 1998 1999 141. Among private domestic banks.1 10 47.2 161 214.9 291.5 7 7 7 5 15. while BUN has been closed down by the Government.4 10 35.8 391. Bank Danamon.9 10 11.8 10 37.1 Growth of the Banking Sector.9 304. Bank Danamon (ranked 7th).

09) 1. In the 1990s. especially through bank loans.01) (0.09) (0.2.15) — = not available. they still amounted to a large sum for the economy to absorb. foreign investment also had a strong presence in the services and infrastructure sectors. In 1994. 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.88) — — — — — — 8.2. when the financial crisis hit Indonesia. the Government allowed foreign investors to own 100 percent of an Indonesian company. In effect.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. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. FDI flows were strong.63) (1. initially from Japan and the Republic of Korea. Increasingly. there was a phenomenal growth in direct borrowings by Indonesian corporations. textiles. But FDIs were only one form of foreign capital inflows to Indonesia. Indonesia received capital inflows averaging about 4 percent of GDP.40) (0. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). November 2000.01 (2. 1. Successive policy deregulation facilitated FDIs in various light manufacturing industries. September 2000. foreign creditors were eager to provide financing to Indonesia. except in certain strategic sectors.33 (13.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).81 3.10 5. Until the onset of the crisis. Net FDI flows increased to $5.74 5. Source: IFS CD-ROM.11 3. Between 1990 and 1996. IMF.78 2. such as metal goods.50 (0.09 1. Most FDIs came in through joint ventures with business groups having strong political connections. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.2 Foreign Capital Flows. .88 4.48 1.59 4.59 billion in 1996. From the mid-1980s until July 1997.00 2. and footwear. as shown in Table 1.87 7. Table 1.

Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. The Government relaxed this restriction in 1988. the average borrowing rate for dollar loans was 9 percent. This increased to 30 percent by the end of 1993.2. and conglomerates. increasing the total trading value from Rp8 trillion in 1992 to Rp120. By the end of 1997. especially the short-term ones. of which two thirds were rupiah-denominated. . This is lower than the average borrowing rate of 18 percent for loans in domestic currency. plus 4 percent for the depreciation of the rupiah. 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. 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. From 1987 to 1996. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. state-owned companies (SOCs). an interesting question is whether standard measures of corporate profitability and performance also indicated the same. foreign banks became a significant source of financing for the corporate sector. Between 1989 and 1992. participation in the Indonesian stock market was exclusive to domestic investors. total corporate debt reached nearly $118 billion. the average foreign ownership of listed companies was 21 percent. but declined to an average of 25 percent during 19951997. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. foreign investors began to dominate daily trading. Due to data constraints. In November 1998.5 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. Vol.4 trillion in 1997. with the onset of the Asian crisis. II Up until the late 1980s. Consequently. In the 1990s. The external corporate debt owed to foreign commercial banks was $67 billion. Domestic corporate debt was about $50 billion equivalent. 1. In September 1997. 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. The following section looks at the growth and financial performance of the corporate sector. Private borrowers preferred foreign loans since these were relatively cheaper.8 Corporate Governance and Finance in East Asia. the analysis focuses only on publicly listed companies.

3 Growth and Financial Performance of Publicly Listed Companies. ranging from 220 to 250 percent between 1992 and 1996. During 1992-1997.4 percent. 174 firms.6 48. the average DER increased to 310 percent from 230 percent the . and 1992. Note: The number of firms is not identical for each year.4 31.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.4 1997 7. 248 firms.4 38.9 310. total sales of listed companies grew at an annual average rate of 31 percent.1 4. 1993.6 3. 1996.4 1993 45.6 1994 50. although the contribution increased over time.5 240.8 220.0 64.6 percent in 1997. Despite such rapid growth. but fell to 24.0 12.5 34.2 7.5 37.4 1996 18.8 percent between 1992 and 1996.1 percent in 1997 when the crisis began to buffet Indonesia.7 percent in 1997. In 1997. but declined to 0. 226 firms.2 30.9 37. a Value added was assumed to be 30 percent of total sales. while total assets grew at 43 percent. Table 1.0 33.0 10. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.1 220. there were 204 firms.0 3. 1995. Average return on equity (ROE) of listed firms was 11. Asset turnover was above 30 percent until 1996.5 34.0 11.0 12.0 1. The growth of listed companies was sustained by continuing investments.1 0. publicly listed companies as a group contributed less than 10 percent to GDP.7 3. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines. When the crisis battered Indonesia in 1997.0 12.3 3. 246 firms. averaging 3. Source: JSX Monthly (several publications).5 3. Return on assets (ROA) was also relatively stable during 1992-1996.3 shows the growth and financial performance of Indonesian publicly listed companies.6 24. but turned negative in 1997.3 6.8 6. 250 firms.0 6.7 — 250.8 230. b Asset turnover is defined as sales over assets.7 — = not available.2 1995 37. 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. but dropped to 1. 1994.

the banks eagerly provided credit to property development companies. miscellaneous industry. the companies in the sector did not operate with a high leverage. the mining sector had the highest ROE. indicating its reliance on equity to support growth. The same applied to the trade sector. the dominant sector was the finance sector.7 percent during 1992-1996. finance. In terms of sales and asset levels in 1997. Overall. increased from 0. However. real estate. and services. helped in part by the relatively strong demand for consumer goods. Vol. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. But the sector’s ROE fluctuated a lot. and property. The consumer goods sector ranked second in terms of ROE. Meanwhile. During those years.3 percent between 1992 and 1996. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. infrastructure. basic industry and chemicals. Before the crisis. and building construction. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. For instance.4). followed by agriculture (Table 1. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. Four sectors (basic industry and chemicals. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. and services. and trade. due mainly to the domination of the International Nickel Company of Canada. II previous year. trade. real estate. in terms of growth of sales and assets. averaging 21. When interest rates increased. although asset turnover was slow. miscellaneous industry. The finance sector’s contribution to GDP.64 percent in 1997.10 Corporate Governance and Finance in East Asia.73 percent in 1992 to 1. which operated in nickel and copper mining in 1992 and 1993. consumer goods. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. only two sectors (mining and finance) showed a consistently increasing trend from 1992. In terms of share of value added to GDP. ROE fell drastically because the sector had one of the highest DERs. averaging 17. property. mining. the property sector was severely affected by the crisis. investment. meanwhile. Also. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity.5 presents the financial performance of listed companies by sector. The finance. the mining sector had the lowest DER. Table 1. property. still posting a positive but lower ROE. with ROE falling to -11. investment. This sector was less affected by the crisis. and trade) even posted . ROA of all sectors dropped in 1997. the mining sector ranked first. From 1995. when the property sector was booming during 1993-1997.2 in 1997.

5 0.3 92.0 0.. Investment.6) 25.8 62.9 64.7) (113.4 1.7 43.1 16.1 — 39.1 0.9 53.4 64.0 16.5 (8.3 0.3 340.9 0.5 53.4 30.6 0.7 90.7 40.8 0. Real Estate.1 0.1 0.5 0.0 0. and Bldg. Real Estate.7 112.7 0. Investment.0 1.4 0.1 35.6 0. Infrastructure Finance Trade. Source: JSX Monthly (several publications).5 (11. Real Estate.9 123.4 103.6 85.5 1.8 28.4) 6.0 (20.4 30.Table 1.4 1.7 28. and Bldg.9 54.0 0.1 1. Investment. Infrastructure Finance Trade.5 1.0 68. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.6 0.0 64.2 13. Infrastructure Finance Trade.2 11. Industry Consumer Goods Industry Prop.7 (82.7 1995 51.7 62.5 45.3) 53.1 71.3 17.3 31.8 29.1 1.4 1993 155. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.9 59.1 0.2 14.0 18.4 38. Constn.8 50.5 1.8 1.6 133.9 .9 8. Constn.3 0.6 26. and Bldg.4 31. Investment.6 51.5 28.0 (28.5 61.1 28.8 66.6) 19.5 13.1 0.6 15.6 24.7 — 36. Industry Consumer Goods Industry Prop..9 25.1 (11.5 68. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.4 (149.0 0.9 54.7) 26. and Bldg.4 21.2 0.7 54.3 31.7 17.9 14.1 0.0 1996 1997 58.5) 6.5) 13. Real Estate.0) 46.1 1.0 22.4) 8.5 92.5) 49.7 34.2 35.6 83.3 1.9 36. Industry Consumer Goods Industry Prop.1 23.2) 0.2 0.7 21.1 1. Infrastructure Finance Trade.0 24.8 27.4 77.0 31.5 95.7 24.5 23.4 Growth Performance of Publicly Listed Companies by Sector.0 (192.4 43.3 51.4 170.3) 39.8) 0.4 44. Constn.7 — — 11.3 (203.6 1.3 0.8 (76. Constn.7 133. Industry Consumer Goods Industry Prop.1 0.1 32.3 0.1 (41.6 135.3 0.8 32. and Services — = not available.0 43.1 0.6 (41.8 51.9 (7.8) (12. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.6) 119.2 5.9 31.1 0.2 41.6 28.5 9.6 22.9 0.8 1.0 0.1 67.7) (27..0 0.6 0.8 24.1 42. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.7 0.2 41.9 1.2 59.7) 17.1 1.6 1994 (75..1 0.4 1.6 (0.

5 56.4 20.0 180.4 5.4 13.7 61.6 1.0 560.9 7.6) 18.8 168.Table 1.0 140.6 (11. Industry Consumer Goods Industry Prop.2 15.1 4.1 89.5 43.6 13. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc. Constn.7 9.0 90.2 3.0 (0.5 1995 80.3 17.0 80.0 8.0 120.7 10.0 100.0 160.1 6. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.8 20.8 8.0) 7.5 Financial Performance of Publicly Listed Companies by Sector.6 8.0 700.0 120.7 10.0 150.0 39. Constn. Industry Consumer Goods Industry Prop.0 190.2 (4.0 110.1 8.0 120.5 17.2 23.5 13.5 14.0 160.7 46.1 1994 80.7 71.5 4.7 12.1 9.9 38.1 4.7 4.8 25.1 3.0 15. Investment. Infrastructure Finance Trade.8 5.0 66.0 130.0 70.3 1.0 190.0 3. Investment.4 79.3) 5. Industry Consumer Goods Industry Prop.8) 8.9 40.1 11.2 6.8 382.0 110.3 13.6) 36. and Bldg.4 4.3 5. Constn. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.0 110.4 .0 12.2 3.1 10.9 41.2 13.1 13.7 8.6 18.4 13.4 35.5 4.4 6.2 1993 130.8 16.6 74.0 220.4 35.3 7.0 120.0 46.2 39.0 110.6 13.0 650.0 19.0 69.0 150.0 110.0 380..1 4.4 46. Real Estate.1 (5.7 8.0 14.0 100.3 38. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.9 87.7 1. Real Estate.0 9. Real Estate.0 80.8 44.0 86.5 5.9 17.0 140.2 7.7 5.3 0.9 14.2 53.6 14.1 (3.0 190.0 210.1 10. Infrastructure Finance Trade.1 1996 100.7 12.6 23.0 110.9 38.0 50. and Bldg.5 11.8 9.3 7.7 10. Real Estate.2 11.1 7.0 100.0 1997 230.2 30.3 17..1 63.0 630.7 4. Constn. 1992 20.1 65.7 26.0 680.4 46.4) (1.1 2.8 81.7 12.2) 7..8 3.6 (2.0 70.0 60.8 11.7 4.1 9.8 11.1 10. Investment.1 1.0 3.0 110.0 8.9 10. and Bldg.4 17.9 29.4 71.9 42. and Bldg.2 111.9 4.3 73.6 8.0 180. and Services Source: JSX Monthly (several publications).7 5..0 17.7 13.8 479.0 650.3 18.5 7.7 1.0 150.4 1.2 7.8 67.7 (3. Infrastructure Finance Trade.0 11.2) 15. Investment. Industry Consumer Goods Industry Prop.0 170.3 64.0 160.3 33.2 8. Infrastructure Finance Trade.5 19.6 19.0 100.0 180.0 70.4 6.0 80.

increasing from 21. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. respectively. there were 58 SOCs with subsidiaries and affiliates. Asset turnover rates were lower relative to those of publicly listed companies. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. the subsidiaries and affiliates number 459 with total assets of Rp343. For instance.7 to 7 percent for publicly listed companies. Trade had the highest ROA of 39.Chapter 1: Indonesia 13 negative ROA. Just like private companies.7 percent in 1990 to 6 percent in 1996. Taken together.7 percent. averaging 24 and 31 percent.8 percent between 1992 and 1995 (Table 1.4 percent the following year. insurance (11 companies). These growth rates were low compared to those for listed companies during the same period. This was relatively high compared to the 3. This was due to large sales by the National Oil Company (Pertamina). and basic industry and chemicals sectors had relatively stable ROA before the crisis.6). Six SOCs were listed in the Jakarta Stock Exchange. there were 165 state-owned companies (SOCs)3 in Indonesia. between 1993 and 1995. ROA had been at high levels from 1992 to 1995. banks (seven companies). The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). By 1995. 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. Assuming a fixed ratio of value added to sales. .3 percent in 1995. much lower than that of companies listed in the stock exchange. registering an average annual rate of 10 percent. which collectively had the largest assets. growth of net profits and assets was erratic. The finance and miscellaneous industry. SOCs’ sales growth fluctuated during 1990-1996. Only the agriculture sector showed an increase in ROA in the couple of years before 1997.6 to 8.3 trillion. and finance company (four companies). SOCs diversified into many businesses. the ratio decreased from 8. The DER was slightly higher than for listed companies. SOCs’ ROE ranged from 6. However. SOCs actively operated in various sectors4 under the supervision of “technical” departments.1 percent in 1992 to 28. State-Owned Companies At the end of 1995. but dropped dramatically to 4. the Department of Finance supervised 30 SOCs.1 percent in 1993. indicating SOCs’ declining contribution to GDP.

b Asset turnover is defined as sales over assets.6 Growth and Financial Performance of State-Owned Companies.5 percent in 1995.6 percent in 1994. Assuming a constant ratio of value added to sales. a Value added was assumed to be 30 percent of total sales.1 32. Vol. mostly private companies. II companies consistently declined over time.4 1993 16.4 13.8 percent in 1990 to 13.3 12. Source: Indonesian Data Business Center.0 7.2 — 370.7 Growth Performance of the Top 300 Conglomerates.2 — = not available.766 business units.6 28.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.4 percent in 1994.0 8.0 12.8 21.1 trillion in 1990 to Rp234 trillion in 1997.0 17.4 7.3 250. but dropped to 11. SOCs’ asset turnover rates showed a downward trend from 32. but climbed to 30.1 12.7 16.8 12.2 18.1 310.4 13.7).1 19.4 percent in 1992 to 28.1 30.3 30.6) 260. these conglomerates owned 9. Their total sales increased from Rp90.6 28. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.7 (2. Table 1.14 Corporate Governance and Finance in East Asia.7 1994 (9.2 23.4 13.0 6. 1992 — 7.0 8. the contribution of conglomerates to GDP increased from 12.8 11.1) 5. Source: Indonesian Data Business Center.7 13.1 6.4 16.0 28. 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.5 3. Table 1. In 1997.6 1995 25. a Value added was assumed to be 30 percent of total sales. .0 24.2 percent in 1997 (Table 1.

The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. The BOC. mergers. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. the legal and regulatory framework of the corporate sector was far from adequate. For mergers. the decision to use certain company assets as collateral for bank credit might need BOC approval. and declaration of bankruptcy. and the board of directors (BOD). In general. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. The law also holds the directors and commissioners jointly responsible for decisions made by the company. If the BOC does not perform well. except in strategic issues stated in the law. and the accountant. tasked to provide direction to the company. For instance. For instance. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD.Chapter 1: Indonesia 15 1. shareholders lose control. For example.2. the Government promulgated a number of laws and regulations to protect investors.6 Legal and Regulatory Framework During the 1990s. This guards against shady intercompany dealings within a group of companies. tasked with supervising the firm. By international standards. is the only shareholder mechanism for monitoring and controlling the BOD. . The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. however. as representative of shareholders. and consolidations. The law replaced an earlier statute that was based on the Dutch system. commissioners. The meeting decides on important issues. an approval needs the majority (50 percent plus one) vote. such as the appointment (or replacement) of directors. and the attendance should at least be two thirds of total shareholders. The company charter details the issues that need shareholder meeting approval. acquisitions.

Because of such requirements.16 Corporate Governance and Finance in East Asia. (iii) proxy voting by mail. (v) preemptive rights on new share issues. (xi) mandatory disclosure of transactions by significant shareholders. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. consolidations. (xvi) independence of auditing. and the attendance should at least be three fourths of total shareholders. and other supporting agencies. investment advisors. 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. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. (ix) mandatory shareholders’ approval of interested transactions. and administrative and legal punishment. investment managers. (ii) proxy voting. (xv) mechanisms to resolve disputes between the company and shareholders. (viii) the right to make proposals at the shareholders’ meeting. (vii) the right to call an emergency shareholders’ meeting. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. (xii) mandatory disclosure of connected interests. the decision should be approved by three fourths of the shareholders present. Controlling shareholders have no vote on the matter. underwriters. . decrees of the finance minister. (x) mandatory shareholders’ approval of major transactions. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. securities companies. (xiii) mandatory disclosure of nonfinancial information. transparency requirements. (xvii) mandatory independent board committee. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. and (xviii) severe penalties for insider trading. (iv) cumulative voting for directors. brokers. It regulates the requirements of investment companies. 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. The law is supplemented by Government regulations. It also regulates reporting and auditing procedures. and bankruptcy. such as custodian banks and the securities registration bureau. II acquisitions. A tender offer is also required for acquisitions of up to 20 percent of listed shares. insider trading (including market rigging and manipulation) investigation. and guidelines promulgated by the head of capital market supervision. Vol. (vi) one share one vote.

the viability of a project). creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. . for instance. A Commercial Court was also set up to deal with bankruptcy cases. It aimed to protect creditors by providing easier and faster access to legal redress. Discussions on corporate ownership cover listed companies and conglomerates.Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. 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. whether they are individuals. The two most important elements of ownership structure are concentration and composition.. amended in October 1998. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. For instance. 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. five. It reveals characteristics of controlling shareholders.g. capital adequacy. However. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. 1. families. holding companies.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. the Banking Law (1992).1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study).3. or 20 shareholders. Ownership concentration is usually measured by the proportion of shares owned by the top one. states that a bank is not allowed to provide credit without collateral. etc. Banking regulations also set lending limits. or financial institutions. the collateral could take the form of nonphysical assets (e. A new bankruptcy law was passed in August 1998. net open positions.

1 1.8 1. the founder usually continues to own the majority of shares through a .2 11.7 1994 48.0 4.6 percent.9 2.3 1995 47. mining. When a company goes public. Zebra Nusantara (taxi services).5 12. and 0.9 Source: The Indonesian Capital Market Directory.8 Ownership Concentration of Publicly Listed Companies.1 4. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.0 67. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table).18 Corporate Governance and Finance in East Asia.9. Meanwhile. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.8 68.9 2.0 0. Table 1.8 68.2 1.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.2 67.6. II Publicly Listed Companies Table 1. 2.5 72.5 1997 48. Vol.4 percent.6 13.9 14. This is because a few companies in the transportation sector issued high proportions of shares to the public.6 3.0 0.6 68.9 percent of total outstanding shares. 3.7 3. The percentage owned by each of the five largest shareholders was 48.0 1.1 13.6. and basic industry and chemicals sectors than in others.7 1996 48.5 16. On average.4 2.6 3. consumer goods. for instance. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.8. the five largest shareholders owned 68.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. When a company makes a rights issue. respectively. This preserves the pro rata share of existing shareholders. issued 93. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. Table 1. Rig Tenders Indonesia (shipping services) issued 51. the controlling shareholders usually act as standby buyers. The pattern of ownership concentration changed little over this period.1 0.9 0.0 2.5 percent.6 4.5 Average 48. 13.

1 1.7 9.9 1. In fact.4 6.7 13. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.5 1.9 44.9 3. is strong.1 11. In terms of capitalization. and Transportation Finance Trade.2 0. and Services Average Source: The Indonesian Capital Market Directory. in a cross-country study.1 0.6 0.4 1.1 2.6 1.7 percent of the market.6 8.2 15. Constn.1 1. Claessens et al. which shows that in 1996.4 11.1 0.2 46.2 This is confirmed in Claessens et al. Indonesia has the largest number of companies controlled by a single family. Real Estate.2 10.4 44..6 9. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. as well as the existence of corruption. Investment.5 4.1 2.3 36.0 5. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.1 1.1 1.2 2. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54. and only 0.4 54. Util. (1999) also found. Industry Consumer Goods Industry Prop.6 percent of total market capitalization while the top 15 families control 61. that the correlation between the share of the largest 15 families in total market capitalization. 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.7 1. (1999).5 58.7 4.9 0. the rule of law. on the other.3 0.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).3 14. the top family controls 16. and Bldg.3 2. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.6 2. and corruption. Table 1. Infrastructure.9 44. and the efficiency of the judicial system.1 2.1 percent) of Indonesian publicly listed companies were in family hands..9 Ownership Concentration of Publicly Listed Companies by Sector. on the one hand.7 6.3 48.4 4.3 0.6 percent were widely held.1 13.9 50. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .8 14. two thirds (67.

In Indonesia. their number increased to 5 In 1997.5 Conglomerates Table 1. The nonindigenous businesspeople are usually Chinese. However. with all its regulations. But these benefits are few and often dubious compared to the high costs of concentration. Coordination is easier because informal communication channels exist. the Government allowed foreign investors to buy up to 100 percent of listed shares. Sundanese.20 Corporate Governance and Finance in East Asia. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. 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. In September 1997. Among the top 300 conglomerates. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. . the onset of the crisis negated this development. it rose to 30 percent. Indian. Batak.42 percent in December. political affiliation. 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. the proportion of foreign ownership declined from 27. most were established during the New Order Government. ethnicity. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. In 1993. numbering 162 in 1988 and 170 in 1996. accounting for 64 percent of total conglomerate sales in 1988-1996. This may indicate that the New Order Government. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. From 193 in 1988. conglomerates established before 1969 dominated in terms of sales. was able to create a favorable environment for business development. Vol. but later declined and steadied at around 25 percent. the legal system is less likely to evolve in a manner that protects minority shareholders. or other ethnic groups. Indigenous businesspeople include the Javanese. and Padang.55 percent in August to 25.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. foreign ownership increased to 21 percent. and family origin. During 1988-1996. II the small number of families and the tight links between companies and the Government. However.

1 87.7 64.5 106.4 18. 204 in 1996.1 52.6 114.9 137.7 40.2 48.0 28.0 58.6 34.1 103. For instance.8 36. due to their “go public” activities.8 Source: Indonesian Business Data Centre.4 15.2 159.7 28.2 23.0 18.8 28.4 86.1 46.2 33. 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 9.6 95.8 25.6 54.9 35.6 trillion in 1988 to Rp137. Meanwhile.7 106.0 58.9 13.4 37.3 120.4 69.4 32.9 77.4 31.0 116.9 42.4 68. In 1996. the number of mixed groups declined from 86 in 1988 to 68 in 1996.8 30. more than five times its 1988 level.3 20.9 14.8 68.4 59. Conglomeration Indonesia 1997.2 29.10 Anatomy of the Top 300 Indonesian Conglomerates.8 38.9 47.1 41.3 80.1 42. sales of the Bakrie group before it went public in 1990 were only Rp369.1 33.0 44. its sales reached Rp1.4 31.4 trillion in 1996.8 12.3 134.1 58.3 101.1 21.9 trillion.1 46.1 percent of total .8 57.6 17.5 21.4 59.6 77.0 31.8 49.9 73.Chapter 1: Indonesia 21 Table 1.0 15.4 57.4 16.7 24.5 120.2 76.5 22. Their total sales also increased from Rp38.3 36.4 19.9 billion.4 52.2 30.4 81.4 22.7 49.7 89.4 48.6 12.2 12. While they supplied 20.7 95.1 179.1 25.3 43.

In November 1997. II sales in 1988. Bank Indonesia. In 1996. Out of 174 companies. and Ibrahim Risyad of the Salim group. average sales of official-related conglomerates reached Rp1. Indocement Tunggal Prakarsa (cement industry). Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. In 1997 and 1998. and Wisnu Suhardhono of Apac-Bhakti Karya. and Fast Food (restaurants). collectively controlling . Only about 13 percent were formed by official or ex-official families. owns four groups with many subsidiaries and affiliate companies. including Indofood Sukses Makmur (food industry).2 trillion. Bambang Rijadi Soegomo.22 Corporate Governance and Finance in East Asia. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. But only a handful of these companies are listed in the market. The Suharto family is the largest stockholder in Indonesia. Prudential credit analysis tends to be ignored. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. there were 175 groups that originated from a family business. or have resulted from alliances between entrepreneurs and officials. Djuhar Soetanto. Most of the top 300 conglomerates were established by ordinary citizens. Conglomerates were also classified into nonofficial. 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. Vol.and officialrelated groups. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). for instance. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. 117 are jointly owned by the family and 57 are owned by individual family members. Some of them later became public companies by listing in the stock market. But listed companies within conglomerates were few. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. which is the largest conglomerate in Indonesia. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim.7 percent in 1996. The Salim group. their contribution declined to 13. compared with the less than Rp700 billion of a nonofficial-related conglomerate.

Cases in point are the Bank Papan Sejahtera and Bank Niaga. Both are listed companies and members of the Salim group. the controlling shareholders are able to maintain their special relationship with officials. The Salim Group is also in part controlled by the Suharto family. but those of the entire group. or both. management.. 1999). In so doing. Semen Cibinong.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al. This is because cross-owned banks had to consider not only their own interests. or someone very close to and trusted by the controlling shareholders. besides Suharto himself. The families retain control of the companies through ownership. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). If the family members cannot actively manage the companies as directors. 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. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. Indonesian law allows cross-shareholdings. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. served in some government function (see Figure 1. and hence. In 1996. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. Although they are not actively involved in the daily operations of the companies. While the source of the . Cross-holdings between financial and nonfinancial firms potentially create more serious problems. as well as other relatives and business partners. families mostly manage the groups and make strategic decisions themselves. Some of the groups related to officials have a unique share ownership structure. for instance. continue receiving some kind of protection and special treatment. But it is difficult to obtain data on cross-shareholding among firms. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. He or she could either be the biggest shareholder. Although some groups employ professional managers. with no restrictions. many of whom.1). they maintain their position as commissioners. The BOC chairperson often represents the controlling party of the company. they still control the work of the directors.

and Larry H. Simeon Djankov. Lang. P.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. World Bank. Who Controls East Asian Corporations? Financial Economics Unit. 1999). (Feb. Financial Sector Practice Department. .Figure 1.

the BOC has the right to obtain any information concerning the firm. one possibility is that legal lending limits had been violated. both controlling and minority.2.2 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. This is based on the Dutch system. The BOD leads the company and makes strategic and operational decisions. Figure 1. 1.3. Therefore. request a shareholders’ meeting. management and managerial compensation.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. role and protection of minority shareholders. the BOC supervises the work of directors. As the owners’ representatives. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. and. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. The managers execute the BOD’s decisions and lead employees in their departments. the directors. seek an audience with directors. Shareholders are at the top of the organization. including the boards. . and accounting and auditing procedures.Chapter 1: Indonesia 25 problem is inconclusive. if necessary.


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


External Control

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 takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. 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. to Hashim Djojohadikusumo.6 In this case. except for publicly listed SOCs. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. at a large profit. 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. the Government took over NPLs and put them under IBRA management. Control by the Government Government control could be in the form of state ownership. appointment of management. One famous takeover was Bank Papan Sejahtera.Chapter 1: Indonesia 31 external acquisitions. The Government appoints the BOD and BOC of these firms. Since the NPLs reached up to Rp300 trillion. State ownership for listed SOCs ranges from 25 to 35 percent. or direct subsidies. The bank was reported to have high NPLs and had broken the legal lending limit. the owner of Tirtamas group. who was acquiring his second commercial bank. Most Indonesian state companies are 100 percent owned by the Government. They then replaced the BOD and later sold the bank. the bank was liquidated. . restrictions on market entry. In these two latter cases. IBRA found itself tasked with managing large amounts of assets in the private sector. Bank Niaga was under a recapitalization program. This used to be a common practice in companies associated with the Suharto regime. which was acquired by Yopie Wijaya in 1995. However. For instance. the acquiring interest was apparently seeking economic profits. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. Before the financial crisis. a state-owned insurance company may invest its funds in a private firm. 6 7 Later in March 1999. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. Wijaya and his friends bought shares of the bank on several occasions until they gained control. with the minister’s approval. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. it was common for the Government to invest in certain private companies. In April 1999.

9 378. stocks. Bank Credit As shown in Table 1. jointly providing almost 90 percent of loans until 1997.3 9.3 66.6 4. because of the restrictions discussed below. remain the major financing instrument for the corporate sector. However. this market was not well developed.9 trillion in 1992 to Rp487. and others offered by nonbank financial institutions or finance companies.4 1.6 6.6 292. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.4 percent in 1992.7 112.4 225. bank credit surged from Rp122.0 168.9 234.5 7.0 6. Bank loans. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.8 193.9 150.3 60.5 108.1 Corporate Financing Financial Market Instruments Prior to 1977. Data from Bank Indonesia show that from 1994 to 1997. however. Vol. when the Government reactivated the stock exchange. Table 1.1 220.14.7 122. new instruments have been introduced to the corporate sector. Private national banks and state-owned banks were the biggest domestic creditors. Since then. II 1. companies considered alternatives to bank loans.6 3.3 188.2 5. From 34.0 3.5 42. private national banks overtook state banks as the dominant credit source.2 27.4 86. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).2 71. equities became available to the corporate sector. .4 24.0 93.6 150.3 111.6 48.5 80.6 percent in 1997. the share of private national banks in outstanding total loans increased to 44.7 50.9 153.2 6.14 Banking Sector Outstanding Loans.32 Corporate Governance and Finance in East Asia. 1992 1993 1994 1995 1996 1997 1998 1999 68.1 Equities In 1977. including bonds.4 trillion in 1998.4 56.0 487.3 14.4.7 18.

0 15. the stock market has gained a bigger role in corporate sector financing (Table 1. allowed to accept deposit accounts from the public.g.15 Value of Stocks Issued and Stock Market Capitalization. factoring. when foreign investors were not yet allowed to purchase listed shares.9 406. Table 1.1 10.6 91.5 333. 1992 1993 11. and consumer credit. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. legal lending limit.7 9. Prior to 1995.0 70. 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 1996.7 percent in 1997. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity.6 310. credit cards. thus increasing the role of the capital market in raising long-term funds.Chapter 1: Indonesia 33 Some companies went public.4 207. i.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares..6 859. however.1 17.5 1995 35. During the 1990s.2 16. Overall. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.7 15.1 18. finance companies were increasingly used as channels for the inflow of foreign loans. The ratio reached 8. In 1995.0 206.7 14.9 1999 76.15).e. It gradually increased again starting in 1991.6 123.8 48. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.1 1994 26. In 1988. They were not. capital adequacy ratio. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.. .4 1996 1997 1998 50. offering services such as leasing. shooting up to 18. and net open position).6 301. the Government issued regulations to supervise and promote prudential practices in finance companies.

6 12. 1.4 13. While banks had some exposure to these instruments. .2 26.1) 23. they were not rated by a rating agency.4.4 23.0 1986-1996 17.8 percent.5 percent and 36.5 (0. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases. Table 1. otherwise it would be classified as a loss in the banks’ books.5 11. II Commercial Papers Commercial papers. averaging 26. Thus in November 1995.6 100.3 (0.0 39. respectively.0 — = not available.6 100. PACAP Research Center.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. at 81 percent of total borrowings. In terms of composition.6 23.34 Corporate Governance and Finance in East Asia.0 100. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. 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).6 8. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).2 Patterns of Corporate Financing Table 1.3 37. In the second half of the 1980s.7 22.0 3.1) 23.3 16. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. Vol. 1996.16 Financing Patterns of Publicly Listed Nonfinancial Companies.8 17.4 8.5 21.0 1991-1996 16. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.5 — 26. This is in contrast to the lower share of borrowings during the same period.3 14. short-term borrowings were greater than long-term debts.9 16. have been popular in Indonesia since 1990.8 7.

rising from Rp54. the pattern changed. For instance. Bank loans also surged when the banking sector was liberalized in 1988.9 trillion in 1996. except Semen Gresik (an SOC). Corporate debts grew over time. was due largely to a rapid rise in long-term debts. in the context of Indonesia and some other countries. reaching Rp229.4.4 trillion in 1993 to Rp112. corporate debts accounted for 39. Hence.9 trillion.3 Corporate Financing and Ownership Concentration It has been suggested. that ownership concentration may be associated with heightened risk-taking by companies. Of the various financing sources. with longterm debts increasing rapidly. Many companies suffered big losses in 1997 due to their high exposure to dollar loans.3 percent during 1991-1996. also suffered from foreign exchange losses but managed to post profits of Rp0. Two telecommunications companies. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. Table 1.1 trillion. The results indicate that firms with higher ownership concentration tend to have a higher DER. They also do not want to dilute corporate control and are more likely to finance growth with debt.2 trillion.2 trillion (mostly foreign exchange losses). All companies in the cement industry suffered from foreign exchange losses. These liabilities grew significantly because corporate expansion was largely financed by debt. the corporate sector’s high leverage. which managed to post significant profits due to low exposure to dollar-denominated loans.17 compares the DER of listed firms by degree of ownership concentration. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market.6 trillion and Rp1. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. . 1. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.Chapter 1: Indonesia 35 In the 1990s. Most corporate charters require commissioners to approve debt issues or sign debt agreements. Indofood registered losses of almost Rp1. which was masked by the rapid growth in investments. Indosat and Telekom. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. respectively. while Semen Cibinong’s losses reached Rp2. This amount doubled in 1997. 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.

0 351.358. As a result. Table 1.17 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. to maintain control of the company.36 Corporate Governance and Finance in East Asia. the private sector borrowed heavily in unhedged dollars. In addition. Vol. Controlling parties rely on external financing to maintain their equity share and.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. since commissioners represent the controlling party.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders.0 1. II However. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. heavy reliance of companies on bank credits to finance investments. ultimately. 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. 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.0 386. The test of the difference between the two means found the t-value of 1. 1. aided . decisions on debt are made with the implicit endorsement of owners.5 1. the borrowings swelled. Source: Author’s estimates. 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.56 significant at the 10 percent level.5. Between 1987 and 1996. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.

e. However. large amounts of credit were directed to the companies within the group. .. and the negative net open position (short position in dollars) continuously rose to precarious levels. The supervising agency was caught unprepared. 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. In the process. A director at Bank Indonesia revealed that in 1995.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. This often led to the violation of prudential credit management practices. 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. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. only created to serve the companies to which they lent. those with high DERs) established their own banks. after all. The Government later specified the legal lending limit and the net open position that banks had to follow. However. averaging about 4 percent of GDP. did finance many viable ventures. As a result. 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. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. A lot of short-term foreign funds were used to finance long-term investment projects. It was only in 1995 that some regulations on the activities of finance companies were contemplated. Conglomerates that had difficulty in getting loans (i. the level of corporations’ foreign debt could not even be ascertained. many firms became highly leveraged. to circumvent these banking regulations. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. 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. It was doubly difficult to exercise supervision when groups with political clout owned the banks. They were. 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. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections.

Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. In early 1998. This was often the case in the banking industry. where private banks are usually in the hands of big businesses. as they had done so in the years before the crisis. and power generation) require huge capital. by setting up their own banks. but on the basis of who the borrower was. most often to people who were close to the ruling regime. In many cases. II By mid-1997. toll roads. and investing shares among nonfinancial companies within the group and in other groups’ companies. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. Projects involving massive capital investments and long-term operating deals (in telecommunications. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. contracts were granted to the private sector. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. there was also almost universal confidence that the economic growth would continue indefinitely. and in the process maintain control of the company. Vol. Corporations were certain that they could roll over short-term loans when these fell due. .5 billion was owed directly by corporations. or both. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. Since the Government could not afford to undertake these projects. Collusion between big businesses and the political elite was widespread in Indonesia. of which $64. banks did not lend on the basis of the soundness of the project.38 Corporate Governance and Finance in East Asia. total private sector foreign debt stood at $72.5 billion. This fact was usually not disclosed in financial statements. They enhance their control over companies through cross-shareholdings. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. politicians. Families retain control by keeping the majority percentage of outstanding shares. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. partly because they used nominee accounts to register ownership rather than set up a holding company.

1 (1. This continued in 1998. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.5) (18.8 1997 1.0 2.1 5. and Restaurants Transport and Communications Financial.4) 2.18 GDP Growth by Sector.6 12. The average DER was found to be 1. and Fisheries Mining and Quarrying Manufacturing Electricity.8 0. and 128 companies reported a total loss of Rp46.8) (13.6 8.7 1998 (0. much higher than the 307 percent registered in December 1997. Table 1.3 12.7 6. real estate.8) (11. DER and ROE were calculated per sector.0) (15.1) (26. and Business Services Other Services GDP 1996 3. The consumer goods industry reported the lowest ROE. 1996-1999 (percent) Sector Agriculture.1) 1. Sectors with lower ROE generally had higher DER.8 7.7) (8.6) (3.52 trillion.0) 1999 2.8 8.19. Real Estate.5.7) (2.4 7. Hotels.370 percent.6) (0.9 3. BPS).4 5. except utilities.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. Only 86 companies reported profits.0 3.4) (0.4 7.2 8. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. Livestock.7) 2.58 trillion (meaning their losses were greater than the paid-up capital).6 13. followed by property.2 (1. and building construction.18 shows that growth in most sectors significantly fell in 1997.Chapter 1: Indonesia 39 1.3 11. when all sectors. indicating a rapid rise in .2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. followed by the finance and trade sectors.6 (36. 53 companies reported negative equity of Rp6.1 6. Gas. Forestry. and Water Supply Construction Trade. posted negative growth rates.6 4.0 5. Most sectors showed significant increases in leverage. as shown in Table 1. The construction sector was the worst hit.24 trillion for the first six months of 1998.

097.0 697.0 635.1 (5. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104. Mostly suffering from a liquidity squeeze. from only 8.8) 36.370.0 105.1 (124.0 631. Source: JSX Monthly.0) 10.0 97.7 percent in July 1998.7) 6.0 205.8 percent in 1996.0) (78.4) 18.0 158.2 13. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.625.9 12.271.0 92.0 111. foreign exchange losses came about with the use of unhedged foreign debt. . Second.0 12. Third.0 864.0 1998 186.0 1.1 1. small foreign banks enjoyed the highest profits.0 307. private banks posted negative ROEs in the same year. several publications.0 1.19 DER and ROE of Publicly Listed Companies by Sector.40 Corporate Governance and Finance in East Asia.1 30.1 (92. Impact on the Banking Sector Table 1.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity. The huge losses suffered by most companies were caused by three factors. Vol.1 (3.0 177. This figure further increased to 47.0 2.2) (264.3 7.0 177. as shown in Table 1.0 229.8 17.4 (6.0 a ROE 1996 1997 1998a 14.4 5.2 23.0 1997 234. the NPL ratio rose to 25.5 8.6) 15.0 65.4) 8.0 191.21.0 2. II Table 1.0 1.0 108.0 219. losses in operation were due to declines in sales and increases in the cost of imported inputs.6 (11.20 reveals that the banking sector’s ROE decreased significantly in 1997.395. and would have kept on increasing if interest rates had not declined.0 193. but annualized to approximate full year values.6) (115. a Actual data for 1st semester only.2 (4.8 (373.1) 7. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits. As the rupiah weakened and interest rates increased.5 percent in April 1998.0 108.0 72. First. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. Financial and banking analysts estimate that by September 1998.0 163.7 1. the NPL ratio had reached more than 60 percent.

37 19.0 622.2 10. Source: The National Banking Association.3 361.89 27.0 — 32.9 percent.2 37. coupled with negative spreads (deposit rate was higher than the credit rate).1 274.70 1995 7.67 8.69 14.8 14. 230/1998.20) Table 1.43 10.8 187.86 11.6 — 1.5 222.2 1.21 Nonperforming Loans by Type of Bank.8 8.9 297.4 7.0 — 4.5 128.24 15.6 6.6 — 13.1 198. July No.9 11.9 — 11.09 11.1 30.34 16.28 5.12 15.09 (11.24 (4.5 31.7 4.30 5.2 8.20 ROE of the Banking Sector.84 27.9 Regional Foreign and Development Joint Venture Banks Banks — 9.8 11.72 16.1 1.0 129.Chapter 1: Indonesia 41 Table 1.7 29.7 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 331.8 3. Source: Infobank. private national banks overtook State-owned banks when their NPL ratio jumped to 57.91 21.39 13.06 20.5 34. State-owned banks initially had the highest NPL ratio. put pressure on the banking sector.15 20. 227/1998 and October No.81 13.2 8.7 — 1.5 2.7 106.2 — 19.3 Private National Banks — 179. 1992 7.44 15. In July 1998.47 20.3 445.45 — 1993 15.2 — 8.45 21.73 30.7 — = not available. however.07 1994 14.50 9. The high and increasing NPLs.1 47. 1996-1998 (Rp trillion) State-Owned Banks — 140.1 13.6 — 4.25 22.2 47. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.3 22.68 1996 1997 8.2 48.07 13.38) 11.5 57. .

While the process of restructuring was in progress. Corporate debt accounted for 46.6 billion) of Indonesia’s total external debt in March 1998. However. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. only a . The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. The scheme encourages negotiation between creditors and debtors. II 1.7 billion of foreign exchange debt. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring).000/$1) in debt from domestic commercial banks. Aside from being described as overly complicated. about 80 percent of which was private. a more comprehensive scheme to tackle domestic and foreign corporate debt. such as Garuda (a national flag carrier). Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. companies were not servicing their debts. particularly in terms of debt resolution. have been subject to restructuring deals under the initiative. the scheme failed. In June 1998.2 billion debt. Thus. 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. 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. assembling the legal and policy framework to facilitate corporate restructuring. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. few companies were in a position to resume interest payments. the Government and private sector formed a committee to help corporates deal with the crisis.4 trillion of domestic debt and $6. In addition. Since September 1998. and Ciputra (property business). The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. a number of prominent companies.5. by mid-September 1998. By end-November. Unfortunately.000 eligible firms had signed up for the scheme. Astra International (automotive). Vol. the committee launched the Jakarta Initiative. In November.7 percent ($64.42 Corporate Governance and Finance in East Asia. On 9 September 1998. none of the 2.

and sell noncore businesses or nonoperating assets. lay off workers. plantations. Standard Chartered. the companies’ financial performance deteriorated. mining. some companies attempted to restructure their businesses on their own. and mining equipment.. especially in preventing unjustifiable delays in the adjudication of bankruptcy. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). i. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. For instance. Bank Niaga also negotiated with some of its creditors. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. a publicly listed company operating in the automotive industry. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. with the requirement that adequate compensation and protection will be provided to such creditors during that period. for equity infusion. consolidate business units. Bank Bali agreed on a debt-to-equity swap with its creditor. Meanwhile. 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). When credit from the banking sector became unavailable and interest rates increased significantly.Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. Astra International. Debtors. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process . under which the latter would become one of the bank’s shareholders. Rabobank and Citibank. A Commercial Court was set up to handle corporate restructuring and debt settlements. as well as general commercial disputes. In the banking industry. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. forcing them to cut costs. 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. Moreover.e.

Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. . To push bankruptcy reforms. Capital Market Reform In the capital market. There will be changes in the implementation of the bankruptcy law. (ii) the resolution of nonviable private banks. in consultation with IMF and the World Bank. However. and recapitalization of state banks. legislation against corruption. including procedures for handling operational issues and processing bankruptcy cases. is also reviewing the Bankruptcy Law. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. However. Rather. The Government has also been concerned with the issue of capital controls. Vol. Previously. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. The Government. 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. the Government did not impose restrictions nor did it attempt to regulate capital flows. II to achieve liquidation of the company.44 Corporate Governance and Finance in East Asia. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. the Court’s early record has been a disappointment. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. since the market reflects the condition of the economy. reform. 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. The bias in favor of debtors has retarded the pace of corporate restructuring. companies were allowed to sell shares only by issuing stock rights. Realizing that they undermine investors’ confidence. collusion. with only 17 cases filed as of November 1998. and nepotism (anti-KNN) was signed in 1999. (iii) the merger. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. The Court has also declared only two companies bankrupt. In the longer term. and (v) a strengthened banking supervision system. the measure had only a minimal impact.

and follow-up action on bank restructuring. Other Regulatory Reforms To push corporate restructuring further. Conclusions. BBD. the Government established IBRA to supervise problem banks. However. improvement of rules and prudential regulations. The merger process will be finished within two years.1 Summary.6 1. It has also drafted regulations to remove obstacles for converting debt to equity. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. To obtain a clearer picture of the banking sector. To overcome these problems.6. BEII. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. In particular. or sold (after transferring NPLs to the AMU). providing Bank Indonesia with substantially enhanced autonomy. Liquidity support given to troubled banks should be repaid in four years. Bank Indonesia has announced a recapitalization program for potentially viable private banks. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. A new central banking law. was enacted in 1999. depositors will be fully protected by the Government. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. merged. the Government required banks to be audited by international external auditors. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. Some 175 groups that originated from family businesses controlled . and Bapindo) will be merged into one bank named Bank Mandiri.Chapter 1: Indonesia 45 In 1997. The four state banks (BDN. Banks deemed ineligible for recapitalization will be closed. The Bank Indonesia 21st package includes recapitalization. The importance of this legislation may need to be emphasized. In October 1998. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. 1. it is doubtful whether pure holding companies are able to enter into swaps.

Indonesian companies borrowed short term. meanwhile. The restructuring and resolution of financial distress may. allowing them to maintain their equity shares and. while a single family controlled 16. Companies relied heavily on bank credit. 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. II 53 percent of total assets of the top 300 Indonesian conglomerates.46 Corporate Governance and Finance in East Asia. These banks also obtained cheap offshore funds.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. On average. corporate debts grew over time. lacked the information necessary to allow them to assess projects’ risks and chances for success. These figures show the extent of power wielded over the corporate sector by a small number of families. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government.1 percent of publicly listed companies in Indonesia. Therefore. However. conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. Vol. 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. not all of the conglomerate-affiliated companies are publicly listed. however. However. retain ownership control of companies. Among those listed in the Jakarta Stock Exchange. Financing Patterns Controlling shareholders opted to use debts to finance expansion. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. But because foreign creditors were reluctant to lend long term. thus. When the Government regulated the legal lending limit and the net open position of banks. when barriers to entry in the banking sector were lifted. Rapid growth in investments masked the corporate sector’s increasing leverage. the majority remains family-controlled. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption.7 percent. Foreign creditors. families control 67. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. As a result. On the one hand.

On the other hand. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision.24 trillion in the first half of 1998. and the rapid decline in equity due to losses. Meanwhile. The financial crisis led to the closure of several dozen banks. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. and strengthen prudential regulations and supervision of the financial sector. the high domestic interest rates that prevailed from 1998. NPLs rose and capital adequacy ratios fell. At the height of the crisis.21 trillion in 1996. were the most adversely affected. although at a declining rate. Sales of conglomerates as well as those of publicly listed companies were increasing. When the crisis hit Indonesia. Impact of the Financial Crisis Prior to the crisis. The Government introduced reforms to improve bankruptcy procedures. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. To restructure the corporate sector. particularly those with large short-term foreign loans. the corporate sector was in quite good shape in terms of growth and profitability. The Government and the private sector responded with measures to mitigate the negative effects.1 percent in 1997 to -124. the highly leveraged companies. and registered a net loss of Rp39. As the rupiah weakened and interest rates increased. DER increased to 307 percent in 1997 and further surged to 1. facilitate debt restructuring. corporate-initiated debt restructuring . Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. followed by the property sector. the consumer goods industry was the worst hit. financed by issuing nearly $80 billion worth of bank restructuring bonds. ROE dropped from 1.370 percent in 1998. Bank Indonesia extended emergency loans to many banks. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts.1 percent in 1998. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative).1 trillion in 1997 from Rp13.Chapter 1: Indonesia 47 without diluting their control. Total profits of publicly listed companies dropped to Rp3.

and (iii) strengthening transparency and disclosure requirements. but inadequate protection to minority shareholders from the dominance of large shareholders. Most companies claim to have adopted international standards of accounting and auditing procedures. Vol. (ii) delineating the functions of the board of directors and commissioners. 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.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study.6. II measures included internal business restructuring (e. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. Specific recommendations include protecting the rights of minority shareholders.48 Corporate Governance and Finance in East Asia. The Government should ensure that all laws and regulations are effectively enforced. 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. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. but it is not clear whether in practice these standards are in place. In particular. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . improving the legal and regulatory framework for bank supervision. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. and protecting creditors’ rights. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts.g.. 1. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector.

Further. Protecting Creditors’ Rights To protect creditors’ rights. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. However. recapitalization. Banks should be required to provide data on such transactions and charged penalties for noncompliance. the Court has been slow and ineffective in processing bankruptcy suits. it has been difficult to implement standstills. most of banks’ NPLs resulted from credit to companies within the same group. in contrast to the Republic of Korea and Thailand. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. and liquidation of corporate assets. The Government should also continue strengthening the monitoring system for foreign exchange transactions.Chapter 1: Indonesia 49 financial institutions. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. the Government lost monitoring and control powers over foreign fund flows. The regulatory framework was also weak in supervising and monitoring foreign transactions. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. orderly restructuring. Because foreign creditors are faced with more information asymmetries than domestic creditors. 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. Consequently. 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. This is a significant factor in . In the first place. with necessary legal sanctions for violations. When finance companies were used to channel offshore loans in lieu of commercial banks. 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.

Vol.50 Corporate Governance and Finance in East Asia. . 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. II explaining the greater depth of the crisis in Indonesia. Only when creditors have the confidence that their rights are protected will they resume financing companies. despite the smaller level of capital inflows (as a percentage of GDP).

Keasey. and Larry H. various publications. Financial Sector Practice Department. The Economist Intelligence Unit. Risks. Institute for Economic and Financial Research. 1995. P. Embassy of Indonesia.Chapter 1: Indonesia 51 References ADB Programs Department (East). 1995. Maryland. Manuscript. P. Indonesian Central Bureau of Statistics. 14 May 1999. Asia in Crisis: The Implosion of the Banking and Finance System. Indonesia: An Emerging Market. 1996. 1996. Wright. The Economist Intelligence Unit. 1999. John Wiley and Sons. Working Paper #58. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Indonesian Business Data Centre. Lang. and M. Large and Medium Manufacturing Statistics. John Wiley and Sons. various publications. Bank Indonesia. Jonathan. 1997. University of Maryland. and Remuneration. 1998. Indonesia: Sustaining Manufactured Export Growth. Embassy of Indonesia Homepage. various publications. various publications. World Bank. Yogyakarta. Unpublished thesis MMUGM. Indonesian Business Data Centre. 1998. Corporate Governance: Responsibilities. K. Indonesia Country Report. Indonesian Capital Market Directory 1992-1998. F. and Richard Turtil. Conny Tjandra Rahardja. Claessens. Economy of Indonesia. Stijn. Indonesia Country Profile. 1997. JSX Monthly Statistics.. Jakarta Stock Exchange. Who Controls East Asian Corporations? Financial Economics Unit. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. . Delhaise. Economic and Financial Statistics. The Private Debt Anatomy. Michael Krill. Letter of Intent of the Government of Indonesia to the IMF. Forest. Simeon Djankov. Center for International Business Education and Research. 1999.

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. 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. The authors wish to thank Juzhong Zhuang. a practice that was not checked by creditors. Chung and Yen Kyun Wang1 2. and corporates were sent reeling. This has been the crux of the corporate governance problem in Korea.2 Republic of Korea Kwang S. timely exit of poor performers from the market. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. internal control mechanisms. Korea) in November of that year. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. 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. 1 Professors. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. Department of Economics. the Government and business sector had good reason to reflect on the causes of the crisis.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. David Edwards. markets. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. Seoul. and Graham Dwyer for his editorial assistance. both of ADB. or capital market discipline. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. the Republic of Korea. Further. As the Korean currency. the Korea Stock Exchange for its help and support in conducting company surveys. Business managers and controlling shareholders were maximizing firm size at the expense of profits. The country’s winners would then emerge based only on economic efficiency.1). . Chung-Ang University.

Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. June 1999. Weaknesses in the overall corporate governance system in Korea had many ramifications.1 1997 518 104 20. 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. the corporate sector. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. 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.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. Vol. II Table 2. and improvement of bankruptcy procedures. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. which distributed and collected the questionnaire. especially chaebols. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. .1 Listed Firms with Positive Economic Value Added.9 1994 531 165 31. Government reform goals for the corporate sector include enhancement of corporate transparency. Source: Korea Stock Exchange. Copeland.54 Corporate Governance and Finance in East Asia. accountability of controlling shareholders and boards of directors. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital.1 1995 560 163 29. This study collects and analyzes data on the Korean economy. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms.4 1993 513 174 33.1 1998 490 164 33. and individual companies.1 1996 561 163 29. The EVAs are the same as the economic profit as explained in T. capital market discipline. Koller. Many firms left some questions unanswered. and J Murrin (1995).

Section 2.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols.2. It then presents recommendations for further reform in corporate governance and financing. which account for a substantial portion of the Korean economy. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn.2 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.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. corporate control by the Government. Section 2. the board of directors system. reviewing government policies responsible for the development of the modern corporate sector. In the period 19481961. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. Section 2. This chapter is composed of six sections.2. It traces the country’s economic development. From 1948 to 1961. and other necessities domestically. The Government tried to produce food. . clothing. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation.4 contains analyses of corporate financing and its relationship to performance. creditors. 2. Section 2. and employees and their role in shaping corporate governance practices.2 presents an overview of the corporate sector.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. and Yim (1998). Section 2. Yang. and naturally adopted an import substitution policy. It reviews such elements as shareholders’ rights.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. The evolution of the modern Korean economy can be divided into four periods. Major economic indicators for some of these periods are shown in Table 2. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent.

c Refers to 1989. The Government tried . largely because of political instability.0 27.2 30. 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.2 Key Macroeconomic Indicators Annual Average (percent. This goal required very high savings and investment rates.5 250.1d 9. b Refers to 1979.4 10.2 757.265. Source: Bank of Korea. e For maturities of one year or more. However.9) (7. and large current account deficits.102.4 29.1 9. IMF.2 452.7 14.1 35.8 15. and inconsistent economic policies.8 24.6 11.949.0) 492.2 31. In the Plan. the Government called for an unprecedented average annual economic growth rate of 7.3 8.8 (8.5 38.9) 1.9 794. a Refers to 1971. d Refers to 1997.0 41.7c 11. II Table 2.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.4 29.2 1980-1989 8.4 1990-1997 7.5) (1.8 (724. high unemployment and inflation. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.447. Vol.4 (1.2 1. Export Drive: 1962-1971 Between 1962 and 1971.2 314.7 30. Economic Statistics Yearbook. International Financial Statistics. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).753.9 — — 21.1a 21. modernizing the industrial structure.8 12.1 — = not available.2 32.4 24.1 15.2 6.855. lack of strong drive. the Government was not successful in solving the problems of slow growth.7 37.0) (297.5) 8. and implementing new budget and tax measures. 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 8.9b 15.1 29.332.56 Corporate Governance and Finance in East Asia.

the import liberalization rate was 55 percent. 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.2 billion in 1972. imports of consumer goods and luxury items were highly restricted. the Government tried to provide exporting firms with a free trade environment. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. Exports increased sharply from $41 million in 1961 to $2. The exchange rate system was a kind of crawling peg until 1974. but tariff rates were raised to 40 percent in the 1960s.5 percent.3 percent to 60.4 percent. The well-educated.3 percent average between 1954 and 1959. and maximizing mobilization of domestic savings on the other. a modest improvement over the 4. But the liberalization trend turned out to be short lived as current account deficits continued. resulting in high real interest rates.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. but the average growth rate for 1965-1969 shot up to 10 percent. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. In 1963-1964. . Bank deposits increased rapidly. abundant. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. the growth of gross domestic product (GDP) raised domestic savings. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. However. and cheap labor force was well utilized by the export-led growth strategy. channeling funds from curb markets into the banking sector. This change raised the import liberalization rate from 9. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). while the average tariff rate was 39 percent. The average growth rate of the economy from 1960 to 1964 was 5. due to continuous current account deficits. During the first five-year plan period. boosting internal investment resources. In 1964. In 1971. up from 30 percent in the late 1950s. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. During this period. Also. which laid a solid foundation for a steady growth path.

machinery (including automobiles). It promoted HCIs by supplying massive capital for construction and development. nonferrous metal. and chemicals—as future core industries. 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 . It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation. These practices contained an implicit government guarantee that large businesses and banks could never fail. overburdened with debts and high interest rates. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. announcing rescue packages for businesses and banks. shipbuilding. it tried to substitute imports and export high value-added HCI products. the emergence of competition of other low-wage. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). The Government targeted six industries—steel. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. investing a total of $9. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. and assigned them to specific chaebols. the domestic economy was stagnant and many businesses. The Government took emergency measures.58 Corporate Governance and Finance in East Asia. In 1972. and giving low interest rate loans to banks from the central bank. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). The Government encouraged a variety of business projects. These included rescheduling business debts. the Government felt the need to strengthen the defense industry. less developed countries forced Korea to adjust its industrial structure. and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. The HCI promotion policy was much more comprehensive than past economic development plans. in the face of a world economic slump. becoming a seed of the economic crisis in 1997. faced the danger of bankruptcy. Third. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. Vol. Second.6 billion between 1973 and 1981 into these sectors. Unlike the previous system. There were three reasons for the switch: first. reducing or exempting debts of farmers and fishermen. electronics. By promoting HCIs. where preferential export credit was given to almost every exporter.

The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. Macroeconomic policies became hostages of the industrial strategy. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. exacerbated the overcapacity problem. 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. met increased difficulty. Such an approach gave the Government increased control over the economy. low . In 1986-1989. as it had to control only a few large chaebols. fiscal expenditure maintained zero growth. Firms that followed the Government expanded greatly. Evaluations of HCI promotion policies are mixed. New start-up firms. imports were further liberalized while tariff rates were lowered. faced with high inflation. Cheap credit and distorted prices resulted in overexpansion in the HCIs. price controls were abolished. such as widespread underutilization of capacities of HCIs and related plants. including forced liquidations and mergers and acquisitions (M&As). with many turning into the now well-known chaebols. Meanwhile.2). and their utilization ratios were very high. and the large excess capacity of HCIs. The plan of the 1970s was thought to be successful in the long run.Chapter 2: Korea 59 through state-controlled banks. the Government adopted comprehensive measures to promote economic stabilization. coupled with political uncertainty due to the assassination of President Park in 1979. the Government restructured some large businesses through forced liquidation and M&As. various measures to increase competition were taken. However. Economic Liberalization and Globalization: 1980-1997 In 1979. The growth rate of the money supply was reduced drastically. In order to improve economic efficiency. This required industrial restructuring by the Government. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. a heavy foreign debt burden. however. the policy wasted substantial amounts of resources in the short and medium terms. especially between 1979 and 1985. Meanwhile. The severe world recession caused by the second oil shock. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. including denationalization of banks. The incentives available became more market-based.

giving up its foreign exchange controls related to the current account. 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. Korea began participating in many multilateral trade negotiations during the Uruguay Round. total assets. 47. Vol. the import liberalization ratio reached 98. Meanwhile. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. In 1990. whose business activities are controlled by an identical person. total debts. the Government committed itself to further liberalization of the goods and capital markets. II world interest rates. and total workforce. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII.3 percent. 2.” A large-scale business group is called a chaebol. The low value of the dollar led to a low won and high yen. but it chose to liberalize gradually. and acceded to the World Trade Organization (WTO) in 1994. The Government tried to adjust economic policies and regulations to meet global standards. the importance of chaebols was increasing.1 percent. with the 30 largest in the total economy in 1997 standing as follows: value-added. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. and declaring that it would follow Article XI of GATT. In 1993. and low oil prices. further increasing its pace of import liberalization. which gradually widened.9 percent.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies.1 percent and average tariff rates 8. 45. 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). total sales. In 1988. Industrial and trade policies were modified to be consistent with WTO.2. 4. 13. while continuous and large current account surpluses saved Korea from the foreign debt problem. 46.60 Corporate Governance and Finance in East Asia. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems.9 percent.9 percent. . The most important element characterizing chaebols is the concentration of ownership.2 percent. The official rate fluctuated within a band. Korea adopted a market average exchange rate system. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993.

Chaebols are also excessively diversified. Table 2. This galvanized the fast growth of chaebols. and they are aided and supported by one another. In this sense. In the mid-1970s. One reason for this controlling power is inter-company shareholding among subsidiaries. it was more effective to deal with a small number of companies to secure tangible outcomes. However. This policy contributed greatly to the expansion of chaebols.3 Subsidiaries of the 30 Largest Chaebols. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. the number of subsidiaries declined drastically due to corporate restructuring. of Subsidiaries per Chaebol 20. Important managerial decisions are made primarily by owners. Chaebols have a history of substantial concentration of ownership.Chapter 2: Korea 61 War II. the ownership and management of a chaebol’s subsidiaries are not separate. . Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols.1 20. 1993-1996 Year 1993 1994 1995 1996 No.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. chaebols that maintained a close relationship with the political authorities were able to grow fast. of Subsidiaries 604 616 623 669 Average No.when the Government put a great deal of emphasis on development of the HCIs. reaching 669 in 1996. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. after the financial crisis.5 20. and tax breaks to key industries to promote exports and industrial upgrading. financial assistance. The Government provided subsidies. Table 2.8 22.3 Source: The Fair Trade Commission. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. Since the Government controlled most business activities. From the standpoint of the Government. Since the 1960s.

II Theoretically. and were allowed extra depreciation charges for tax purposes. Since chaebols are engaged in many different businesses. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms.3 Role of the Capital Market and Foreign Capital In the 1960s. Meanwhile. which may ultimately lead to the decline of social efficiency. 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. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. Vol. . if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. there are many negative assessments of organizational structures and practices of chaebols. Under this law. etc. years since establishment. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. profitability. 2. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol.62 Corporate Governance and Finance in East Asia. This could ensure their stable growth and enhance their investment abilities. In the early years after the enactment of the law. they can reduce uncertainties and dilute risks through sharing of information and diversification. chaebols can benefit from synergies. 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. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares.2. including the “economies of organizational size” inherent in multi-product and multiplant firms. diversification can make chaebols stable through the portfolio effect. On the other hand. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. They had to meet certain requirements in terms of firm size. For example. in addition to the usual economies of scale. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. However.

7 934. 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. 1985-1998 No.151 117.370 70. Inc. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused.0 49.5 406.1 Market Capitalization (W billion) 6. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.217 141. The aggregate Table 2.798 Market Capitalization as a Ratio to GDP (%) 8. continued until 1989.0 965. especially those paying small or no dividends. In this regard. The Korea Fund.1 16. a country fund.4. however. several important policy measures were implemented to promote the development of the stock market..9 918.Chapter 2: Korea 63 During the 1980s and 1990s.1 30. Also that year. Third.020 151.9 833. Because of government policies and the booming economy. . This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997.4 40.4 Development of the Stock Market.476 79. 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). the Government announced the gradual opening of the capital market to foreign investors in January 1981.9 34. The policy to expand the size of the stock market. was established to invest in domestic shares beginning in September 1985.6 747.570 95.989 137. Second.2 44. the stock market grew rapidly during the 1980s. As shown in Table 2. Beginning 1990.4 654. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.0 79. First. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.

924 (1.868 (518) (418) 63 1.017) 1. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.287 (340) 73.875 21.944) 8.413) 56.352 471 3.183 12.239 19.870) (1.126 (1. Other investments include loans.650 (1.59 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 1986-1989.858 4.141 4.2 percent by 1989.542) (1.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.5 Private Capital Flows to Korea. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis. The growth in the number of listed firms also slowed in the 1990s. Table 2.264) (3.008) (3.450 24. Source: Balance of Payments.583 25 10.817 16.742 (3. The relative size of the stock market diminished to 44 percent in 1990.382 Permit basis.414) 5.123 3. Table 2.910) 2.433) (9. The aggregate market value of listed shares bottomed at 16.737 (333) (297) (607) (2) 218 2. currency and deposits. trade credits.500 7. and other liabilities.658) (3. and 1993.534) 1. and stayed at the 30-40 percent level up to 1996.453 (2.785 (1. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.953 10.150 5. due to declining stock prices.571 2. 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) (2.339) (9.296) (6.64 Corporate Governance and Finance in East Asia.852) (2.149 13.338 4.440 1. but rose again to 34.255 2. .546 (2. but increased sharply to 79.085 2. However. Bank of Korea.86 percent of GDP in 1997. II market value of all listed firms represented only 8 percent of GDP in 1985.455) 13.347 3.800 (7.001 4. Vol.326 1.553 8.642 21.714 1.694) 2.942) 42.

and (iii) chaebols. Profit rates of Korean firms were relatively low compared to those of Taipei. Net private capital inflow. Return on equity (ROE) and return on assets (ROA) showed similar patterns. Korea had substantial current account surpluses and experienced net private capital outflow. and high production costs were the main reasons for low FDI in Korea.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. The same categories will be analyzed in later sections. This indicates that a substantial proportion of debt was denominated in dollars.2. (ii) listed firms. The contribution of the corporate sector to GDP was 73. However.9 billion. Taipei. This would lay the foundation for evaluating the effect of corporate governance on performance. the growth rates of equity and sales dropped sharply in 1996 and 1997.Chapter 2: Korea 65 Complicated government regulations. but dropped in 1996 and were negative by 1997.China and the US. portfolio investments amounted to $73. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. and US.7 billion and loans $42. Corporate sector net proft margins increased from 1993 to 1995. increasing to 76 percent in 1997. Of this. Japan’s was consistently higher. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424.6 percent in 1997. Table 2. other net private capital inflows amounted to $130 billion during 1985-1998. following the sharp depreciation of the won. The growth rates of total assets.2 percent in 1987. 2.China. excluding FDI. and sales of the aggregate sector during this period were very high (Table 2. equity. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. The ratio is generally in the same range for Japan and Korea. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. The dismal performance of the Korean corporate sector compared to the .6). but between 1988 and 1993. In addition to FDI.5). Between 1986 and 1989. weak incentives for attracting FDI.

4 2.2 13.6 13.8) 297.3 3.0 13.3 335.6 4.Table 2.0 7. ROA = return on assets (ratio of net income to total assets).9 8.9 16.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.4 2.3) 5.9 18.3 14.1 8.0 8.9 2.3 308.8 1.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.7 4.9 2.9 5.1 2.6 1.2 1.9 16.4 1.6 318. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).7 1.2 13.9 13.5 7.0 6.9 3.8 22.7 3.5 1.3 21.7 2.7 15.8 21.8 3.9 5.1 5.5 1. Source: Bank of Korea.0 13.8 8.0 0.0 (0. 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 23.2) (0.2 1.0 305.5 2. Financial Statement Analysis Yearbook.7 3.7 15.3 1.4 1.6 1.7 325. .3 21.3 — 3.3 11. Source: Bank of Korea.1 2. Net profit margin = ratio of net income to sales.9 5.0 10.4 10.1 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).3 6.6 3.0 4.6 9.5 (0.0 3. ROE = return on equity (ratio of net income to stockholders’ equity).2 19.9 18.5 1.6 2.2 9.4 2.9) DER = debt-to-equity ratio.5 4. Financial Statement Analysis Yearbook.4 1.6 424.7 4.4 — 6.5 3.8 1.2 1.6 (4.3 17. Table 2.7 4.4 4.8 2.2 18.1 — — — = not available.3 312.9 3.1 6.5 0.9 4.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.5 4.9 2.4 19.

Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2.5 percent while the aggregate sector recorded only 13. This preference of Korean firms has its roots in the structure of corporate governance. A comparison of performance by firm size reveals some interesting results. with the wholesale and retail trade sector and the construction sector having the highest figures. Growth rates of total assets are generally high. this may be an indication of the bias toward large firms in terms of access to credit. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. However. followed by mediumsized firms and large ones. and transport sectors recorded negative profit rates in 1997. Performance followed similar patterns across different industries (Table 2.and small-scale firms (Table 2. gas. a year ahead of the other industries. Profit rates of most industries are also quite low. trade. sales of listed firms grew 18. while their average net profit margin was lower than that of medium firms. but higher than that of small firms. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. construction. It is notable that the construction sector’s profit rate began its decline in 1995.4 percent. Small listed firms were hardest hit by the financial crisis.10). In most years. However. the average ROE was lowest for large firms. In 1997. 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. ROEs. both ROA and ROE were lower for the listed firms compared to the latter. and steam supply industry. The other financial ratios follow the general pattern of the aggregate corporate sector. All sectors experienced a sharp decline in equity and sales growth in 1997. This may be related to its having the lowest DER. The manufacturing. Again.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits.9). Net profit margins. The growth performance of large firms for the 1988-1997 period was better than that of medium. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. . the exception being the electricity.6).8). with equity in wholesale and retail trade even contracting.

3 10.Table 2.6 1.7 4.4 1.9 538.4 350.3 15.1 1.8 32.6 12.2 12.5 (1.8 24.1 290.4 2.0 15.7 10.4 740.8 22.2 6.2) (0.9 16.3 14.4 17.4 291.4 (0.5 14.8 17.0 18.8 616.4 458.7 5.5 1.6) 3.0) 0.1 (0.9 10.4 .4) 0.0 (0.0 2.0 9.5 1.1 10.8 12.1 1.5 6.3 1.7 514.5 1.8 16.6 14.2 20.3 25.7 228.4 9.1) (3.2 5.7 17.4 1.0) 1.3 2.0 3.0 2.2 6.6 24.8 1.2 15.2 0.7 1.0 22.5 (0.6 3.0 1.5 239.9 (0.9 19.0 37.1 0.8 13.0 245.1) 0.7 520.1 0.9 3.4 10.6 3.7 0.4 2.1 16.3 8.0 5.9) 1.6 17.9 25.5 6.9 2.8 0.2 16.6 16.6 14.7 (0.4 10.0 16.8 10.8 14.5 19.6) (6.1 2.0 5.0 12.0 23.2 36.7 22.3 8.1 20.0 24.3 285.0) 0.3 18.1) 3.4 12.2 16.8) 0.9 14.9 0.1 2.9 13.7 21.0 2.8 34.7 317.5 483.2 0.3 15.9 16.6 12.8 526.8 461.8 562.3 15.0 1.8 2.4 2.8 24.7 30.4 3.1 396.1 27.5 (5.4 5.4 2.5 23.5 4.3) (1.6 0.0 22.2) 15.8 Real Estate.4 0.6 11.9 428.6 655.8 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 13.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.2 5.4 348.0 1.5 338.9 9.3 13.6 17.4 5.3 10.5 1.8 0.3 1.4 14.5 569.8 16.8 2.0 (0.0 7.3 2.2) 6.9 (0.6 375.0 1.2 7.0 (4.2 241.2 (1.5 3.9 29.1 28.6 7.8 302. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.4 4.1 17.5 270.9 16.3 15.1 1.0 21.2 0.5 432.6 5.5) 0.3 31.9 (0.7 7.2 315.6 6.8 345.9 31.8 10.5 5.9 10.8 16.6 2.2 2.8 1.4 15.5 473.7) 2.9 340.0 15.8 2.8 23.8 7.8 14.2 20.6 1.0 1.0 2.0 24.4 2.0 19.9 2.5 16.2) 22.1 21. Renting.3 288.0 16.8 35.4 474.4 10.4 5.2 24.0 1.7 9.8 3.2 423.8 12.4 0.0 22.0 254.6 15.1 296.1 (0.5 306.2 5.3 11.2 25.7 294.3 11.0) 4.7 16.7 (3.0 18.5 5.6 318.9 5.8 22.5 1.0 1.5 30.5 286.3 8.4 10.8 3.5 1.3 14.2 18.6 0.5 27.1 0.6 14.5 13.9 1.1 22.1 7.1 1.5 28.3 8.

7 — — — — — 14.3) 4.7 19. Source: Calculated using data from Bank of Korea.3 0.4 10.9 10.6 34.6 3.0 14.7 15.6 9.5 47.0 2.6 4.6 15.0 1.0 5.1 (11.6 — — — — — 17.4 9.5 30.5 0.9 8.4 2.4 (2.5 8.1 15.1 21.3 1.0 89.1 12.5 11.4 13.8) 1.9 (11.6 8.1 323.9 18.3 543.3 0.0 Transport.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 — — — — — 31.5 15.2 143. a New equity does not include capital surplus.6 1.5 14.5 11.0 98.0) 1.9 4.7 116.4 633.8 14.6 9.0 5.9 (10.6 (2.6 8.8 529.6 172.9 18.4 14.4 3.1 3.2 90.4 12.1 6.7 510.7 11.0 21.4 6.8 3.2) 13. Gas.8 3.9 12.4 12.8 111.5 14.3 740.4 6.4 7.5 12.2 18.7 11.3) 15.1 14.5 (2. Financial Statement Analysis Yearbooks.7 0.7 2.4 0.3 (2.8) (12.2 3.3 18.7) (4.1) 1.3 2.2 11.5 15.6 19.0 1.1 17.6 512.2 14.9 456.5 14.5 482.2 14.0) (0.2 10.1 4.1 (2.9 6.0 7.8 7.0 14.7 7.8 8.5 26.3 4.6 8.1 (0.062. .2 1.5 307.3 — — — — — 10.3 4.4 — — — — — 448.8 14.7 12.4 1.4 11.5 14.6 20.9 9.3 9.2 2.9 321.9 12.7 16.8 12.3 18.4 15.6 6.6 18.6 — — — — — 0.1 11.5 539.3 524.2 10.9 1.8 12.8 6.9 3.0 (1.0 (15.5 462.6 2.4 3.6 9.3 12.0 1.6 21. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.0) 1.9 9.8 15.7 0.8 11.2) 0.7 14.2 18.3 112.9 8.5 13.4 1.1 11.4 3.Table 2.7 11.2 10.4 1.6 1.4 0.3 4.0 13.9) (8.1 8.1 2.8 4.8 0.6 16.9 10.2 698.6 12.4 7. b NPM denotes net profit margin.5 344.9 Electricity.8 0.3 1.9 4.3 34.3 3.6 12.8 6.3 23.1 15.1 16. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.4 341.6 6.2 18.6 19.3 19.1) (0.4 0.6 0.6 14.3) (1.4 2.5 117.7 20.9 332.2 122.4 16.4 30.8 9.2 7.9 17.9 7.5) 22.5 612.3 8.3 125.2) 9.2 — — — — — 2.7 187.6 (2.5 4.7) 0.9 17.4 21.4) (1.2 15.1 15.4 169.4 367.0 921.5 2.7 7.0 2.0 106.3 17.6 6. Storage.1 1.5 16.4 (0.7 2.3 8.1) (0.7 — = not available.1) 5.3) 11.6 4.

3 (0.9 2.8 0. and net profits (46. the top 11-30 chaebols experienced a decline of . and close to half of total assets (46.11).8 5. the 30 largest chaebols accounted for 13.9 6.12). The criteria for selection of largest chaebols have changed a few times. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.1 percent of the economy’s total value added (excluding the financial sector).7 percent) of the corporate sector. Chaebols have been the most important actors and engines of growth in the Korean economy. of which four were listed.6 and 2.7 Net Profit Margin 0.9 percent).3 0.1) 4.6 22. Generally. but the number of designated groups has been fixed at 30 since 1993. the largest chaebol.7 1.4 1.1 6.8 6.9 26. had 46 member companies.6 2.5 5.9 1.5 19.2 9.4 1.7 1.9 2. The smallest group had 16 members in 1995.0 3.9 11.1 1. followed by the top 6-10 (Table 2.5 0.2 9.5 ROA 0. Kis-Fas. The top five chaebols registered the highest growth rates.6 0.12).6 1. II Table 2. Vol.8 24. Hyundai Group.2 6.9 Source: Constructed using data from Korea Investors Service. The number of Hyundai member companies rose to 57 in 1997. sales (45. 1985-1997 (percent.6 (1. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.9 percent).4 22.6 23.3 15. It should also be noted that when the financial crisis struck in 1997.2 0.5 ROE 3. In 1995. Performance of Chaebols This section uses available data on the top 30 chaebols.7) 0.3 2. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.9 Growth and Financial Performance of Listed Companies.1 1.3 4.0 18.4 0.6 3.3 percent).5 19.9 21.0 0.4 2.4 1.2 2. Between 1993 and 1997. In 1997.9 0. 1998.7 (5. debts (47.3 20.70 Corporate Governance and Finance in East Asia.4) 1. of which 16 were publicly listed (Table 2. it is the chaebols’ large firms that are listed.

7 2.4 1.3 6.9 2.2 10.0 17.2) 0.5 5.8 1.6 0.1 2.8 0.1 8.5 25.5 2.8) 6.5 0.8 0.9) (6.0 1.6 1. Source: Korea Investors Service.4 1.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.2) (1.2 0.6 3.8 10.6 7.Table 2.6 2.9 1.5 (1.8 7.6 1.5 3. Kis-Fas.3 (0.3 15.5 17.9 14.2 2.7 (1.4 16.9 6.8 0.1 0.3 11.4 Medium Small Large Medium Small ROA Growth Performance Large 17.8 6.0 16.2 (0.7 (1.6 6.3 Medium 14.6 3.4 3.8 (5.2 Small 13.4 2.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.9 22.7 (0.6 13.4 11.0 (4.9 2.8 17.7 4.6 8.3 (0.5 1.2 12.0 10.6 2.2 2.6 (0.1 2.0 15. .0) 1.2 13. Others are medium firms.1 1.6 5. 1988-1997 (percent) ROE Large 9.9 25.7 3.0) 0.9 6.8 16.4 3.6 2.9 2.9 0.2 7.9 0.6 0.9 3.5) 1.6 (1.9 5.2 3.1) 5.0 1.8 6.5) 1.2 1.0 19.9 0.8) 1.7 2.2 13.0 4.7 1.2) (1.4 5.3 3.8 0.10 Growth and Financial Performance of Listed Companies by Size.1 11.4) 1.9 1.3) 5. 1998.9 (0.7 18.3 1.4 6.0 1.5 5.3) 0.3 15.0 6.6 1.8 3.6 9.3 9.0 1.6) 0.

455 22.475 2.131 3.303 3.597 351.313 14.924 2.690 3.364 5.574 3. Source: Fair Trade Commission.346 3.246 11.929 12.798 — No.651 38.677 3.853 1997 53.457 14.158 7.147 5.935 2.743 40.927 16.Table 2.599 — 2.287 10.774 7.640 4.090 6.486 6.996 1.761 31.873 2.766 3.445 4.910 3. 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.376 35.956 3.117 4.756 5.501 13.395 31.129 2.309 14.370 6.423 5.398 — 2.427 9.995 2.177 — 6. 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.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 43.158 1.967 7.990 2.180 2.433 3. .951 3.458 6.

7 13.1) 0.1 (1.3 9.3 0.9 18. 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 12.3) 0.5 5.3 1.4) 1.3 19.9 3.9 3.3 16.6 4.6 25.7 1.0) ROA 1.4 30.9 17.1 27.4 0.1 (3.12 Growth and Financial Performance of the 30 Largest Chaebols.7) Source: Bank of Korea.8 Assets 12.1) 0.1 2.2 (16.0 0.5 20.6 Financial Performance Net Profit Margin 1.0 6.0 17.1) (1.0 19.8 18.0 0.2 (2.4) (0.6 18.9 20.5 (0.2 0.1 19.Table 2.1 (2.7 10.6 (0.3 1.0 2.3 3.0 31.2 1.5 27.5 19.7 4.4 26.2 3.4) (14.5) (0.4 12.0 2.7) ROE 5.9 20.3 15.2 0. .0) 3.1) (0.3 0.1 10.3 11.9 24.1) (0.2 0.4 38.8 27.0 1.0) 12.5 2.7 15.4 (2.2 11.8 0.7 10.0 2.2 20.6 19.6 1.2) (2.2) (0.2) 1.3 27.7 0.7 15.5 32.2 (5.5) (0.3 14.9 1.5) (0.2 (2.

The Commercial Code stipulates the basic governance framework and applies to all corporations. Vol. 2. II 2 percent in their sales and a very low 4.” in Korea’s legal and regulatory framework. and vulnerable balance sheets. except for 1995.74 Corporate Governance and Finance in East Asia. and led to a high concentration of ownership.7 percent growth in total assets. and the companies that are under the control of the largest shareholder. internal and external control mechanisms. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated.13). and government intervention interacted through a set of laws and regulations to bring about the existing structure.765 percent (Table 2. 2. technology. In general. his/her relatives. and access to credit. more important.3.5 Founding families are mostly still the largest shareholders and.95 percent. the average DER of the 30 largest chaebols reached 519 percent. Their worst year was 1997 when ROE hit -15. a pyramidal structure of corporate ownership is prevalent. 5 While “ownership concentration” can be defined and measured differently in different contexts. However. By the end of 1997. coupled with weak corporate governance. includes the largest shareholder. from 190 to 3. weak corporate control. resulted in the chaebols’ excessive leverage. Only the top five chaebols registered a positive net profit margin in 1997. There has been a wide range in DER among chaebols. in this instance. chaebols had a higher average DER than the corporate sector as a whole. However.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. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols.” This “identical person. The better showing of the top five chaebols was a direct result of their dominance in human resources. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. it refers to the degree of concentration and shareholdings in the hands of an “identical person. 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. . loopholes and inconsistent policies spawned strategic behavior and agency problems. Ownership patterns.

1 477.5 464.2 471.7 354. LG 4.4 556.2 292.5 383. Hansol 23. Newcore 30.7 267. Samsung 3. Samsung 3.065. Hanjin 8. Kolon 21.2 2. Hanbo 15.2 328.5 2.1 190.8 312.1 3.6 516.764. Doosan 13.1 278.0 218. 1995-1997 (percent) Chaebols 1995 1. Kumho 12. Dongbu 24. Ssangyong 7.855.6 2.1 385.441.0 506.4 175. Sammi 27. Hyosung 18. Daewoo 5. Sunkyung 6.3 315. Jinro 20. Dongah Construction 16.9 321.2 346. Kia 9.13 The Top 30 Chaebols’ Debt-to-Equity Ratio. Hanjin 8.7 620.3 297. Dongkuk Steel 19.4 192. LG 4. Hyundai 2. Kia 9.3 572.2 924. Haitai 26. Hanwha 10.5 3. Tongyang 22.6 409.2 423. Hanil 28. Byucksan 1996 1. Hyosung 18. Daelim 16.7 621. Dongah 14.3 328.244. Daewoo 5.7 688.6 . Hansol 17.8 313. Sunkyung 6.1 674.7 416. Kukdong Construction 29.4 622. Kumho 12.6 936. Hanwha 10.5 343. Halla 13. Dongkuk Steel 19. Lotte 11.Table 2.9 751. Daelim 14.0 486.5 337.8 336.0 370. Kohap 25. Halla 17. Ssangyong 7. Lotte 11. Doosan 15. Hyundai 2.4 205.0 436. Jinro Debt-to-Equity Ratio 376.

0 419.214.1 375.5 386.498. Keopyong 29. Haitai 25.8 338. Dongah 11. Halla 13. Newcore 26. Lotte 12.8 658.1 472. Hanil 28. Hanwha 9.9 472. Kolon 19.6 416. Doosan 15. Dongbu 21. Shinho 26.Table 2. Dongkuk Steel 20.1 433. bBank of Korea. Hyosung 17.1 359.0 305.9 490. Anam 22.6 590. Hyundai 2. Kohab 22. SK 6. Tongyang 24. LG 5.4 1.6 Sources: aFair Trade Commission.3 676.9 578.5) 404.4) 513.13 (Cont’d) Chaebols 20. Daesang 27.5 323. Shinho 1997 1. Kolon 21. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Hansol 16.0 505.6 478. Tongyang 24. Jinro 23. Newcore 28. Haitai 25.9 465.1 438.8 399. Financial Statement Analysis Yearbook. Kohab 18. Keopyong 29.8 468.5 261.0 907.5 576. Miwon 30. .3 1. Kumho 10. Kamgwon Industrial 30.225.7 1. Hanjin 7.7 370.5 (1.6 335.5 519.7 944.6 424.501.3 347.9 1.9 216. Daewoo 4. Samsung 3.8 590. Anam 27.3 399.8 347.600.5 1.784. Daelim 14.8 307. Ssangyong 8. Dongbu 23.5 (893.8 647.

The holdings of financial institutions. From 69. The pattern of distribution changed little through 1992-1997. Thus. Among listed nonfinancial companies. managerial entrenchment becomes more likely. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992.” foreigners. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. individuals were also the largest shareholder group. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. including banks and other financial firms. i. However. and insurance companies increased during the period.. The percentage of shares owned by “other corporations. 10 to 30 percent).7 percent by 1997. Theoretically. while those owned by banks. the Government.6 percent by 1997. However. that is. the incentive effect once again dominates. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. The next important group was “other corporations.1 percent. the ownership structure can bring about an incentive effect. fluctuated widely during the period.14). the entrenchment effect outweighs the incentive effect. large ownership can also bring about the entrenchment effect. resorting to extensive use of pyramiding to maintain control. including investment trust companies. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. the extent of ownership by these individuals declined gradually after 1988. the year the stock market was in a frenzy due to buying sprees. the percentage of holdings by individuals slipped to 60. with a given range of managerial shareholdings (for instance.” followed by banks. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. and state-owned companies and securities companies declined. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. Composition of Ownership Among listed companies. Beyond that range. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. The reduction can be .e. but their shares declined to 21. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. and then steadily declined after 1993.

0 60.1 3.1 2. c Data from Korea Stock Exchange. merchant banks.6 16.6 9.7 59.2 9.9 15.5 6.6 12.2 B. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.14 Ownership Composition of Listed Companies.6 16.1 68.2 1993 511 2.9 37.7 8.3 1.3 5.8 17.3 18.6 36.5 60.4 5.5 1992 508 2.4 1997 551 1.3 17.2 3.7 18.1 18.3 26.8 4.4 14.1 8.8 5. a The State covers the Government and state-owned companies.9 2.5 62.1 21.1 18.8 17.3 17.7 14.4 34.3 1996 570 2.9 19.5 12.3 39.2 9.2 4. mutual savings.9 17.6 22. b “Banks.8 59.” includes commercial banks.5 1989 498 0.4 5.6 16.1 8.8 59.0 27. and finance companies.7 9.7 3.5 Note: Ownership is based on number of shares.2 18.1 11.5 7.6 2.8 69.4 6.4 13. of Firms The Statea Banks.2 8.4 Insurance Firms Other Corporations Foreigners Individuals 39.6 13.3 18.1 4.2 7.1 21.1 10.9 1.0 5.9 2. .1 1.2 1.8 1995 548 2.4 13.6 20.5 16.8 2.6 8.0 5.5 1.6 Year No. etc.1 17.4 18.2 8.2 5. etc.7 7.7 6.8 2.7 1990 531 0.0 7.3 1. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.0 4.5 6.6 1991 505 0.7 9.3 8.2 5.3 1994 521 1.0 28.9 26.5 18.6 19.0 59.b A.Table 2.3 2.9 5.5 4.9 1.5 7.9 36.9 4.7 4.2 2.3 5. Listed Nonfinancial Companiesd 1988 406 0. d Constructed from data files of the Korea Listed Companies Association.0 8.0 9.6 9.1 60. investment trust companies.5 1.2 17.8 5.

Compared with its holdings in all listed companies. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms.17). Individuals held the majority of the shares in all industries except in telecommunications. electricity. In most instances. whether partial or absolute. 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. and US (Table 2. Corporate holdings averaged 16 percent throughout 1988-1997. government ownership in nonfinancial companies was remarkably smaller and more concentrated. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. held 26. categorized into large. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and .18). Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. the Government was the sole owner. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. other corporations’ holdings shifted toward service industries.8 percent of listed shares in 1997. This trend can be explained by government ownership. In 1998. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. indicating their increased investments particularly in the service industries with high growth rates. of some banks. The holdings of other corporations are mainly equity investments in affiliate companies. Before such liberalization. and service of motor vehicles (Table 2. did not vary significantly (Table 2. However. In general. UK. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. medium. This is low compared with those in Japan. Over the years. However.15). foreign holdings were derived from purchases through country funds and direct capital investments. financial institutions had more shares in the manufacturing sector than in primary industries.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.16). When independent companies are distinguished from firms affiliated with the 30 largest chaebols. The ownership distribution in listed nonfinancial firms. Institutional investors. as distinguished from individual and foreign investors. and small companies. indicating their heavier reliance on inter-firm financing investments.

5 — 1.2 1. Rubber.9 1.5 17.1 65.0 8.5 0.1 10.2 — — 0.5 0.3 6.7 17.0 — 0.9 66.8 7.8 3.4 — 0.8 7.7 14.3 9.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.1 8.3 62. 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 Printing Pulp.6 8.7 64.9 19.3 2.6 — — 2. Gas.8 7.8 1.7 6.9 15.4 8.9 59.8 Individuals 83.7 20.0 0.3 7.9 52.2 0. and App.5 — 0..3 0.0 9.2 0.7 2.4 2.3 1.7 29. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.8 8.0 2.1 1. Etc.5 — — 0.7 2.6 5.9 55.1 27.5 6.15 Ownership Composition of Listed Nonfinancial Firms by Industry.3 1.8 73.9 23. Motor Vehicles Electricity.3 0.9 1.8 7.2 64.1 0.9 60.4 7.2 9.4 8.1 88.4 Banks.4 56.9 8.5 85.9 16.3 11.9 10. Paper.7 22.5 19.5 4.0 1.1 8.5 0. Elecl Mach.3 38.6 11.2 — 0.2 7.4 5.4 62.8 5. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.4 14.5 3.4 0.3 57.1 19.3 2.2 9.6 18. Paper.3 10.4 56.7 1.6 1.2 0.3 13.9 4.1 7.2 1.0 9.Table 2.5 0.9 0.7 22.4 1.9 42.1 0.2 0.0 7.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.5 7.6 3.0 — 39.0 9.2 22.8 6.7 59.0 20.2 54.1 0.8 3.2 17.0 9.0 10.2 2.3 4.7 63.2 9.1 4.7 2.6 24.1 0.4 8.5 12.7 14.8 7. and Printing Chemicals.3 0.4 1.7 20.

1 25.6 75. a The State covers the government and state-owned companies. Note: Ownership is based on number of shares.2 23.2 13.0 60.9 2. etc.0 3.4 1.3 6.5 3.9 1.0 4.6 2.3 7. and Printing Pulp.5 6.4 20.2 4.5 0.9 5.7 19.8 2.0 11.8 3.8 11.9 69. mutual savings.6 14.9 78.1 1.4 76.7 1.4 43.3 60.0 8.2 0.6 3.8 5.1 2.3 65.3 1.6 18.2 7.9 6. 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 1.9 6.7 17.1 2.2 6.9 1.1 — 1.2 1.8 0.1 1.2 49.5 — 2. merchant banks. Source: Constructed from data files of the Korea Listed Companies Association.7 23.2 0.8 0.8 6.4 9.4 0.2 3.1 4.4 1.5 3.2 5.3 1.5 59.5 7.7 4.6 6.9 2.7 2.9 1.0 1.0 6.9 7. and finance companies.2 1.3 15.6 — = not available.9 7. Rubber.2 4.7 2.8 2.3 31. Elecl Mach.8 57.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.8 2.78 81.1 — 0. .8 27.5 1. and App.8 5.1 18.2 5.8 54.9 20. investment trust companies.6 20.4 58.8 4.6 59.0 7. and Printing Chemicals.4 4.6 6.2 4.1 54.3 57.1 3.7 2.4 4.4 2.5 4.9 2.4 58.5 63.6 2.6 5.1 9.5 12.9 5.4 45.5 3.6 1. Motor Vehicles Electricity.9 2.9 18.3 0.9 20.1 9.4 1. Gas.3 8.4 2.0 5.1 3. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.0 43.9 0.2 8.4 6.5 3.6 2.7 2.4 — 1. b “Banks.” includes commercial banks.7 5. Paper.9 57.5 4.6 7.3 6.4 2.7 6.4 16.4 3.3 2. Paper.8 12.5 5.6 0.1 6.4 68.2 4.6 0.0 6.6 60.

7 6.5 2.4 1.” includes commercial banks.4 61.5 8. b Table 2.9 5.8 6.4 21.1 8.4 5. 1997 (percent) The State 1.4 4.4 5.1 2.5 Individuals 60.1 Banks.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.4 2.4 61.0 Other Corporations 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. 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.7 Control Type No.4 Firm Sizea No.6 16. Others are medium firms. . 1997 (percent) The Stateb Foreigners 4.8 4.5 16. Securities Firms Insurance Firms 2.Table 2.9 2.7 0. c “Banks. The State covers the government and state-owned companies.3 Banks.7 8.c Securities Firms Insurance Firms Other Corporations Individuals 58.7 4.8 3. and finance companies.7 1. etc.5 6.0 1. investment trust companies.7 Foreigners 4. etc.9 4.8 4. etc.8 1.4 17. Source: Constructed from data files of the Korea Listed Companies Association.5 62.5 4.2 1.8 2.16 Ownership Composition of Listed Nonfinancial Firms by Size.4 2.1 6. merchant banks.8 60.0 6.6 60.5 18.5 19.3 6.

7 16.20).4 26.6 39. defined as those holding less than 1 percent of shares. At the moment. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. and the companies under the control of the largest shareholder. Generally. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. for example.3 47. This has had profound implications for corporate governance and the market for corporate control in Korea.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. Foreign holdings of Korean shares were 9. corporations held 70 percent of the controlling blocks of shares.China United Kingdom United States Source: Stock Exchange of Korea. 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 .8 9. rather than the individual.5 20. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. the majority shareholder group in all listed companies consists of the corporate. while family members accounted for only 30 percent.1 8. minority shareholders.3 6. only closed-end investment companies and traditional investment trust companies are allowed. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. Among nonfinancial listed firms.6 Individuals 23.5 45. Institutional Investors 42.3 54.Chapter 2: Korea 83 Table 2. 1997 (percent) Country Japan Korea Taipei.8 56. In 1997.1 financial institutions’ establishment of corporate pension fund accounts.6 Foreigners 9. his/her family members. investors (Table 2. including those of the largest shareholder.19).8 10.18 Ownership Composition of Listed Firms in Selected Countries.

6 46.2 2.5 43. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.1 21.1 4.7 7.7 18.9 33.0 25.6 73.19 Ownership Concentration of All Listed Firms.6 26.0 1.Table 2.1 5.9 32.4 5.3 30.8 Individual Subtotal Other Shareholders Corporation 3.6 2.9 Individual 2.7 6.8 72.4 3.7 16.1 28.9 6.6 5.2 2.1 32.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41. Source: Stock Exchange of Korea.7 Note: The majority shareholder includes the largest shareholder. his/her family members.7 44.2 Minority Shareholders Subtotal 71.3 Subtotal 5.2 26.9 2.0 4. and the companies under the control of the largest shareholder. 1992-1997 (percent) Majority Shareholders Corporation 15.1 15.1 23.4 7. .8 8.9 7.0 2.6 22.8 73.1 37.3 2.0 69.1 5.0 66.3 18.0 29.1 14.0 22. Minority shareholders are those holding less than 1 percent of shares.9 3.

the Government has retained a large number of shares. in the small firms. thereafter.8 25.20 Ownership Concentration of Listed Nonfinancial Firms.9 25.9 27.Chapter 2: Korea 85 Table 2.22).4 Source: Constructed from data files of the Korea Listed Companies Association. .0 20. It was highest in medium-sized firms before 1993 and. rubber and plastics.0 58.8 57.9 12. Besides.5 60. collectively owned less than 50 percent of an average firm.9 Other Shareholders 18.8 Majority Shareholders 27.1 50. 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 2.8 12.6 58. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.5 23.2 15. Across industry. In such cases. Majority ownership is also high in the chemicals. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average. and mining categories.3 62.6 11. The practice of hidden shares seems to have been less prevalent in recent years. In most industries.8 54. In telecommunications.7 18. hiding shares offers no additional tax or other benefits.8 28.9 29.9 48. 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. ownership was relatively diffused due to government regulation.4 23. 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 2.21]). minority shareholders.5 13.4 28.3 25. Meanwhile.5 12. Ownership concentration tended to be lower in large compared to medium and small listed firms.0 22. which held less than 1 percent of a company’s outstanding shares as of 1997. the majority owner held more than 20 percent of an average firm.6 57.

9 Minority Shareholders Majority Shareholders Other Shareholders 12.2 23. Paper. and Printing Pulp.8 44. Elecl Mach.0 21.2 26.1 49.7 26.2 22. Motor Vehicles Electricity. 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.3 39.8 31.4 53.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 16.2 46.. .8 25.2 20.1 19.8 24.4 16.5 20.7 21.9 44.5 52.8 55.8 51.7 24. Paper.Table 2.9 26.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.0 30.0 39.6 19.2 37.0 51.6 25.6 53.1 17. 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 36.3 19.3 26. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.4 11.1 43.9 10.2 34.5 19.8 29. and App.0 54.6 38.5 23.5 47.7 29.6 34.7 17. and Printing Chemicals.5 44.2 19.7 27.5 41.6 50.2 48.5 21. Rubber.8 41. Gas.7 36.8 21.

5 19.7 14.4 51.9 16.0 55.9 56.2 21.9 17.3 19.5 12.2 32.1 16.2 50.6 55.7 31.2 Source: Korea Listed Companies Association.5 21.2 18.3 26.2 Majority Shareholders 26.8 50.5 10.5 26.5 12.6 59.0 26.2 56.9 12.6 11. 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 53.8 62.6 24.2 55.1 15.6 65.3 21.8 28.1 58.Table 2.9 22.4 21. 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.8 56.0 59.4 30.6 62.7 17.1 20.8 52.2 26.5 49.7 16.3 27.3 25.7 15.8 11.9 23.4 30.4 29.9 55.2 21.2 12. .3 55.2 52.2 11.1 48.6 15.7 57.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.5 19.8 17.6 27.5 Other Shareholders 19.5 51.5 28.4 30.9 21.7 57.9 60.8 52.2 21.0 66.6 31.8 27.5 27.9 28.9 26.4 47.1 27.5 33.9 53.0 24.7 28.7 22.

although turning points in the value of firms are different. one company from a chaebol group could obtain debt payment . TQ is below 1. the firm destroys value. TQ increases as the SCS increases. Hong. 1988). and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. Kim (1992) found the relation between TQ and SCS to be nonlinear. H. J. The Code prohibits a subsidiary company from owning shares of its parent company. TQ is above 1. If SCS reaches 10 percent. H. which is the company holding more than 40 percent of outstanding shares of its subsidiary. thus a firm destroys value. TQ has a maximum value. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. One of the merits of pyramiding. and Kim (1995) reached a similar conclusion. The study by Kim. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. if TQ is lower than 1. Shleifer. is effective control of a certain group of companies even with a smaller investment. II Ownership Concentration and Financial Performance J. The relationship between TQ and SCS shows a similar pattern. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. Where direct cross-shareholding is not allowed. often at terms unfair to one of the transacting parties. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. it means the firm creates value. For example. and Vishny. If TQ is higher than 1. If SCS is above 20-25 percent.88 Corporate Governance and Finance in East Asia. They analyzed firms in which controlling shareholders participate as managers. Vol. If SCS is below 10 percent. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. Hong. If SCS is below the range of 20-25 percent. This type of inter-firm investment. which can then pass the equity capital to a third. In Korea. one company can still place equity investments in another. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. from the standpoint of the controlling shareholder. thus a firm creates value. Kim (1992) and Kim. affiliated companies have been able to conduct inter-firm transactions.

neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. standalone setups. Among the subsidiaries or firms receiving investments. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves.4 corporations. the average shareholding of the controlling owners and their families was 8. Until recently.Chapter 2: Korea 89 guarantees from other members of the group at no cost.5 percent. 53 percent were domestic nonfinancial firms. In many instances.9 percent of shares. 62 percent (16 out of 26) had a corporation as the largest shareholder. the top 30 chaebols’ shareholding by subsidiaries was 34. or an average of 13 firms per company. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. 34 percent were foreign companies. together owning an average of 37. not individuals. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place.23. Partial results are shown in Table 2. For the whole sample. for example. Among chaebol affiliated firms. If we define the internal shareholdings of a . Thus. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. Among the 81 listed firms in the ADB survey. or about four firms each. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. 59 were parent firms with one or more subsidiaries. and about 11 percent were domestic financial institutions. 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. or about five subsidiaries each. For the same year. together having a total of 292 domestic subsidiaries.5 corporations and two individuals.5 percent of shares. although they are likely to be insignificant. In the case of the 30 largest chaebols. the top five shareholders consisted of 2. The fact that corporations.14.5 percent as of 1997. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. In Table 2. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. The extent of pyramiding can be seen in some of the previous tables. and 319 foreign subsidiaries. together owning an average of 38. 59 parent companies collectively had investments in 759 firms. Twenty-two of the 81 respondents were independent. there are instances of direct cross-shareholding in Korean firms. Of the 81 respondents. Thus.

9 21.4 42.8 18.7 0.5 2. 1999 Five Largest Shareholders No.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.1 1.5 1.6 34.7 5.0 21.3 26.4 2. A few companies reported less than five largest shareholders. 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 20.9 5.0 17.5 24.8 37. .7 37.6 3.Table 2.8 38.5 2.8 8.7 39.5 38.4 38.6 3.5 31.1 3.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.0 2.7 19.0 3.3 12.5 2.4 21. a Number of shareholders.6 16.0 13.2 37.5 2.8 31.9 29.6 3.4 25.0 3.4 18.4 1.2 25.5 4.9 34.5 4. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.0 1.0 1.5 18.1 22.4 11.

15 October 1998.24 shows the average internal shareholdings in the 30 largest chaebols.1 1997 43. 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. 1989. C. Table 2.” In Korean Managerial Dynamics. Chicago.2 15. New York: Praeger. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. 1987 56.5 Judging from the historical record.0 8.5 34. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. the controlling families owned 8. 1998. Ungki Lim.4 1993 43.7 31. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. Lee.5 percent. 6 7 Hattori.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.8 40.2 12. H.4 10. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. As of 1997. Tamio. Table 2.8 33.4 13. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. the ownership patterns can be described as follows. “Japanese Zaibatsu and Korean Chaebols.” Paper presented at the Annual Conference of Financial Management Association. . Chung and H.6 33.24 Internal Shareholdings of the 30 Largest Chaebols. 79-95. pp. Lee. edited by K. Based on these studies. Jae Woo.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group.7 9. Hattori (1989) identified three patterns based on data in the early 1980s.2 33.5 percent and member companies.2 1994 42. 34. 1997. it appears that the chaebol families have had a strong desire to expand their business bases. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. 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.7 1992 46. The family and member companies’ shareholdings have been declining over time.4 1990 45.

” Under this type of ownership pattern.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each.” shows a simple pyramidal structure. financial. The fourth type (Type D) is “management control. called the “indirect control via base company. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. The Kia Group was about the only management-controlled group but was out of existence by 1999. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. Sun Hong Kim. consisting of eight listed and 16 privately held firms as of 1997. The Hyundai Group exemplifies this. But the former chief executive officer (CEO). holdings of the nonprofit foundation.92 Corporate Governance and Finance in East Asia. or merged into. For example. investments made by the base companies. there is no controlling shareholder. Most of its member firms were acquired by. the family controls the group’s member companies by its own shareholdings. The two base companies have investments in three other base companies. Vol. The third (Type C) is “indirect control via complex shareholding. and his management team exercised full control over the group without much interference from major investors. The Hanjin Group.” Here the family directly controls a base company and a nonprofit foundation. and subsidiaries’ equity participation. other firms. The Hanwha Group can be classified as such a company. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. It consists of seven listed and 24 privately held firms. The controlling family has sizable investments in two base companies and smaller investments in many others. Also. One of the . completely dissolved under financial distress. Thus. Hyundai Motors acquired Kia Motors via an international auction. it had 18 listed and 39 private companies. which then make investments in the subsidiaries. The second (Type B). A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. is an example of this type. As of 1997. subsidiaries have extensive investments in other subsidiaries. II The first (Type A) is called “direct family ownership. Investments between the lower level subsidiaries are rare. which in turn hold shares in some of the other subsidiaries. and business activities. The family itself holds shares in some subsidiaries.

It remains to be seen whether they will adopt the holding company structure in the future. bankruptcy reorganization. . This limit was also applicable to banks and insurance companies. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. only operating holding companies were allowed to be established. However. The prohibition of holding companies was also abolished in 1999. following the amendment of the law. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997.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. These amendments prohibited holding companies and direct cross-shareholding. Until the end of 1998. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. thus hurting the shareholders of stronger firms. A third disallows multiple layering of holding companies. 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. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. One condition requires that the DER of the holding company should not exceed 100 percent. Also. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. 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. the Fair Trade Act). direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. They hindered early exits (liquidation. Existing guarantees had to be resolved by March 2000. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. 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. The Government is also considering whether to allow consolidated taxation for pure holding companies. 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. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. At this early stage. Initially. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols.

who is universally called the “group chairman. In 1998. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. Their operating costs were borne by the member companies rather than by the controlling shareholder. Since the economic crisis.) 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 Internal Management and Control Monitoring of corporate management by shareholders. The 30 largest chaebols are now required to publish “combined” financial statements. The office established strategies for the group as a whole. and the capital market was almost nonexistent until the recent reform . usually in the rank of a company president. Chaebols maintain that the restructuring headquarters will exist only for a limited period. and transferred funds generated by one firm to another.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. 2. until urgent restructuring is complete.94 Corporate Governance and Finance in East Asia. These offices were legally informal and functioned as the headquarters of chaebols. 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. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. 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.3. Vol. there have been no significant changes. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. planned for capital raising and allocation on a groupwide basis. II etc. Despite chaebols’ decision to dismantle the chairman’s offices. Some chaebols have disintegrated or shrunk in size. boards of directors. The chairman’s office had its own chief executive officer. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. which put together the accounts of all members of a chaebol. The staff of these organizations were employees of member firms.

. As of 1997. The board elects one or more representative directors from among the board members. and takeover codes were not accommodative to active monitoring. only the Government could play an effective role in monitoring corporations. Most companies have one representative director. control is not separate from ownership. Even when the covenants were violated. or at least acts as the de facto CEO.Chapter 2: Korea 95 efforts. Even where the largest shareholder is not the representative director. the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. With few exceptions. he or she generally approves major decisions made by the management. corporations should have a board of directors consisting of at least three members. the creditors did not declare defaults. In most listed companies. Meanwhile. had their own governance problems. There are many reasons for this. Directors are elected at the general shareholders meeting for a term not exceeding three years. creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. Loan agreements and debt indentures did not include strict covenants. were too big to fail. The Government’s policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. but some large ones have two or more. especially chaebols. the controlling shareholder is officially the representative director and the CEO. Banks. This policy managed to hamper any monitoring initiatives from the capital market. However. in most Korean firms. this was complicated by the prevailing attitude that large companies. Thus. as the major creditors. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. the concept of fiduciary duty of managers was not well established. except for banks. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. Legal provisions to protect investors were limited. the representative director was also the chairperson of the board. Board of Directors General Characteristics of the Boards Under the Commercial Code. Under such circumstances.

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. Vol.96 Corporate Governance and Finance in East Asia. However. 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. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. II When the Commercial Code first introduced the corporate board system in the 1960s. 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. With the boards consisting only of insiders. and their positions (accept or reject) on matters voted on in board meetings. were supposed to be outside directors. almost all companies succeeded in adopting cumulative voting. Recent Reform Efforts on the Board System In 1997. In the 1999 annual shareholders meetings. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. 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. . 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. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. all of whom were managers. members of the board. the attendance rate of outside directors. 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. Further. Despite the qualification requirements. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. companies have to disclose in their annual reports the frequency of board meetings. 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. However. A few large companies had more than 50 directors. other than the representative director(s). Moreover. In order to address this concern.

9 percent on average. this committee adopted the Code of Best Practice in Corporate Governance. he or she held 6.4 directors. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. In September of the same year. The controlling shareholder of some banks is the Government. a blue-ribbon committee. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. the chairperson of the board was also the CEO and on average held 10.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. These results are in accordance with the new listing rules introduced in 1998. are required to have a majority of outside directors. In March 1999.1 percent of outstanding shares of a listed company. Among the firms with no outside directors. inside directors owned 16. Among others. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). 88 percent had plans to hold elections in the near future. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. In 78 percent of the responding firms. Where the chairperson was not the CEO. having no controlling shareholders.1 percent and outside directors 1. which had extended financial support in their recent recapitalization efforts. and a nominating committee. who would comprise at least 50 percent of the boards. Directors were also chosen on the basis of their relationship with the controlling . although some banks recently have established board committees.2 percent and the CEO 14. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. Meanwhile. they had a parent/child relationship in 20 percent of the cases. On average. the Korean Code recommends that large listed firms should have at least three independent directors. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. This is because most banks. an audit committee.5 percent of the shares. the Corporate Governance Reform Committee. Where the two were separate. The average board had 8.

Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. 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. among the 81 sample firms. and shareholding (10 percent). 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 91 percent of the sample firms. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). The current chairperson has been in office for 6. As discussed earlier. and fixed fees plus performance-related pay. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. In 13 percent. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. In 1997. . Most frequently.2 years on average. the term of appointment of directors and board chairpersons is three years. About five directors per firm have been in office for more than one term. In some instances. 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). Vol. relationship with controlling shareholders (21 percent). These were established only recently. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. II shareholder (30 percent). a total of 562 directors were sitting on two or more corporate boards. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. In a very small number of firms. In one case. the management determines the remuneration. Less frequently. the management nominated director candidates (64 percent of the directors). However.98 Corporate Governance and Finance in East Asia. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. the board had a nomination and an audit committee. founders of the company acted as the chairperson (22 percent). In most firms. This rather long tenure must be due to their status as controlling shareholders in most firms. one person was sitting on nine boards and this person was the CEO of a chaebol firm. including stock options. the board had no committees. in some firms. in 23 percent. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). According to the Commercial Code.

and fixed salary plus performance-related pay including stock options in 13 percent. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms.2 years. fixed salary plus net profit-related bonus in 9 percent. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. It indicates that CEO. decides on important matters on his/her own in 13 out of the 44 firms. CEOs have been in their positions for an average of 9. it was proposed by CEO and approved by the board. In 21 percent of cases. compensation is by fixed salary in 74 percent of the firms. and in another 21 percent CEO bought shares in the market. In a handful of sample firms. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. 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. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. According to the survey. the survey tells a slightly different story than is generally believed in Korea. and was appointed by the Government in five firms. In less than 20 percent of the firms. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. . CEO was given shares by the family. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. When CEO is not the chairperson. In 4 percent of the cases. However. CEO generally has the ultimate power to decide on corporate affairs. shareholding in three firms. CEO is also the founder in 52 percent of the firms. CEO simply follows the orders of the chairperson. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. In cases where CEO is not the largest shareholder and chairperson. in which there is no controlling shareholder. he or she was selected on the basis of professional expertise in 15 firms. In the 25 firms where CEO was not the chairperson of the board. In such cases. the payment is about five times the CEO’s annual salary.Chapter 2: Korea 99 Management CEO In the survey sample. In 20 percent. he or she does not enjoy much power. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. In the survey. who is not the chairperson.

About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. 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. it was common for all senior executives to be elected as directors at the shareholders meeting. Korean firms have rarely used shares for executive compensation. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. disclosure. 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. II Senior Executives In the past. The bonus is supposed to be linked to company performance. in particular. Vol. However.100 Corporate Governance and Finance in East Asia. Penalties for fraudulent financial reports were increased. 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. and . The commission has played an active role in introducing new rules on corporate governance. from IMF and the World Bank. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. Senior managers were even often called directors although they were not official members of the board. 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. and accounting standards. This action was in response to calls by international investors and. (ii) establishment of accounting standards for financial institutions. 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. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards.

Those that never adopted international standards show their willingness to do so once the Government introduces international standards. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. In the ADB survey. 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. they also have the power and duty to monitor the activities of executive directors. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. Consolidated reporting was introduced before the outbreak of the crisis. 41 percent of the companies believed that they have followed some international accounting standards. 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. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. 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. but 49 percent confessed that they have not followed international standards at all. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. the internal auditor is considered to be a subordinate of the . Under the Commercial Code. Thus. In practice. however. 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. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. 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. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities.

almost all firms affirmed that the external auditor is independent from the company. 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 general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. 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. Big Korean accounting firms are affiliated with US accounting firms.6 years. underdeveloped market discipline for accounting firms. then the Securities and Futures Commission can appoint a new one. Listed and registered corporations must publish financial statements audited by external accounting firms. Previously. If the company changes its external auditor for reasons that are not listed in the relevant regulation. and creditors selects it. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. 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. But this problem can be mitigated if auditors function under the umbrella of the board. this problem will largely disappear. The current external auditors have been associated with the surveyed companies for an average of 4. 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. This is because the auditor. outside directors. If the status of internal auditors is elevated to that of independent board members. 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. Accepting these arguments. . there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. In the ADB survey. II controlling shareholder/CEO.102 Corporate Governance and Finance in East Asia. does not have the power to hire and fire the managers. In order to increase independence. the board of directors had the power to appoint an external auditing firm. About 100 listed firms will be subject to this requirement. External auditors are selected for a term of three years. but since 1998 a committee consisting of internal auditors. however. Vol. and lack of strong professional ethics in the accounting profession. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. In the past.

The securities companies and banks are the second and third. However.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. About one fifth of the listed firms issued nonvoting preferred shares.” The survey shows that the Korea Securities Depository holds 69. The above results indicate that.79 percent of the shareholders. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. The management is the most important proxy. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. This shows that a relatively larger number of shareholders send in their proxies. the Depository is subject to “shadow voting. attended the last annual general meeting. or telephone. Internet. and dismissal of directors and internal auditors require a “special resolution. No companies have so far introduced voting by mail. or 10. in general. respectively. Approval of mergers and major divestitures. the Depository is instrumental in getting resolutions passed.93 percent of the shareholders but 26.” Companies can increase the number . These voters represented only 5. One common share should have one vote. for some firms. 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. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). 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. representing 62.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code.Chapter 2: Korea 103 2.21 percent of total shares issued. Thus. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. The Depository represented 20 percent of the shares attending the meetings. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management.77 percent of the shares. small shareholders do not attend the annual meeting and that. Under the Commercial Code. charter amendments. corporations cannot issue common shares without voting rights. However. A total of 326 shareholders per firm. amendments of the articles of incorporation require a “special resolution.53 percent of the total shareholdings.

01 percent. demand changes in business policy. However. 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. 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. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. Those that are most likely to be rejected relate to election of directors.0 percent. laws and regulations were generally very loose in protecting the rights of minority shareholders. or block charter amendments considered harmful to minority shareholders. from 3 to 1.5 percent. and major investment projects (only five firms answered this question). It also attended the shareholders meeting of several companies to present the views of outside shareholders. Due to the changes in rules for investor protection. In February 1998 and again in March. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. and for access to unpublished accounting books and records. dividend proposals. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. an institutional investor based in the US. Vol. mergers and acquisition plans. the requirement was lowered from 1 to 0. Changes in the authorized capital require an amendment of the articles of incorporation. Various measures have since been taken to improve investor protection. For recommendations for dismissal of directors and internal auditors. but these can be waived by an amendment of the articles of incorporation. Shareholder Protection Before the economic crisis. In four out of 62 respondents. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings.104 Corporate Governance and Finance in East Asia. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. The company also agreed to the right of the fund . the Tiger Fund. Proposals put forward by management are rarely rejected at the general meetings. II of votes required for a resolution to amend the articles. As an example. was able to force a change in the charter of SK Telecom. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0.

but it was not entirely clear whether they had the duty of loyalty as well. In fact. underwriting securities firms acted also as trustees. However.Chapter 2: Korea 105 to recommend two directors to the corporate board. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. Banks have played some limited role in monitoring the investment activities of chaebols. The laws and regulations of the country protect shareholders from interested transactions. simple. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. As for bond issues.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. mergers and acquisitions. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. . creditors did not interfere with the management of a debtor. Before the amendment. and transactions with major 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. 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. affiliated lending or guarantees. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. For further protection of investors. loans to directors. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. 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. and not strictly enforced.3. The covenants in loan agreements and bond indentures were very loose. After the economic crisis. In 1974. Thus. 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. This has strengthened the accountability of controlling shareholders as de facto CEOs. 2.

including. 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. 11 banks. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. there have been concerns that the Government might use the system to intervene in the management of the business groups. However. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. In 1994 the approval requirement was abolished. 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. Besides the setting up of an “External Auditors Committee” by firms. Under the system. as discussed earlier. Purchase of real estate should be financed by equity capital and not by borrowed funds. II acquisitions. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers.106 Corporate Governance and Finance in East Asia. Vol. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. and purchases of real estate. 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. creditors now have a bigger say in court proceedings for receivership and composition. 10 nonbank . The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. on average. However. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. On the other hand. In 1996. this proposal has only a slim chance of being accepted by the Government or legislature. In turn.

holding companies. and other financial institutions. The borrower’s relationship with most banks has lasted for more than five years. collateral is more likely to be required of loans for working capital than for fixed investments. controlling shareholders. collateral was taken away. With respect to the types of loans. banks are most likely to require collateral. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. More than half of the firms think that creditors have no influence on their management and decision making. Only a few feel that creditors have very strong influence. Creditors usually exercise their influence through covenants relating to the use of loans. Most of the financial institutions are not affiliates of the borrowing company. in order of importance: affiliated companies. A few creditors exercise influence through covenants relating to major decisions by the company. renegotiation took place after the crisis. penalty was involved in rescheduling. mutual guarantee agreements. whereas seven of the 17 nonfinancial corporations are. Most firms feel that requirements for collateral have been tightened since the crisis started. holding shares of another company by both the borrower and the guarantor. For more than half of such firms. Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. or through their shareholdings. subsidiaries. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. One tenth of the firms received assistance from the Government in loan applications.Chapter 2: Korea 107 financial institutions (NBFIs). and purchase or supply of raw materials. When loans could not be repaid on time. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. while a third think that creditors have weak influence. or creditors filed for receivership. and 17 nonfinancial corporations. 16 percent . For a small number of firms. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. payments were usually rescheduled through negotiation without any penalty. Among the creditors. NBFIs infrequently ask for collateral. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). The assistance came from. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party.

the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. including commercial and merchant banks. Under a contract signed between the creditors and the debtor. 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. First. 2. 4 percent by subsidiaries. and in continued monitoring of debtors. Separate from but emulating the CRA. and 1 percent by the Government.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. have been the driving forces for restructuring activities of the largest 64 chaebols. are summarized below. Third. major creditors. 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 . 2 percent by holding companies. In cases where the creditors are unable to reach an agreement on a workout plan.108 Corporate Governance and Finance in East Asia. especially banks. Behind these new strengthened roles of creditors is the newly set-up FSC. 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. Second. banks and other institutional lenders are playing more important roles than ever before.3. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. will get involved in the restructuring and workout processes. II by other affiliated companies. Vol. The new ways through which creditors. the delegation has the right to approve wide-ranging financial activities of the firm. This committee was set up in accordance with the provisions of the CRA. the Korean Government maintained a policy of protecting the incumbent management of listed companies. In this connection.

but were completely eliminated in 1998. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. 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). Takeover Activity As soon as the Act was amended. and announcing competitive tender offers by the controlling shareholder. corporations cannot limit the voting rights of large shareholders to a given maximum. 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. Publicly issued CBs require three months before their owners can convert them to shares. 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. Privately placed CBs cannot be converted into shares in one year. . turning to white knights. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. However. As far as institutional arrangements are concerned. a total of 13 hostile takeover attempts occurred. listed firms rely mainly on shareholdings by the largest shareholder. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. In one case. more than half of these attempts failed. hostile takeovers by tender offers began to appear in the capital market. Unlike Germany. 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. Companies have also utilized share repurchases. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. For takeover defense. Stock purchases by tender offer were also exempted. Between 1994 and 1997. Unlike the UK. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. A company cannot issue new shares to a third party without first amending the corporate charter. The reasons for failure are diverse.

in which the Government still holds the largest ownership. 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. the limit will be eliminated when it is fully privatized in two years. and a bank had government ownership.7 percent on average as of the end of 1997 for nonfinancial listed firms).6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress.3. . 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. an electric power company. 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. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. Vol. As of the end of 1997. was newly listed. Another reason is that many listed firms belong to chaebols. In their charters. It is harder now to find such firms. Currently the limit is 3 percent. As of February 1999. 2. In 1998. 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.110 Corporate Governance and Finance in East Asia. Korea Telecom. The Government-owned listed companies. Some had two or more large shareholders who had joint control of the firm but could not cooperate. Hostile takeovers in Korea will be rare in the future. Charter amendments have also been employed by some firms to limit the maximum number of directors. In 1999. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. except for the banks. are designated as public companies. 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. For the others. For the steel company. a steel company. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. Many of the takeover targets in the past did not have a controlling shareholder (group).

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. Labor is not represented in corporate boards. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. The Government has frequently imposed restrictions on the use of capital markets by large companies. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. the main bank system.3. Further. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. Even where employees hold . This was aimed at limiting the supply of bonds thereby stabilizing interest rates. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. But this rule. In addition. especially those belonging to chaebols. and approved by the Chairperson of the Planning and Budget Commission. The Government’s right to send public officials to the boards was eliminated. administering through a self-regulatory committee of the securities industry.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. more state-owned corporations became subject to this new board structure. 2. 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. It was abolished before the economic crisis but another regulation. Meanwhile. The nonexecutive directors are now recommended by a committee. There were also limits on the amount raised and the number of issues per year. There is no active debate or discussion going on about this potentially difficult issue. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors.3. only qualified firms could issue new shares. the Government.1).Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. which limits the total amount of bonds issued by the five largest chaebols. as applied to four large corporations. nominated by the minister in charge of the company in question. For example. which was introduced in 1996. Beginning in 1999.

and 66 percent manual workers. About half of these firms considered the influence of the union on the management of the company to be weak. II shares of their companies through employee stock ownership plans. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees.9 in 1980.5 in 1990. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. Under the Labor Management Council Law. the management usually consults the union on major issues relating to the management. 32 percent technicians and professional staff. which were generally much lower than estimated values. Collective bargaining is. The respondents of the ADB survey had 2. and 2. In actuality. of which 2 percent were senior managers. Under the Capital Market Development Act of 1968. employers are required to meet with representatives of labor unions at least once every three months.654 employees per firm on average. In 1987. The relevant regulation was amended recently in order to facilitate voting by individual employees. Under another law enacted in 1972 to induce private companies to go public. Vol. Local unions in the same industry have established industrial labor federations. The percentage of shares held by the employee stock ownership plans in listed companies was 1. but 27 percent of them felt that it was strong. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. carried out at the enterprise level. The union had no influence on the management in 17 percent of the firms. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. the council meetings have been superficial. At the national level. The typical collective bargaining agreement has a one-year duration. Trade unions are organized on an enterprise basis. 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. In 70 percent of the firms with organized unions.112 Corporate Governance and Finance in East Asia.1 in 1997. union members account for 54 percent of the employees. Two thirds of the respondents had an organized union. they delegate their voting rights to plans’ representatives. In these firms. 2. operation. there are two federations of labor unions. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. . and development of the company. in principle.

Chapter 2: Korea 113

2.4 2.4.1

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

Moreover. Korean firms have been allowed to issue CBs in international financial markets. 2. . II Interest Rate Deregulation Plan. revision of the credit control system. It included such important issues as interest rate deregulation. as a first step toward liberalization of capital account transactions. listed 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. depreciation. and organization of commercial banks. Also. The capital market. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. was liberalized drastically in 1998 after the financial crisis. Internal funds include retained earnings. mutual savings. Since 1985. The Government adopted a cautious approach. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3.118 Corporate Governance and Finance in East Asia. short-term finance companies. and the 30 largest chaebols. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. With the privatization of nationwide commercial banks. the business scope of financial institutions was greatly widened from the early 1980s. the Government simplified various directives and instructions regulating personnel management.2.5 percent in November 1981. In June 1993. especially the domestic bond market. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. etc. On the basis of flows of funds. In addition. Some policy loans were also abolished. 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. implementing the first stage in November 1991. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system.1). budget. finance companies.4. Vol. Meanwhile. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. the Korean Government announced its Financial Liberalization and Market Opening Plan.2 Patterns of Corporate Financing Corporate Financing Practices In this section. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. development of the money market. and liberalization of foreign and capital transactions.

Before 1988. Financing Patterns of the Aggregate Corporate Sector Table 2. Securities finance became a more important source from 1988 onwards. particularly in the 1990s in response to the liberalization of the capital market. depreciation. and government transfers. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. except in 1991. In securities finance.25. on average.Chapter 2: Korea 119 and net capital transfers from the Government. and 1997. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. It measures the degree of financing growth in total assets by additional debts. and allowances) and new equity capital. This means that internal funds after dividend payment were insufficient to finance growth in total assets. was 71 percent during the period. including all sources other than retained earnings. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. It measures the degree of financing growth in total assets by additional equity. comprising internally generated capital (retained earnings. The corporate sector used . 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. Equity capital represents the shareholders’ commitment to the business.4 percent in the precrisis period 1988-1997.25 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. but it remained less than 10 percent of total financing. Meanwhile. capital surplus. depreciation. the proportion of foreign borrowings in total finance rose steadily. the corporate sector’s most important source of external finance was bank borrowings. particularly in the short term. except for the stock market boom of 19871988. In 1988 when the stock market boomed.26 shows the four measures of corporate financing calculated from Table 2. The share of external financing. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. financing by corporate bonds and CPs was more significant than by new equity. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. Table 2. 1994. The SFR averaged 28.

4 9.7 73.0 16.5 2.3 72.7 8.6 8.4 15.6 4.2 5.4 27.1 1.5 9.0 1997 26.2 14.0 0.7 15.3 1.4 2.3 30. Bank of Korea. Bank of Korea. a Includes retained earnings.6 5. 1994.0 (0.3 16.0 17.7 11.4 2.6 4.7 10.5 2.2 — 28.3 3.0 1. 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.6 11.6 2.3) 15.1 1.6 9.0 22.1) 4.5 13. depreciation.5 2.3 6.2 6.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.4 0.7 12.7 32.4 3.6 0.7 4.4 71.6 1.8 27.3 1.3) 11. 1988-1997 (percent) 1988 43.8 — 26.1 27.0 3.1 3.7 8.0) 12.6 0.8 8.8 1.6 25.0 — — — — 8.7 13.1) 4.7 1.6 0.9 28.1 12.2 34. b Includes capital surplus.1 8.4 10.1 36.3 3.2 2.7 4.7 2.7 2.8 4.0 10.3 5.3 27.5 16.2 13.3 1. and Flow of Funds.9 72.3 10.7 71.9 38.1 3.6) 5.8 1.0 70.7 1.0 9.5 0.2 15.4 27.6 9.6 10.3 25.1 17.8 17.0 9.6 (0.6 9.1 10.5 16.8 15.9 73.4 11.6 4.3 6.4 (0.1 23. which is the excess of current value over issue value of stock.8 56.1 0.5 0.9 34.1 — 27.5 2.4 2.7 10.6 0.9 2.0 11.0 5.1 (0.1 (1.4 (2.0 2.1) 6.9 9.2 0.7 — — — — 9.8 1.4 — 28.7 (0.9 10.2 (0.1 — — — — 12. and net capital transfers from the Government.6 3. .6 11.9 10.2 6.9 0.7) 11.3 — — — — 8.2 13.7 10.4 21.2 10. Source: Understanding Flow of Fund Accounts.7 1989 1990 1991 1992 1993 1994 1995 1996 22.7 14.2 — — — — 9.8 30.6 14.4 27.1 72.3 — 30.8 (0.Table 2.3 6.5 29.4 0.4 1.7 7.4 1.1 3.2 26.8 1.0 0.0 3.1 2.8 -2.5 0.6 77.1 1.8 0.4) 13.8 1.4 2.0 3.25 Flow of Funds of the Nonfinancial Corporate Sector.2 1.7 6.3 2.1 0.9 6.7 14.6 3.1 2.4 8.7 2.

Across industry.7 30. The balance. but plunged to 5.1 17.9 22.0 57.3 percent in 1997.3 27.3 59.2 IDFR 36.3 60. IDFR reached 73.6 percent over the 10-year period.1 53. an average of 59.8 percent of its total asset growth through debts.0 42. in the manufacturing sector.2 37.0 27.1 12.2 percent of the growth in total assets.8 28.5 68. 45.4 percent (Table 2. Bank of Korea.6 62.Chapter 2: Korea 121 Table 2. Its IEFR and NEFR dropped to 23. and the total debt ratio was much higher in 1996 and 1997 at 62.4 IEFR 63.6 percent and 1.7 26. declining to 26.3 12.3 73.9 percent by 1997 when net profit margins were negative.4 37. but also continuously fell.9 28. respectively. higher than the aggregate 28.1 39. Incremental financing from equity was 40.5 percent. SFR peaked at 44 percent.4 27.7 40. indicating a high financial risk position.5 12.5 31. average SFR was 37.4 percent.2 percent of incremental asset growth was financed by equity.7 40. NEFR registered 20.7 28.5 and 76.26 Financing Patterns of the Nonfinancial Corporate Sector.6 26.8 62. Manufacturing financed 54.6 percent.4 12.6 percent. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years. was financed by additional debts. higher than the aggregate 40. NEFRs. On average. Lower income diminished the industry’s equity position toward crisis year 1997.6 Excludes capital surplus. and Flow of Funds.8 10.7 9.5 percent in 1997. Bank of Korea.7 40. While SFRs.4 percent. Source: Calculations from Understanding Flow of Fund Accounts. It dropped to 28 percent the following year.0 11.7 percent in 1997.27). the corporate sector relied heavily on external financing for its expansion. respectively.4 NEFRa 20. There were significant time trends. and IEFRs were declining. .1 26.9 60. 1994.3 11. additional equity to finance 12. In periods of high economic growth such as in 1988. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.0 5. dropping to 26.9 46.1 percent in 1988 during the stock market boom.3 59.

0 30. and steam) and the transportation. Vol. and hotels sector and realty/renting/business activities sector were similar.2 percent in 1993.5 7.0 57. Financing patterns of the wholesale.7 37.7 47. Equity financed an average 25. one year ahead of the other industries.4 37.7 37.6 3. the proportion of short-term borrowings in total financing has been high. which decreased to 8.8 50. the utilities (electricity.0 42.and medium-sized firms. explaining partly the collapses of several construction companies in 1995. It had the highest average SFR in 1988 at 31. from 17. and fell to about 10 percent in 1997.27 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. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. the two sectors also had low equity financing ratios and high debt financing ratios.6 54.3 28.122 Corporate Governance and Finance in East Asia.9 6.2 21.6 37.4 63.4 45.4 47. this dropped further to 15. retail.2 .1 29. their average SFR was higher. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. On the other hand.5 NEFRa 9. and low total debt and short-term borrowing ratios.8 4.8 IEFR 65.9 percent. and communication sector had relatively high incremental equity ratios. II The construction industry showed the most cyclical pattern in annual asset growth.6 53.5 76.6 45.6 37.1 percent of total asset growth for the period.9 percent of asset growth.6 36.2 3.8 percent in 1990. then increased to 20. Since 1992. Since large firms were more profitable.9 IDFR 34.4 3.7 47. gas.2 5.7 percent in 1996. Table 2. In 1997. Total debt financed an average 74. Categorized according to company size.6 4.6 62.4 46.5 23.0 42.2 62. large firms showed more cyclical patterns in these financing ratios than small.8 percent in crisis year 1997.6 53.3 52. storage.0 3.5 1.4 54.

8 1994 15.5 12.5 62.3 (9.7 80.0 31.0 3.9 2.7 1997 8.4 28.9 1989 63.9 1993 63.0 1.7 6.9 15.5 29.1 4.6 2.8 70.1 69.5 87.0 1990 50.8 25.7 78.9 80.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.2 1995 16.7 78.0 17.2 3.27 (Cont’d) Year SFRa NEFRa IDFR 53.4 26.9 47.6 73.5 23.6 9.7 42.3 1996 16.2 10.9 33.9 Average 19.8 9.2 18.4 62.0 34.7 1989 26.5 1996 42.6 9.9 1992 56.3 47.0 10.0 4.2 23.2 74.2 20.6 71.0 40.1 59.6 4.9 1.8 76.8 74.4) 2.9 16.5 1993 22.8 29.8 81.8 2.0 1990 12.6 14. Storage.8 1991 51.1 66.7 15.9 9.4 2.5 21.1 1991 14.0 82.3 21.3 7.1 84.9 20.0 0.0 .7 41.7 7.9 30.0 68.9 52.3 19.3 84.2 8.9 29. and Communication 1988 64.0 74.3 57.6 1997 29.4 1995 53.6 37.1 70.4 IEFR 46.0 60.5 76.5 70.3 4.2 70.2 Average 53.7 53.1 25.0 1992 24.6 8.9 1.3 4.9 1. Household Goods.3 10.8 54.2 5.2 4.6 7.0 65.5 20. Hotels 1988 33.7 Wholesale/Retail Trade.6 37.2 29.2 25.6 8.Table 2.5 1.2 46.7 15.7 1994 53.8 4.1 19.1 Trasport.3 8.

The large firms had a higher proportion of external financing in 1996-1997.3 3.8 17.1 1989 34.2 1992 18.0 53.9 64.4 47. Their average IEFR was also higher and IDFR smaller.0 33.4 (107.and short-term borrowings of these firms shot up in that period. Gas.3 31.7 70.4 0.3 29. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.3 81. when large firms had much lower equity financing ratios and higher debt financing ratios than small.1 35. SFR = self-financing ratio.1 71.124 Corporate Governance and Finance in East Asia.4 1995 62.3 207.1 70.0 79.6 Real Estate.1 34.0 (0.3 Electricity.9 57.5 22.8 36.1 54.0 46. II Table 2.5 77.and mediumscale firms.1 42.8 1990 19.0 67.7 1996 18.4 5.8) (35.9 Average 75. Long. however. a Excludes capital surplus.9 IDFR 31.0 1992 51.5 8. Vol.9 28.1 1991 56.3 85.0 21.7 1994 8.9 45.0 56.7 37.7 18.0 0.6 1990 82.9 65.4 IEFR 69. and Steam Supply 1988 118.6 1995 17.0 43.1 0.4) 3.0 0. The trend was reversed in 1996-1997. NEFR = new equity financing ratio.4 1.1 1993 55. Financial Statement Analysis Yearbooks.8 1993 11.0 1997 24.6 52.6 1.4 1994 72.4 1996 45.6 1989 118.27 (Cont’d) Year SFRa NEFRa 6.4 7.6 1991 18.6 1997 23. .3 7. and Business 1988 51.7 69.4 0 0 0 0 1.0 1.7 14.8) 7.3 92.6 7. IEFR = incremental equity financing ratio.6 IDFR = incremental debt financing ratio. Source: Calculated using data from Bank of Korea.9 29.3 62.2 63.8 135.8 Average 22. Renting.

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. .6 percent. compared with the entire corporate sector’s 35 percent and 65. 153.4 percent.5 percent and their total external financing. at an average 70.28). The average IEFR and IDFR were 10. and were large borrowers.1 percent of their equity capital. 91.5 percent is lower than that of the corporate sector in general. the IDFR of listed companies increased to 93. the top 11-30 chaebols had the highest guarantees commitments at 207.30). They were able to borrow easily from banks by issuing corporate bonds and CP.3 and 89.9 percent. The average IEFR of the top 30 chaebols of 29. Financing Patterns of Chaebols For chaebols.7 percent for all listed companies. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. and the top five chaebols. The chaebols’ drive to expand their empires resulted in heavy borrowings. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. External financing reached 94. Their shortterm borrowings accounted for 86. Group-member firms borrowed less. The debt financing ratio of listed companies was high since they relied more on external financing. respectively. compared with 89.9 percent. the lowest ratio of 58. Cross-payment guarantees have been declining since 1993 and reached 91. In 1996-1997. The proportion of their short-term financing averaged 72. the top 6-10 chaebols.3 percent of their equity capital in 1997 (Table 2. In 1997.6 percent of total asset growth. All of the top 30 chaebols relied heavily on short-term borrowings. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.8 percent.8 percent of their total finance in 1997. and higher than that of listed companies (Table 2. about the same as that of the corporate sector as a whole. the average SFR was 28.7 percent. for listed companies.29). and using cross-payment guarantees among affiliated companies. The largest borrowers were the top 11-30 chaebols.2 percent. In 1997. but higher than that of listed companies. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.

9 NEFRa IEFR 14.6 11. Korea Federation of Industries. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.5 2.9 6.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus. 1994-1998 (percent) SFRa IDFR 85.5 8.4 29.2 10.6 1.4 38.9 7. 1994-1997 (percent) SFRa 41.6 0.4 88. .1 93.2 1. Source: Calculated using data of Seung No Choi.6 70.3 IDFR 57.6 61.5 8.3 1.7 13.1 8.8 89. Table 2.7 1.2 36.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.28 Financing Patterns of Listed Companies. Largest Business Groups in Korea.1 1.4 12.3 5.3 28.3 86.5 91.29 Financing Patterns of the Top 30 Chaebols.6 IEFR 42.8 22.4 1.8 76.2 23.5 2.2 NEFRa 1.Table 2.7 12.

inefficient investment and excessive diversification of corporations. the Government provided implicit guarantees on bank lending and large businesses. Fourth.30 Cross-Payment Guarantees of the Top 30 Chaebols. Interest payments on debts were considered a loss when calculating taxes.Chapter 2: Korea 127 Table 2. and extended loans based on cross-payment guarantees.3 64. and loans from NBFIs. There were several reasons for this. And fifth. bond issues.3 200.1 — — — 1995 161.7 150. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control.0 1997 91. . Second. the Korean economy was plagued with high inflation.3 58. more than half of bank loans were priority loans with low interest rates. First. especially in the 1970s when real interest rates of bank loans were negative.9 — — — 1994 258. Further. the Government applied high tax rates on net profits of corporations. Third. loans from banks. rights issues.9 — — — 1996 105. Factors Influencing Corporate Financing Choices Until recently.9 153. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees.1 — = not available. These are followed by loans from banks. and underdevelopment of the stock market. According to the ADB survey.0 207. bond issues. Source: Fair Trade Commission and the Federation of Korean Industries. so that the firms engaged in lobbying to gain access to them. Few firms ranked loans from NBFIs as their first preference. Korean firms preferred debt financing (bank and nonbank borrowings). 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. Financial institutions did not strictly screen their loan projects and monitor their debtors. in order of ranking. and reserves and retained earnings. Firms now prefer internal funds and new equity capital. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. company preferences in financing investment projects before the crisis were. This change implies that firms now give more attention to financial risks. poor financial and corporate governance resulted in overlending by banks.

and reduction in tax burden. Diversification. Other factors include. II In seeking external financing. 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. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general).128 Corporate Governance and Finance in East Asia. many firms (or 42 percent) never considered hedging. and others (29 percent) expected the local currency to appreciate in value. they survived for two to three . This preference has changed little after the crisis. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. A futures exchange launched in 1999 trades foreign exchange options. Among the responding companies that had foreign currency denominated loans. According to the survey. firms give their first consideration to minimization of transaction and interest costs. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21.4. Korea now provides a better environment for financial risk management. Nonetheless. more than half (53 percent) hedged against exchange rate fluctuations. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions.36 percent on average for these companies. in order of importance. Among those that never hedged against exchange rate risks. Vol. 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. Only a few firms sought foreign loans because domestic loans were not available. For these firms. 2. maintenance of the existing ownership structure.3 Financial Structure. in selecting financing sources. and futures and other financial derivatives. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. even with a heavy debt burden.5 percent at the end of 1997. the percentage of foreign currency denominated debt in the portfolio was 14. ensuring the liquidity of the company. some (36 percent) thought that a hedging facility was not available or not working properly.

as well as lax financial supervision (Nam et al. but the ratios of independent firms were much lower. Table 2. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. . the top five chaebols and the top 6-70 chaebols had similar ratios. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). They were also higher than those of the top five chaebols until 1992. the top five chaebols’ ratios were much higher. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. Nam et al. In order to determine the relationship between financing patterns and corporate performance. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. (i) In terms of total borrowings 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.2.3.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. However. 1999). The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. But since 1992. (iv) In terms of EBITDA to total assets. except in 1991. 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.. 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. except in 19931995 when semiconductor prices were extraordinarily high.13). (ii) In terms of net income to total assets. These findings indicate that independent firms have had a lower leverage and performed better financially. Among the main findings were the following.

too. 2. except in the recession years of 1996-1997. debt guarantees for free. Government intervention. had a significant role. second highest in the top 6-30. In terms of the net profit margin (the ratio of net profits to sales revenue). Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. its profit rate declined. During 1985-1997. had easier access to credit than the top 31-72 chaebols. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. however. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. Indicators such as increasing debt-to-equity ratios. Vol.31). The degree of diversification of chaebols that fell into default. the degree of diversification was highest in the top five chaebols. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. Meanwhile. or outright transfer of resources due to poor corporate governance practices. rising nonperforming loans (NPLs) and falling . The diversification of the top five chaebols remained at about the same level within the period. court receivership. 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. The diversification of chaebols under workout was much lower than that of the top 6-30. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. and easier access to cheap credit. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30.130 Corporate Governance and Finance in East Asia. and lowest in the top 3172 chaebols. The differences in the degrees of diversification among the three groups are substantial. Their subsidiaries. larger research and development expenditure.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2.

1 1.6) 0.8) (20.4 2.1 0.8) 1.7) (1.1 1.1 0.3) 0.2 (0. Court Receivership.11.4 (0.8) (3.4 0.3) 0.5) (7.3 3.3 0.6 0.4 (0.4 0.1) 2.7) 0.3 1.8) 0.2 1995 3.3) 0.4 0.6) (0.6 0.6 1.0 (0.6 0.6 0. Background and Task of Structural Adjustment.8 1. Beyond the Limit.9) (9.6 3.7 1.3) 1.2 1.1) 0.9) 2.3) 12.6 (10.2) (0.6) (20.3 0.5 0.7 0.5) (2.8) (37.3) (0.1 (3.4 (1.3) (1.3 1.8 0.1) — = not available.9 (0.2 (1.1 1.0) (3.1) 0.6 (0.6 0.2) (13.0) 0.9) 2.6) (12.7 3.0 1987 1.2) 1.4 1.3 (0.9 1.0 0.0 1.5 (0.3 1.3 1.9 0.9 0.8 (0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.0) 0.4 (1. p.5 (0.9 0.5) 0.4) (2.7 2.4 (1.3 (0.3) 0.5) (2. .1 (1.3 1.4 0.3 1.3 (0.8) (1. Source: Whan Whang.0 0.1) (2.1 (4.3 (3.8) 0.8) (11.7 0.1) (1.4 (2.9) 2.3 1.8 3.0 (7.7 (4.9 1.6 1.1 1.5 (6.1 0.1 0.3) (12.6 1.5 1.0 (2.0) (0.5 1.3 (0.0) (0.8 0.8) 0.6) 0.9) (8.1 0.5 (0.7 1.2) 1.6 1989 1.8) (0.1 2.7) (0.2) 2.6) (12.2) (4.9 0.2 1.0) (4.3) 0.8 3.7) (0.0 6.4) (0.0) 0.8) 2.2 (0.2 1.8 0.7 0.5 (0.9) 0.4 1996 0.1) 1.3 0.3) 0.7 1.1) (6.6 7.7 0.1 0.4 (0.2 (0.5 (4.3) (0.7) 0.8 0.2) (4.2) (4.1 (4.4) (4.1 1.9 1. 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 1.1 4.2 1.3 0. Chung Ang University.8 1990 0.9 1.5 1.4 1.6 0.Table 2.1) (1.0 4.1) 2.5) (1.5 4.7 1.6 1.2 1.8) (4.7 0.2 (0.9) (1.4) (6.2) (3.4) (1.2) 2.8) 0.3 1.1 1.4 1.6 0.8 0.8 1.1 0.6 (0.2) 0.2 0.8) 1997 0.3 0.2) 1.1 (9.1 (0.6 1.6) 0.2 4.8 (0.7 (1.2) (13.6) 0.2) (0. 1998.3) 0.6) (0.7 (0.0 1992 1994 1.7 — (0.7 (0. Management Research Institute.2 1.9 8.5 2.6 5.3) 1.4) (1.8) (1.1) (5.2 (17.31 Net Profit Margins of Chaebols.1) 1.5 1.3 1.0 1.3 1.5) (0.3 1.8 (0.1 1.6 0.5 1.1 0.8) 0.4 1.7 0.1 0.4) (1.

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. Until 1997. Along with government policies to protect the status quo. Ownership concentration also had ramifications on corporate transparency. after the crisis. 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. and creditors should select (recommend) the external auditor. internal auditors cannot be expected to perform their function independently of management. Until 1997. They were then almost automatically elected at the general shareholders meeting. a firm’s board of directors had the power to appoint an external auditor. 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 recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. Now. Thus. the independence and objectivity of the external auditor were often questioned.132 Corporate Governance and Finance in East Asia.5. the boards of all listed companies were composed of insiders only. and to the development of the market for corporate control. But in 1998. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. this has led to entrenched management. . 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. a committee composed of internal auditors. Thus.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. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. Meanwhile. Vol. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. 2. outside directors. Moreover. A remote trigger in the Thai crisis was all that took to push the economy over the edge.

Diversification can reduce chaebols’ risks through the portfolio effect. There were no effective monitoring mechanisms for its management. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. However. These included restrictions of shareholdings of institutional investors.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. In this situation. regulatory and practical difficulty in implementing proxy voting. a large issuance of preferred stocks with no voting rights. 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. corporate accounting information was not reliable due to the lack of independence of external auditors. individuals. participated in the stock market as short-term traders rather than long-term investors. Under the direction of the controlling shareholder. and some differences in Korea’s generally accepted accounting principles from international standards. Meanwhile. and restrictions on hostile takeovers. the Government maintained a policy of protecting the incumbent management of a listed company. hostile takeovers in Korea will likely be rare in the future. Traditionally. Many of the takeover targets in the past did not have a controlling shareholder. however. has an unsound capital structure and . These internal dealings made strong firms weak and helped marginal firms survive. One reason is that the percentage of inside shareholdings for an average listed firm is very high. restrictions of voting rights of shares of institutional investors. when a large diversified chaebol. profitable firms within a chaebol tended to subsidize unprofitable firms. as a whole. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. 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. Many changes were introduced to promote M&A in the 1990s. 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. usually a member of the founding family. as well as institutions. prevalent window dressing practices.

Vol. The new preference ordering is as . prevalence of rent-seeking and morally hazardous behavior by economic decision makers. the typical chaebol firm had an extremely high DER. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. However. As mentioned earlier. Financing preferences changed drastically after the crisis. bond issues. capital. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. share issues. Further. II strong financial links among its member firms through investments and cross-guarantees. 2.2 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. while (non-chaebol) independent firms had much lower borrowing ratios. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. The Government’s supervision and regulation of financial institutions were poor. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. and other individual markets. and a high degree of inefficiency in the economy. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. and internal funds. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins.5.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. 2. Such problems may eventually cause ripples through the entire economy.5. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. as the latter are well established in most business areas. financing choices of listed firms in order of preference were bank loans.134 Corporate Governance and Finance in East Asia.

Nonpolicy loans were also considered to be cheap because of interest rate regulations. obviously contributed to overlending and aggravated the situation. 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. 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. At the end of 1996. However. consisted of high proportions of policy loans. As of the end of 1997. share issues. signaling a bearish speculative move on the won. The lending practices of banks.5 billion. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing.Chapter 2: Korea 135 follows: internal funds. The preference for debt finance also led to a relatively large foreign debt. bank loans. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. won/dollar nondeliverable forward rates increased rapidly. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. which generally required guarantees or collateral. total foreign debt amounted to $157. 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. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. reducing foreign exchange reserves to a dangerous level. and bond issues. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. . The ratio of external debts to GDP reached 48 percent at the end of 1998. 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. In November 1997. In the international financial market. After the financial crisis erupted in Indonesia and Thailand. which were the most important financing source until 1987. as evidenced by occasional. Bank loans. the top 30 chaebols showed a DER of 519 percent. the Government and the Bank of Korea defended the currency. 63 percent of which was short-term. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. Implicit guarantees by the Government on bank loans to large businesses. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. Other factors also contributed to this preference. large-scale bailouts of financially distressed firms.

starting 1 July 1998. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. Financial Sector Vulnerability Because of financial losses in the corporate sector. These were the definitions until 30 June 1998.000 during January-September of 1998. nine out of the 30 top chaebols failed. the ratios of net profits to sales. total assets. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. Following the “three months” definition. and there is collateral. decelerated from March 1998. the NPL ratio of commercial banks increased rapidly from 4. reaching highs of 6 percent in 1997 and 8. and returned to about 1.000 in September 1998 (Table 2. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. . Doubtful loans are those for which interest is not received for six months or longer. However. Fixed loans are those for which interest is not received for six months or longer. According to the “six months” definition. Moreover. the NPL ratio reached 7. The monthly number reached more than 3. they are defined as loans for which interest payments are overdue by three months or more. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. The banks and merchant banks lent to large businesses. and there is no collateral.200 in 1997.6 percent in June 1998. especially chaebols. The inevitable result of inefficient investment was a fall in corporate profits. has given rise to various types of self-dealings by the controlling shareholder. Vol. Further.1 percent in 1996. the NPL ratio8 of banks and other financial institutions began to increase.136 Corporate Governance and Finance in East Asia. without strictly evaluating the creditworthiness of businesses and the profitability of projects. excluding the financial sector. It jumped to 17. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. were low in 1996 and 1997. In 1997 they became negative.000 from December 1997 to February 1998. and shareholders’ equity of all industries.7 percent in 1997. and estimated losses.32). 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. The Government could hardly help them because of the number and magnitude of business failures. Meanwhile. and the pursuit of growth through excessive diversification and inefficient investment. then 20. Before the crisis. legal and other barriers prevented the exit of financially nonviable firms.000 per year starting 1992.

457 2. low efficiency.502 11.133 3.265 6. and continuous and large current account deficits. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.890 4.238 4.135 1.769 9.657 3.573 3. Compared to ROAs and ROEs of domestic branches of foreign banks.244 3.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.759 6.637 6.386 5.32 Number of Firms with Dishonored Checks.754 3.647 8.544 2.69 20. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.850 3. In 1990-1993.Chapter 2: Korea 137 Table 2.159 10.5. This speculation was said to be one of the causes of the financial crisis in Korea.259 2. 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. This was mainly due to the high ratios of NPLs.673 Construction 380 354 242 195 294 585 1. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.589 171.114 811 706 696 866 1. and Taipei. and large government-directed loans.517 2.107 6.131 1. As a result they had largely overvalued currencies.985 Services 3.992 11.553 3.979 8.250 2. the ratio reached 7-8 percent.027 Manufacturing 1.33).053 5. Meanwhile. European countries.856 7. and declined to 4-6 percent in 1994-1996 (Table 2.China. Source: Bank of Korea. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.210 1.855 6. 2.255 13.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.859 3.751 1.472 2. those of domestic banks were lower in the 1990s. The current account deficits in terms .

Korea -4.8 5.6 percent (1995).390 12. because of the rigid labor market.176 7. of percentage of GDP were as follows: Malaysia -8. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90. In 1997. which led to large corporate losses.562 18.584 Fixed (A)a 5.6 percent (1995).138 Corporate Governance and Finance in East Asia.221 8.0 8.China.China.077 NPL Ratio (%) 8.537 10.310 6. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.475 143.1 6. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.1 percent (1995).910 1. the ratio of short-term debt to foreign reserves was very high. Thailand -8. Businesses served as a social safety net.4 5.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.8 percent (1996).874 22. and Indonesia -3. In addition to the overvaluation of the won.484 11.170 1. even in times of economic slowdown.33 Nonperforming Loans of General Banks.600 10.997 9. Land prices and real estate rents were also high compared to trading partners. although per capita income in Korea was much lower. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.556 118.639 1. II Table 2.705 160.736 8. Vol.266 10.652 29. Mass layoffs became legally possible only after the economic crisis. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei. . It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.190 9. Related to this. and 30 percent in 1996. Source: Bank of Korea. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.2 4.649 375.520 194.116 1.827 289.1 7.0 7. Meanwhile large businesses could not legally lay off workers.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.832 337.954 9.192 Doubtful (B)b 952 1. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.929 11.160 11.0 7.430 12. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.739 241.584 2.

6 2. had been forced into bankruptcy proceedings or merged into healthier entities. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. Nonviable firms and financial institutions. . To achieve this. including banks. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. Corporations. which were laden with huge amounts of debt and were on the verge of bankruptcy. However.Chapter 2: Korea 139 2. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. 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. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. 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. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999.1 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. and subsidizing money-losing units. They have been pressured to stop such practices as providing loan guarantees. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. 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.6.

while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. Noticing this disincentive. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. 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. 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. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. This number was at 779 firms in April and grew to 1. 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. The reasons are manifold.281 in April to 2. The data also show that about 24 percent of acquisition negotiations ended up in actual deals.138 by the end of October. In their first review. Banks did not have the incentive to force financially nonviable firms to liquidate. the number of potential sellers decreased somewhat from 2.045 in October. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. 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. Internationally.140 Corporate Governance and Finance in East Asia. In many cases. More important. More than 59 percent of potential buyers were foreign firms. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. the creditor . Locally. potential foreign buyers waited for the price of acquisition targets to come down further. On the other hand. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. Vol. banks and other creditors were reluctant to absorb losses realized by debt compositions.

not only for the design of corporate workout programs but also their implementation. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. The plans were put into action immediately following finalization. the results thus far have not entirely been as desired. The workout plans were completed for most firms by early 1999. Also. 24 were liquidated. Upon completion of the evaluation. . workouts are being applied to non-chaebol firms identified as financially weak. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. and 16 non-chaebol corporations that had been selected as possible workout candidates. interest reductions.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. was allocated to the six largest banks for them to employ outside experts as advisors. Among the sell-offs. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. 11 were merged into other group members. 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. Among the 55 firms selected. Corporate Workouts Workouts in the forms of debt rescheduling. and 12 were sold off to other firms. three filed for courtsupervised bankruptcy reorganization. By the end of 1998. FSC has been monitoring the processes from a prudential regulation standpoint. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. by their creditors. provided by the World Bank. These chaebols submitted plans for restructuring to improve their respective capital structures. write-offs. but viable. A portion of the Technical Assistance Loan of $33 million. 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. Based on these plans. two were acquired by newly organized employee stock ownership plans.

142 Corporate Governance and Finance in East Asia. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. the foreign buyer demanded specific protections against adverse developments in the business environment. purchase of divested assets. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. most of the big deals have entered their final stages of negotiation. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. First. Thus. inducement of foreign direct investments was considered to be the most effective means of achieving that end. vessel engines. Big deals would. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. Vol. These deals could eliminate excess capacity in such industries as semiconductors. Korea adopted and implemented policies to open its capital market completely. In the case of automobiles. Restrictions on foreign ownership of land were also abolished. automobiles. and petrochemicals. As of April 1999. oil refineries. In one case. In another. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. some of the acquisition agreements have been discarded for various reasons. labor union demands of the seller were not acceptable to the transacting parties. enable chaebols to streamline their overly diversified operations and focus on several core business areas. However. Big deals have been elevated to the status of the most important means of effective corporate restructuring. aircraft. On 3 September 1998. Big Deals Ever since the outbreak of the economic crisis. and equity participation—reached about $8. railroad cars. power plant facilities. In the early days after the outbreak of the crisis.5 billion on agreement basis during the 10-month period after December 1997. it is hoped. This figure contrasts sharply with the total of $700 million for all of 1997. Foreign investment—in the form of acquisition of controlling interests. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. uncertainty over the future .

Fourth. (iv) to focus on a small number of core businesses. Overhaul of Bankruptcy Procedures In February 1998. 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. 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. these goals were: (i) to enhance managerial transparency. Sixth.6. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. 2. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. In effect. As set forth in the agreement. With this in mind. The presence of . Seventh. but it also has important implications with respect to corporate workouts.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. (iii) to reduce financial leverage. foreign buyers were concerned with the inflexibility of the labor market. Third. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. Not only does this represent progress in terms of an improved institutional framework for market competition. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. Second. Fifth. (ii) to remove cross-guarantees of loans among group members. 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.Chapter 2: Korea 143 course of the Korean economy remains high.

the Composition Act was amended to narrow the eligibility of applying for court-supervised composition.01 percent in May 1998. and economics professions should be organized to provide for expeditious proceedings in court. . In the past this stage usually extended for as long as two to three years. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. etc. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems.” comprised of experts in the legal. First. Fifth. The changes in the reorganization procedures can be summarized as follows. accounting. 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. the court may annul its previous decision and force the firm into immediate liquidation. Fourth. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. (ii) legal changes have been made so that domestic accounting practices conform to international standards. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. Vol. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. Third. Also. October 1998. 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. Second. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. The purpose of this rule is to shorten the reorganization planning period. number of creditors. Also. Korea’s Economic Progress Report. the right to revoke court receivership is allowed to the creditors. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court.144 Corporate Governance and Finance in East Asia. (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. a “Management Committee.

Chapter 2: Korea 145 (as of the end of May 1998. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. These new standards are and will continue to be strictly enforced. 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. to FDI). either partially or fully. (v) by the end of May 1999. only 31 out of 1. Capital Market Liberalization Since 1998. In addition. (vii) by the end of March 1998. including financial subsidization. administrative procedures for FDI will be dramatically simplified and made transparent. 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. various supporting measures. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. According to the law. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. As for promotion. and (viii) as of 1 April 1998. an additional nine industries will be opened or further liberalized. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. including tax exemptions and reductions. 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. beginning on 1 April 1999. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. have been instituted for FDI: .148 industries remain closed. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. (iv) during April and May 1998. 514 listed companies had appointed 677 outside directors). which was passed in August 1998. 21 industries were further liberalized or newly opened to FDI (now. financial institutions could no longer require cross-debt guarantees.

including infrastructure and tax support. the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. such as the high-tech industry. Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. These liberalization measures.146 Corporate Governance and Finance in East Asia. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. The location of the FIZ will be determined at the request of foreign investors. To minimize potential risks. It aims to establish a benchmark by consolidating various government bonds. Also. Vol. the Korean Government is strengthening prudent regulations and market monitoring. These bonds will be issued . Three-year government bonds will be used to establish a benchmark. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). as well as building an early warning system. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. however. are not risk-free. will be provided to foreign firms in the FIZ. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. The law allows rental cost exemptions and reductions for FDI. Various support measures.

No qualification requirements are being imposed on investors who are sponsoring new mutual funds. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. Related legislation was put into effect in September 1998. Moody’s signed a joint venture contract with Korea Investors Service. These are expected to operate for the next three years. Mutual funds (or open-end investment companies) will be allowed starting 2001. To ensure transparency and efficiency of the fund operations. they will be managed by foreign investment management companies. 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.Chapter 2: Korea 147 monthly. As a pilot program. 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. invested a total of W1. financial institutions . In August 1998.6 trillion for the debt restructuring fund. and W1 trillion divided equally between the three balanced funds. The Government established specific qualification criteria and selected the primary dealers in 1999. but it will also help improve financial institutions’ risk management. both domestic and foreign. If interest rates stabilize at a low level.6 trillion in these funds: W0. It is now easy for private investors. Twenty-five domestic financial institutions. but may be extended as required. including the Korea Development Bank. Prior to the introduction of this system. to establish closed-end investment companies. According to the law. with only minor standard exceptions. and the demand for longerterm bonds increases in the future. In order to promote a greater market demand for government bonds. a primary dealers system will be introduced for healthy financial institutions. It also opened the credit rating service market to foreign competition. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. and is promoting joint ventures between foreign and domestic agencies. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more.

greater efforts to improve corporate governance are preferable to regulation of interfirm investment. 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. which is the case for many chaebols. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. can utilize ABS. More important. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. 2. then the regulation will inhibit efficient investment of firms. foreign business corporations with good credit standing are now also permitted to issue ABS. there is another view that placing a maximum limit on interfirm investments.148 Corporate Governance and Finance in East Asia. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. There must be stronger rules to control agency problems. As markets become more efficient. A good governance system is essential for the healthy growth of corporations and financial institutions. as stipulated by the government measure. On the other hand. cross-subsidization. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. unless the limit is tight and binding. In principle. this regulation may not be effective in curtailing pyramidal structures. Vol. However. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. However. is inevitable. II and qualified public corporations. A investing in B.. and C investing in D. However.) and the level of interfirm investments is very high.6. For instance. when the limit is binding. It would be more desirable for the market-oriented measures to be put into place and strictly enforced.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. 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. such as the Korea Asset Management Corporation (KAMCO). Selfdealings. the role of the board of directors as the internal control mechanism must loom large in corporate governance. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional .g. B investing in C. etc. this can only be a temporary measure.

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. Class action suits are an efficient means for corporate monitoring. Further. If and when the law is introduced. 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. One way of motivating institutions to do this is to 10 M. 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. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. it will have to include making self-dealings by directors and officers. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. and requiring that all directors hold shares of their companies. and also negligence of external (independent) auditors actionable. using audit. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. 23-26. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. various measures have been implemented to promote investors’ rights. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. 1997). Proposed: A Governance Monitor. The Corporate Board.Chapter 2: Korea 149 investors or their trade associations. Institutional investors will play an increasingly important role in corporate governance. pp. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. 1997. Since the economic crisis. governance. Latham. Listing rules may recommend that all or large listed companies adopt an audit committee. September/ October 1997. .10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. 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.

and thus cannot be expected to be actively involved in monitoring portfolio firms. securities companies. Another measure. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. II provide comprehensive guidelines for their actions in matters related to corporate governance. 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. In the coming years. Rights of minority shareholders should also be strengthened for these institutions. more drastic in nature. 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. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. . Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. possibly. 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. Many of the larger investment trust companies. insurance companies. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. strengthen its supervisory activities. by all nonfinancial companies (or “industrial capital”). and impose stronger penalties on violations of the rules on portfolio investments. 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. an audit committee. 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. Vol. such as the Korea Investment Trust Association. reviewing independence and expertise of candidates for outside directors. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. The Government recently proposed the revision of bankruptcy-related laws. could prepare such guidelines. objecting to certain defensive measures proposed by the management. etc. The Government can also lower the limits on investments in affiliated companies. The institutions’ respective trade associations.150 Corporate Governance and Finance in East Asia. and compliance officers. the Government will have to come up with appropriate policy measures to solve these problems. Also. strengthening incentive compensation schemes for executives.

such as application of higher interest rates by banks to chaebols with higher DERs. excessively diversified into nonrelated business areas. Many corporations are burdened with excessive debt and. bank managers should be made accountable to shareholders but not to the Government. In order to minimize government intervention in bank and corporate management. (ii) provision of reliable accounting information. Such measures include providing an effective corporate governance system. the elimination of implicit guarantees for financial support to chaebols. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. The Government should substantially reduce the proportion of policy loans from bank loans. The current obligatory system of disclosure that emphasizes “hard” .Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. Banks should adopt strong incentive compensation schemes for management. which could provide alternative sources of long-term corporate finance. and (iii) a good corporate governance system to protect investors. the banks have great leverage over the management of debtor firms. lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). to concentrate instead on a small number of core businesses. reduction of protection of domestic markets and entry barriers. The public and corporations should be taught or fully informed of the best practices in corporate governance. through them. and consistently show low profit rates. 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. and thus full-scale education programs should be developed. Chaebols are overly indebted. For this. the important issues to be addressed are: (i) improvement of the corporate disclosure system. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date. therefore are vulnerable to economic shocks. and financial institutions. The Government should put more efforts into developing the capital market. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. and stop unfair internal transactions. In turn. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. private firms. To facilitate the development of the Korean stock market. This means that the Government can control the banks and. large firms. and introducing disincentive schemes for excessive borrowings. Bank boards also need to be made more independent from management.

on a real time basis. the information system of the bond market should be better organized to transmit. Policies are needed to help develop more reliable services by bond rating agencies. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates. 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. no economic reforms will be effective. Future research could include causes of corruption. especially among business people. At the same time. The establishment of a Corruption Prevention Institute will be helpful in this regard. In determining optimal exchange rates. The network should cover not only the exchange market but also OTC transactions of investors and dealers. Vol. These should be lengthened to make them a source of stable long-term funds. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. is considered to be one of the major causes of the economic crisis. The function of securities companies as dealers of bonds should be improved. and measures to reduce corruption. wage rates. and bureaucrats. The development of the OTC bond market requires a well-developed dealer system.152 Corporate Governance and Finance in East Asia. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. Without successfully addressing this problem. . reasons for different degrees of corruption in various countries. politicians. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. Currently. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. Prevalent corruption. data on quotations and trading volumes. penalties on violations of disclosure rules are not effective enough to have a significant impact. and labor productivity should be considered. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts.

1992. and K. Choi. The Corporate Board. Understanding Flow of Fund Accounts. Korea Development Bank. 1999. September 1998. Determinants of Diversification of Korean Business Groups. Lee.. 1996. Kim. W. KERI. Kim. Economic Statistics Yearbook. Chon. 1997. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. International Monetary Fund. S. N. Korea’s Chaebol. 1998. An Empirical Evidence on Value of a Firm and Ownership Structure. Corporate Restructuring. C. 1995. Financial Studies. H. Ju Hyun. Hattori. C. Survey of Facility Investment Plan. 1989. Korea Economic Research Institute. S. 79-95. H. Hong. pp. September 1998. New York: Praeger. D. KERI. 1995. Korean Managerial Dynamics. Lee.Chapter 2: Korea 153 References Bank of Korea. Chon. . Financial Studies. various issues. Bank of Korea. and J. Kang. and 1998 issues. 1993. 7995. H. 23-26. K.. Korea Economic Research Institute. Kim. Bank of Korea.). S. Is the Fair Trade Policy Fair? Korea Economic Research Institute. Market Concentration and Diversification of Business Groups. Chung and H. S. various issues. Kwon. H. T. Evolutionary Chaebol. Bibong Publishing Co. H. S. International Financial Statistics. in Korean Managerial Dynamics. Bank of Korea. Y. Maeil Daily Economic Newspapers. Korea’s Large Conglomerates. Financial Statement Analysis Yearbook. and H. 1994. 1989. S. 1996. K. I. edited by K. W. Proposed: A Governance Monitor. W. September 1997. 1996. Korea’s Financial System. Latham. M. 1997. Jae Woo. 1997. C. 1998. Cho. various issues. Cho. Chung. pp. Hong Moon Sa. Lee. KERI. September/October 1997. Center for Free Enterprise. Tomio. W. D. Japanese Zaibatsu and Korean Chaebols. various issues.. pp. New York: Praeger. I. Jua. Lee (eds. 1997.

Korea Institute for Industrial Economics and Trade. . Vol. and H. Ungki. Yonsei University. II Lee. Korea Institute for International Economics and Trade. K. October 1998. Y.154 Corporate Governance and Finance in East Asia. Annual Conference of Financial Management Association. Capital Liberalization. Whang. Ungki. W. Lee. 1996. and J. Korea Development Institute and World Bank. Management Research Institute. I. Whan. KIEP Working Paper 98-05. 1998. 2nd Sangnam Forum. Corporate Governance in Korea. Seoul. U. H. Korea’s Trade and Industrial Policies: 1948-1998. Kim. S.. H. Chicago. 23. 1999. 1995. November 1996. Ministry of Finance and Economy. Sohn. C. Real Exchange Rate and Policy Measures. March 1999. J. Conference on Corporate Governance in Asia: A Comparative Perspective. October 1998. Business Groups in Korea: Characteristics and Government Policy. Nam. Background and Task of Structural Adjustment. Chung Ang University. 1998. K. K. Y.. Kang. Beyond the Limit. KIET Occasional Paper No. Wang. J. I. Korea’s Economic Progress Report. S. Joh. C. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Lee. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Y. 1996. September 1998. 1998. Lim. Korea Finance Institute. and J. Korea Institute for International Economic Policy. S. Yang. Lim. 1998. Kim. January 1995. A New Trade and Industrial Policy in the Globalization of Korea. Yim.. S. J. 1999.

aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. Saldaña1 3.1 Introduction In recent years. This has come about following a political and economic upheaval from 1983 to 1987. David Edwards. in particular Francisco C. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. staff. the Philippine economy and corporate sector were in a relatively sound financial position. The author wishes to thank Juzhong Zhuang. both of ADB. and Liza V.. the PSR Consulting. Inc. The lifting of the debt moratorium in 1991. and government subsidies were tackled during that period. Denise B. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. state-sanctioned monopolies. . about a decade before the recent Asian crisis. PSR Consulting. for their research assistance. overall. Pineda. Issues such as State ownership of businesses. Inc. the Philippine Stock Exchange for its help and support in conducting company surveys. From 1993 to 1996. 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). and David Webb of the London School of Economics for their guidance and supervision in conducting the study. 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.3 The Philippines Cesar G. the Philippines. Roble. The Asian financial crisis revealed that. after the completion of debt negotiations with the IMF and Paris Club. 1 Principal. and Lea Sumulong and Graham Dwyer for their editorial assistance. When the Asian crisis erupted in 1997. Serrana. Companies of other Asian countries were already using these markets to finance investment and growth.

These early industrialists naturally opposed any initiative to reduce tariffs. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. To implement these policies. Banks have significant presence as members of affiliated business groups. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. The policy was crafted by the martial law regime at that time. This study reviews the Philippine corporate sector in terms of its historical development. composed mostly of families previously in trading businesses. 3.156 Corporate Governance and Finance in East Asia. The Board of Investments (BOI) was created to draw up an investment priorities . Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. their growth could not be sustained. It analyzes the impact of corporate governance on company financial performance and financing. and responses to the financial crisis.2 3. and on the financial crisis. therefore. patterns of ownership. on family-based and controlled conglomerates.2. companies were necessarily large and capital-intensive. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. usually with the acquiescence of bank creditors. An industrial elite. regulatory framework. the Government overvalued the local currency and imposed high import tariffs. II Still. Corporate financing relies excessively on bank loans. But protectionist policies made labor relatively more expensive and. While new manufacturing industries were successfully established. patterns of financing. emerged to influence industrial policies. Companies finance long-term investments with short-term debt. Vol. which leads to their easing of due diligence and monitoring standards when lending to group members. control by internal and external governance agents. Companies were profitable because of protection from foreign competition.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s.

. made less associated with capital investments. assumed ownership of the largest petroleum refining company. the legislative body passed the Foreign Investment Act (FIA). The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. organizing industries into sectors and picking “winners. In many industries. quantitative restrictions. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments.e. the “pioneer” industries identified in the IPP. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. and initiated the development of alternative energy sources in response to the oil crises. Nevertheless. and oriented toward exports. including the reduction of tariffs. The 1980s were marked by a peaceful transition of political power. dominance by large companies. advance notice of areas where the country disallowed or restricted foreign investment. Reforms in policies. Foreign ownership was allowed only in industries with high technological and market barriers. In 1991. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. Following government initiatives in the control of the infrastructure and utilities sectors. and orientation toward domestic markets. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. the Government continuously revised the enabling law of BOI so that incentives were reduced in number. the top three companies accounted for a disproportionately large share of total sales and assets. and import licensing requirements. i. Exports were not competitive because of the high costs of imported materials. 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 .” No strategic industry could take off without the Government’s participation in its management and operations. The Government signaled through the IPP its intent to shape the future industrial landscape. Starting in 1981. Quantitative restrictions and tariff protection of preferred industries remained firmly in place.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. the State took over the generation and distribution of electricity. In the early 1990s.

7 Malaysia 9.2 During 1988-1997.2 8.4 4.2) 0.0 8. Table 3.7 8. II market.6 7. Vol.3 7.5 8.6) 0.2. net sales of the top 1.1). In this section.8 8.5) 3. which was taken as a representation of the Philippine corporate sector.7 5.1 5.8 5.8 4.0 7.5 8. .5 (7. however. Key Indicators of Developing Asian and Pacific Countries 2000.1 8.9 5.2) 4.7 (13.4 Philippines 3.7) (10.1 4. Rep. of 9.2 7.000 Corporations covers financial and nonfinancial companies.0 8.0 (0.2 Thailand 11.8 8.2).1 GDP Growth of Southeast Asian Countries.000 corporations.158 Corporate Governance and Finance in East Asia.3 8.2 Source: ADB.1 5.5 percent per year (Table 3. With economic reforms introduced in the 1980s and 1990s. 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.2 Korea. Its growth rate began to catch up with others in 1996. only nonfinancial companies were used.3 9.2 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 1.8 5.2 (0. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.8 10. 3. only to be unsettled by the crisis of 1997.9 6.000 Philippine companies grew 17.5) 5.2 7.7) 10. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.3 9.3 2.9 (1. This rate of growth was sustained by a comparable 18.9 7.2 9.5 9.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.0 (6.

3 121 12.4 188.8 26. Source: SEC-BusinessWorld Annual Survey of Top 1.4 898 1.3 898 1.8 741.5 64.6 5.9 149 6. .0 900 1. return on assets (ROA) = net income/total assets.4 3. 1988-1997 1989 519.8 411.9 3.000 Corporations in the Philippines.8 4.5 14.1 54 11.4 411.1 181 11.5 508.1 5.9 78 6.9 480.6 290.332.2 707.191.2 1.131.2 Average 146 12.5 887 0.6 35.5 570.1 1.512.4 602.7 1.5 446.1 51.8 618.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.2 2.123.6 149 12. of Companies Sales per Company (P billion) 899 0.4 260.2 Compound Growth (%) 17.9 617.4 8.6 75 6.2 378.160.5 1.7 218. turnover = net sales/total assets.4 861.2 4.6 426.8 6.7 443.9 898 1.7 20.177.9 952.0 1. net profit margin = net income/net sales.3 46.9 2.3 382.000 Companies.8 77 7.1 468.3 941.697.5 1.5 4.2 2.2 27.9 896 2.2 Growth and Financial Performance of the Top 1.1 73 5.6 900 1.1 95.9 629.3 306.3 107 13.5 193.5 Leverage = total liabilities/stockholders’ equity.Table 3.5 72 7.7 903 0.209.2 900.893.1 72.7 238.1 197 14.1 1.5 192.4 63.3 68 7.6 954.978.341.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.4 1.1 Other Indicators No.9 1.1 33.8 902 1.3 60 10.1 714.5 1.1 615.6 18.0 148.0 1.6 109 12.1 6.3 862.6 1990 1991 1992 1993 1994 1995 1996 1997 1.561.2 338.5 51 4.1 4.2 136.1 881.4 555.4 776.5 119 12.6 896 0.9 96.394.7 73 6.6 102 16.225. return on equity (ROE) = net income/ stockholders’ equity.1 66 12.8 5.7 1.6 1.781.7 28.647.6 144.317.8 22.

5 16.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.4 20.178 1.979 17.077 1.5 Value-added is assumed to be 30 percent of net sales.427 13.1 19. Total assets grew at an average annual rate of 22.697 1.7 percent. respectively.172 2. .8 percent per year. 1988-1997 Top 1.000 companies averaged 7. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. but the extent of the increase was not as dramatic as in other Asian countries. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.160 Corporate Governance and Finance in East Asia.3). Further. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.9 23. Net profit margins for the top 1.248 1. This is high compared with developed countries but compares favorably with other Asian countries. These rates of return are high compared with other Asian countries. leverage increased from 109 percent in 1996 to 149 percent in 1997.6 percent and 5. Assuming Table 3.906 2. and by equity that grew at a higher average annual rate of 26.9 21.394 1.3 The Corporate Sector and Gross Domestic Product.4 24.3 percent.352 1.693 1.1 Net Sales (P billion) 465 519 630 741 862 954 1. Return on equity (ROE) and return on assets (ROA) averaged 12. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.474 1.2 percent.5 Ratio of Estimated Value Addeda to GDP (%) 17.9 percent for the period. Asset growth was funded by debt that grew at an average of 20. and the SEC-BusinessWorld Annual Survey of Top 1. various years. Sources: ADB. for the 10-year period. II assets.000 Corporations in the Philippines. Key Indicators of Developing Asian and Pacific Countries 1999. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. Vol.8 17.8 19.5 17.

Chapter 3: Philippines 161 a constant ratio of value added to sales.1 Financial Ratios (%) Leverage 89 ROE 15.8 percent of the corporate sector’s total sales between 1988 and 1997.4 190 5.0 31.8 3.0 28.0 5. 1988-1997 Indicators Publicly Listed Privately Owned Rate.9 17.8 Growth Indicators (Compound Annual Growth Net Sales 20.3 22.3 42. A study of company performance by ownership type.5 Other Indicators Share of Sales (%) 17.9 158 13.0 5.5 27.8 14. and (iv) privately owned.0 4.1 22 10.1 ROA 8.4 Fixed Assets 19.7 22. of Companies 73 Sales per Company (P billion) 2.3 11. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.8 2.0 Turnover 53 Net Profit Margin 15. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.9 196 1.9 22.2 9.5 23 4. Averaging 42.0 Net Income 19.8 606 0.7 2.3 27. The foreign-owned companies were the Table 3.4).8 22.4 28. various years. (iii) Government-owned. The premise is that these variables have a direct bearing on corporate performance and growth.8 ForeignOwned 21.8 No. these figures suggest a significant and increasing contribution of the corporate sector to GDP.0 142 22.5 GovernmentOwned 4.6 Total Assets 29. %) 17.1 12.4 Total Liabilities 26.000 Corporations in the Philippines. size.3 9. privately owned companies constituted the largest group (Table 3. .5 Retained Earnings 30.9 26.2 103 5.3 22.4 Stockholders’ Equity 32. corporate control structure.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.3 146 6. (ii) foreign-owned.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.

foreign-owned companies borrowed more than publicly listed ones. The compound annual sales growth rate was 21. compared with P2.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. Privately-owned and Government-owned companies grew at slower rates. although small in number. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration.2 percent and ROA of 9. However.1 billion per company in 1997. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. Vol. II second largest at about 27. Governmentowned companies in the top 1. exceeding the 17. while there were few of them. Their ROA and ROE were both more than twice as high as those of government-owned companies.9 percent. But by being most efficient in employing assets. or 38 percent. . The privately-owned companies had a high average leverage ratio of 158 percent. and the second lowest asset turnover.5 percent average growth rate of the entire corporate sector.000 companies in 1997. With an average leverage ratio of 142 percent. the second best ROE and ROA.75 billion per company for foreign-owned companies. were among the top 1. the asset base is large. Publicly listed companies had a minor though steadily increasing share in total sales. a level high by Western standards but at par with those of other Asian countries.162 Corporate Governance and Finance in East Asia. Publicly listed companies had the lowest leverage at 89 percent. Bases Conversion Development Authority.000 list. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). registered the largest per company sales at about P9 billion in 1997. the highest net profit margin of 15. but lower than those of foreignowned and publicly listed companies. with an average ROE of 22. 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. followed by publicly listed ones. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. selling an average of P4.5 percent. These were mostly large public utilities.3 percent. they generated the highest return on investments. these companies were comparatively large. meaning that the remaining 62 percent were relatively small in sales and assets. and low return on investment is the norm. 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.

3 percent for the conglomerates. 1988-1997 Indicators Group Member Independent 18. compared with 32. a company can be a member of a conglomerate or independent. %) Net Sales 20. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.5 Growth and Financial Performance of the Corporate Sector by Control Structure.8 ROA 8.0 166 15.2 23. and small companies. the corporate sector is divided into large. and achieved higher returns on invested assets than independent companies (Table 3.8 6.0 25.0 22.0 Turnover 67 Net Profit Margin 12. various years. But the conglomerates were larger measured in sales per company.2 Net Income 21.3 Other Indicators Share in Sales (%) 32.7 2.1 Retained Earnings 32. had a lower leverage ratio.5).Chapter 3: Philippines 163 Performance by Control Structure By control structure.2 Fixed Assets 25. medium.1 124 5. Sales and resources of the . Table 3.3 Financial Ratios (%) Leverage 98 ROE 15.4 24.3 Total Liabilities 30.000 Corporations in the Philippines.3 No. of Company 159 Sales per Company (P billion) 2. Performance by Firm Size By firm size.7 Total Assets 32. depending on assets and sales.6 715 0.1 Source: SEC-BusinessWorld Annual Survey of Top 1.8 Growth Indicators (Compound Annual Growth Rate. grew faster.0 55.6 26.7 Stockholders’ Equity 34.

indicating that they deployed resources more efficiently than large and small companies.6 31. %) Net Sales 15.7 44.4 Total Liabilities 18.164 Corporate Governance and Finance in East Asia.2 Other Indicators Share in Sales (%) 56. sales of mediumsized companies grew faster than large companies.6).6 49. averaging 16 percent.0 730 0.6 Small 19. Vol. defined in this study as the next 200 largest companies in the top 1.000 Corporations in the Philippines.6 47. II Philippine corporate sector are highly concentrated among the large companies.5 Total Assets 18.1 percent of the total sales of the corporate sector. 1988-1997 Indicators Large Medium 19. Large companies accounted for 56. which.1 ROA 5.3 Source: SEC-BusinessWorld Annual Survey of Top 1.6 Growth and Financial Performance of the Corporate Sector by Firm Size.4 billion in 1997.9 32.2 25.3 Fixed Assets 15.9 Financial Ratios (%) Leverage 158 ROE 13.0 32.9 Retained Earnings 13. averaged a far less P3 billion in per company sales.5 25.5 Growth Indicators (Compound Annual Growth Rate.5 73 6.2 29.6 36.9 89 1.5 128 10.0 156 16. .000 list. are defined as the largest 100 companies in the top 1.1 No. However. while small companies.0 7.2 Stockholders’ Equity 18.4 28. averaged only P920 million in per company sales during the same year.5 12. various years.9 26.3 Turnover 65 Net Profit Margin 8. referring to the remaining companies in the list. although they comprised only 8. Medium-sized companies also performed better in terms of ROE.1 81 9. Medium-sized companies. Sales per company in this group averaged P13.7 Net Income 1.1 25.8 percent of the total number of companies in the list (Table 3. of Companies 79 Sales per Company (P billion) 7.000 list. Table 3. for this study.1 4.

as indicated by the negative annual growth. manufacturing. and utilities and services sectors. at 156 percent.7. and equity up to 1996.8 percent.4 percent in 1997 from 11. Leverage was the highest for large companies. real estate. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector.e. For small companies. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets.8 billion in . i.7 billion and P35.7 percent in 1996 to 8.6 percent. Growth of sales.1 percent. reflecting to some extent a “bubble” phenomena in the former two sectors. The growth and financial performance of selected industries. from 14. compared with 9. at -12. at 128 percent for the period. ROE dropped to 7.8 the previous year.. of net income. with their ROE dropping to 3. averaging 10. are shown in Table 3.2 percent for large ones. and profitability in 1997 when the crisis started. assets. and the construction sectors than for the manufacturing. especially during the period 1994-1996. profits. and assets was much higher for the real estate and property. Performance by Industry This study also looked at corporate performance by industry. utilities. The real estate and property sector also suffered significantly in sales. but suffered its largest decline in net profits in 1997. but lower than that of construction. Sales revenue and net income declined from P76. net income. unlike their counterparts in other Asian countries.7 percent a year earlier.Chapter 3: Philippines 165 Small companies.2 billion in 1997 for this sector.8 percent in 1997.5 percent for medium-sized companies and 8.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997.1 billion in 1996 to P4. although the largest in number. Poor returns appear to have been caused by the low profit margin at 6. The Asian financial crisis affected large companies most severely. But small companies’ leverage was significantly lower. specifically those industries least and most affected by the financial crisis. 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. and utilities and services sectors. showed the lowest ROE. net income. ROE dropped from 10. at 158 percent on average during 1988-1997. Large.7 percent in 1997 for medium-sized companies. Mediumsized companies’ leverage level was slightly lower. The sector showed consistent growth in sales. Net income declined from P54. and construction.

Vol.6 69 16.8 48.9 17.7 19.7 192 9.0 31 0. and was also much more limited compared with the property sectors in other Asian countries.1 10. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.4 Total Assets 19.0 25. As a result.166 Corporate Governance and Finance in East Asia.9 23.4 3.7 28.3 20.9 5. various years.6 Growth Indicators (Compound Annual Growth Rate.3 Fixed Assets 20.4 19.2 37.9 2.6 Financial Ratios (%) Leverage 142 181 ROE 13.9 billion and P24.6 Total Liabilities 18.1 24 42.4 16. of Company 454 17 Sales per Company (P billion) 1.3 5.000 Corporations in the Philippines.7 83 2.7 10. II Table 3. .8 Stockholders’ Equity 21.8 41.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 52.1 2.000 companies’ total sales on average during 19881997.2 28 0.0 21. 1988-1997 Utilities Real Estate and and Services Property 39.4 percent. it does not appear to have been excessively exposed to foreign currency-denominated loans.5 12.3 55. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.2 8.5 Other Indicators Share in Sales (%) 82.7 Indicators Manufacturing Construction 27.2 12.7 Net Income (12. %) Net Sales 16. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.0 23.3 Retained Earnings 17.0 Turnover 112 24 Net Profit Margin 5. the sector’s ROE dropped from 15.8) 17.7 billion in 1997.7 Growth and Financial Performance of the Corporate Sector by Industry.9 2.2 45.7 percent to 10. 1996 to P56. respectively. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.6 No.7 ROA 5.

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.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. Overall. The currency devaluation bloated the foreign currency-denominated loans of these companies. One month after registration. nationalities. contains some provisions affecting corporations’ dealings with banks. 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. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. unlike in neighboring countries hit by the Asian crisis. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. privileges. and dissolution of corporations. (vii) number. administrative regulations. the Corporation Code of 1980 is a compilation of important juridical rulings. and residences of original subscribers. nationalities. par value. and amount of authorized capital stock. (v) number of directors (not less than five nor more than 15). (iii) principal office. reaching up to 313 percent in 1997. and (viii) names. It provides the basic constitutional structure for the organization. and the Insolvency Law. and residences of incorporators and directors. (vi) names. (iv) term of existence. .3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. operation. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. which regulates banks and nonbank financial institutions except insurance companies. and amount subscribed and paid by each. Two other pertinent laws are Presidential Decree (PD) 902-A.2. and recognized rules on corporate practices. the leverage of all four industries was low. which is also the organic law governing the operations of SEC. It specifies the minimum information to be indicated in the articles of incorporation. The General Banking Law. (ii) purpose of the corporation. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. and restrictions. For publicly listed companies. 3. Under the Code. which was based on American corporate law.

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. and employees. supervision (regulatory). (iii) controversies in the election or appointments of directors and officers of corporations. place. and (vii) manner of issuing certificates in the case of stock corporations. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. (iii) qualifications. II to adopt a code of bylaws or rules for its internal governance. (ii) required quorum in shareholders’ meetings. (v) manner of election or appointment and term of office of all officers other than directors. duties. 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. and reasonable. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. In addition.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. among shareholders. and should not impair vested rights. However. officers. and public policy. (vi) penalties for violation of the bylaws. between the shareholders and the corporation. manner of voting. must be general. directors. Vol. and between the corporation and the State concerning its franchise or right to exist. . the bylaws must be consistent with the law. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. the corporation’s articles of incorporation. and control (adjudicative) of all corporations. uniform. To be valid. or officers. Its mandate is to supervise corporations in order to encourage investments and protect investors. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. In 1976. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. and forms of proxies and manner of voting them. (iv) time for holding annual election of directors and manner of giving the election notice.168 Corporate Governance and Finance in East Asia. and compensation of directors. (ii) controversies arising out of intra-corporate relations. and manner of calling and conducting regular or special meetings of the directors and shareholders.

Chapter 3: Philippines 169

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.

3.3 3.3.1

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

or 80 percent (only nominally publicly listed) of outstanding shares. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. II analysis of the number of companies in which the top one.2 percent of outstanding shares of publicly listed companies. In four companies. Table 3. a single owner owned more than 80 percent of outstanding shares. nonfinancial corporations held majority control. or almost 75 percent of the total. including pure holding companies. In 116 companies. Individuals did not constitute a significant shareholder group among the top five shareholders. The shares of publicly listed companies are thinly traded and illiquid. or 51 percent of the total. Through these. 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. 66 percent (signifying strategic control). which are mostly privately owned and controlled by family-based shareholder blocs. or 3 percent of the total. Who are the top one. 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. In four of 11 nonfinancial sectors. Vol. the top five shareholders held more than two-thirds majority control of a company. Parent companies usually spin off operating units into new companies that they continue to control as affiliates.174 Corporate Governance and Finance in East Asia. There are advantages to establishing pure holding companies. the top 20 shareholders collectively owned a majority of a company’s shares. controlling an average of 52.9 shows that in 44 companies. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. The largest group is nonfinancial corporations. In 76 companies.10. or about 30 percent of the total. In 21 companies. five.1 percent of publicly listed companies in the Philippines in 1997. a single shareholder held operating control of a company. and share prices are sensitive to movements of foreign funds. In 111 companies. a single shareholder held two-thirds majority control. and 20 shareholders? In Table 3. or 78 percent of the total. holding only an average of 2. five. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. With such high levels of ownership concentration. or 14 percent of the total. or 20 shareholders owned more than 50 percent (signifying operating control). the top five controlling shareholders were classified into eight groups.

10 manufacturing companies. . 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. Beverage.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. and Trading Holding Power Transportation Property Total — = not available. and two companies in the property sector. a Data for top 20 shareholders were not available for five holding companies. Distribution. Source: PSE databank. and Tobacco Manufacturing.

7 0.9 36.0 5.7 3.0 1.8 0.1 0. Source: PSE Databank.4 8.2 0.2 0.1 9.6 0.0 2.6 0.3 1.6 2.0 5.6 0.0 0.3 26.3 12.6 9.7 0.3 37.0 0.1 8.3 1.0 1.7 0.0 7.7 1.6 33. and Other Services Property Mining Oil Average Shareholdinga 33.1 7.3 0.6 1.0 1.7 3.6 0. Recreation.9 0.Table 3.2 3.2 0.0 0.2 1.4 19.6 5.9 0.0 1.0 0.0 0.5 0.1 5.9 6.2 0.3 0.0 0.4 0.0 5.3 5.2 3.0 4.2 5.5 12.6 0.0 0.5 0.0 1.0 0.7 0.7 0.8 0. Distribution.0 5.8 11.8 21.0 0.0 1.2 59.0 10.5 53.2 3.1 1.8 66.1 0.8 0.7 67.5 4.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.0 0.5 26.3 2. .5 13.7 0.4 2.1 6.0 0. Beverage.4 1.6 0.4 29. 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.6 0.6 12.9 52.5 2.2 0.3 0.0 0.0 2.6 18. and Trading Hotel.1 a Weighted by market capitalization.3 0.0 0.0 0. and Tobacco Holding Companies Manufacturing.0 1.0 1.3 0.3 5.2 3.0 45.4 5.6 2.2 10.5 4.0 0.

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. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. 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.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. Holding companies as a sector had the largest market capitalization in PSE in 1997. Petron and MERALCO in power and energy.7 percent of shareholdings). Holding companies were themselves 66 percent owned by other nonfinancial corporations. Because of limited ownership by institutional investors. and insurance companies (0. while still allowing the public to own minority shares. commercial banks (1. with an average of only 7. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. there was no real market for investment information.6 billion or 26. 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. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. They can also better manage their income taxes because income from affiliated companies passes through a holding company.6 percent of market capitalization in 1997. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce.1 percent). The investment funds’ presence in these sectors ranged from 8. respectively.3 percent).2 percent in 1997. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. As a group. accounting for P258. financial institutions did not have a significant ownership in nonfinancial corporations.1 percent). The 7. Investment trust funds were the most important institutional investors.5 to 12.7 percent of market capitalization of the nonfinancial publicly listed companies. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). securities brokers (1. Such advantages have contributed to the popularity of holding companies among publicly listed companies.

8 percent of total companies in number. Family-based groups have larger companies since their total sales were about 33. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. using data on the Philippines’ top 1. remain in force to control excessive lending of banks to insiders. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). suggesting that business groups are common in all major markets. suggesting that most publicly listed companies are parts of business groups. The Central Bank deregulated interest rates and foreign exchange. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks.178 Corporate Governance and Finance in East Asia. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Still. A common feature of corporate ownership of a business group is the centrality of a commercial bank. about three fourths. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. identified the companies belonging to each of these groups. including SBL and DOSRI rules. All major industries were represented. Vol.7 6 7 The study used publicly available shareholder information and published reports. but they comprised only 23. Commercial banks hold the largest share.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. However. . Corporate financing depends on intermediation by banks. Some 20 financial institutions were affiliated with these groups.4 percent of the top 1.000 companies. so far limiting their involvement to selected products.000 corporations’ sales. including 16 commercial banks. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. 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. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. many companies in family-owned groups are not publicly listed. This is significant considering that there were only 31 local commercial banks in the country in 1997.000 Corporations in the Philippines. Large shareholders and their families own these banks directly or through their controlled companies. To understand the ownership and governance characteristics of family-owned business groups. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. and tracked the financial performance of each company from 1992 to 1997. 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. Prudential regulations. the study put together a list of prominent business groups. For this reason. of the financial resources in the country.11). and increased the capital requirements for all types of banks.

The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. with the exception of Banco de Oro.1 percent). the nonfinancial sector was real estate (60.8 percent). It is also noteworthy that. Also. the largest was the Eduardo Cojuangco group. Cojuangco. 25 out of the 50 top corporate entities were familybased groups. The main constraint may be the availability of family members that could be drawn for top management positions.12). the largest family-based business group was the Ayala Corporation Group. Significantly.2 percent). retail merchandising (69. In 1997. in most .4 percent of the group’s 1997 profits). Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. and for the Henry Sy group. the study used the four largest business groups—Ayala.000 corporations in 1997. including business groups and independent companies. for the Lopez group. In terms of sales. Foreign-owned companies mainly serve the export markets. and Ayala. an average group in the Philippines has fewer member companies. In the meantime. Lopez. a substantial proportion of group profits came from its financial subsidiaries. To show this. Together. and banking. which was majority-owned by the Henry Sy group. the top 10 family-based business groups had only 119 companies in the top 1. For the Ayala group. 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. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. the biggest private company in the Philippines. In terms of number of companies. construction. the principal owner of SMC. Family-based business groups are most dominant in sectors such as manufacturing.6 percent of the total sales of the top 1. and more than 20 percent for the Lopez group and Henry Sy group. real estate. the two were closely related through their affiliations to business groups. ranged according to their sales (Table 3.000 companies. the three largest entities were family-based groups. namely. Gokongwei. for the Gokongwei Group.000. Commercial banks are often affiliated to a particular business group. or an average of about 12 per group. it was manufacturing (36. for each of these groups. and Henry Sy—as examples. broadcasting (49. Lopez. with 27 affiliated companies in the top 1. These corporate entities accounted for 53. as discussed in previous sections.Chapter 3: Philippines 179 Compared with other Asian countries.

power. 16. 13.6 3. 10. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. beverages.5 17. 5. and Affiliated Bank of Selected Business Groups.9 3. Eduardo Cojuangco Lopez Family Group Ayala Corp.5 13.11 Total and Per Company Sales.1 4.5 49. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. 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.4 6.3 3.1 4. 17. Real estate. beverages. real estate. Sector Orientation. of Affiliated Companies Total Sales (P billion) 123. food.4 48.3 11.5 46.0 17. 8. 3.0 26.8 84.6 7. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. and food Food.3 2.Table 3. 7.9 2. agriculture. Beverages. 4. 11. coconut oil.1 2.4 . and mining Management. Flagship Company.2 1. 9.5 47.4 10.5 2. 6.2 16. 14.5 6.5 44.5 26.6 2. and tourism Credit card 18.7 98. construction.3 15.0 Average Sales Per Company (P billion) 6. telecom. and packaging Power distribution and mass communications Real estate.0 5. 2.0 13. and personal care prods Shipping. 15. and dairy products Investments.2 1.6 3. Consunji 4 3 Food and dairy products Construction and mining 10. food.

21.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.2 4. distribution.7 4.4 5.0 0.0 1.2 6.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 34. 24.8 1. 29.4 1.7 0. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore.6 2.9 7. 4 238 1.8 1. 26.7 3.6 0.8 1. 27.4 3.8 6. 33. 30.6 3.9 6.19.1 0.1 1.9 0. 38. 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. P.0 5. 32.7 0.3 7.4 3. 22.3 2.5 8.3 2.9 1. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.1 1. 25.9 1.6 5.9 1. 36. 28.9 0.000 Corporations (1997). mining. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.1 805. 35. 37.5 2. 39.7 1.7 0. and various company annual reports.1 2. SEC-BusinessWorld Annual Survey of Top 1. 23. Ramos Gaisano Family Group Felipe Yap Felipe F. 20.2 1. 31. .0 2.

3. 13. 19. 5. 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. 12. Uytengsu/General Milling Group David M. Eduardo Cojuangco Lopez Family Group Ayala Corp. 14. 2. 18. 8. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 15. 11. 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. 10. 21. Inc. 20. 17. Flagship Company. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . and Affiliated Bank of Selected Business Groups. 7. 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. Alaska Milk Corporation DM Consunji. 16. 6. 1. 9.11 (continuation) Total and Per Company Sales.Table 3. 4. Sector Orientation.

48 billion. 25. Sources: PSE Databank. Kepphil Shipyard Inc. Inc. Fil-Estate Development Inc. SEC-BusinessWorld Annual Survey of Top 1. 38. a b Size class is measured in terms of sales: Large = greater than P4. Cruz & Co. unless otherwise indicated. 26.48 billion. 33. PT&T Corp. Ramos Gaisano Family Group Felipe Yap Felipe F. 34.65 billion to P4.000 Corporations (1997). F. 31. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 39. 27. 36. 22. 37. P. 24. and various company annual reports. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 30. 23. 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. .. 35. Refers to commercial banks. medium = P1. 29. 32.65 billion.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. 28. small = less than P1.

5 46. 22. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. construction. food. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. banking. agriculture. and mining Gold and other precious metal refining .5 17. 6. 7. coconut oil. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. and car manufacturing Power Refined petroleum products Refined petroleum products Banking.5 44. Inc. and food Food.6 26. 9. and real estate Banking.2 49. and personal care products Shipping.1 60.5 15. bank. food. power. 15. First Pacific/Metro Pacific Group 21. beverages.3 15.8 22. 11. 3.4 19.8 53. 19. 13. mass communications.2 Business Group Business Group Business Group Government.0 38.0 24.6 18.5 26. telecommunication. and packaging Power distribution.12 Control Structure of the Top 50 Corporate Entities. 17. beverages.Table 3. 2. 23. Texas Instruments (Phils. of the Phils.2 16.4 48. and bank Real estate. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 5. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. 12.8 84.). 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.5 77.1 17. Beverages.0 37. Inc. and telecommunications Department store and banking Airlines. 8.). 20. and dairy products Investments.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. food. 10. 14. Philippine National Bank Mercury Drug Corp.5 47.7 98. Fujitsu Computer Products Corp. 18. car manufacturing. 24. 4. 16.

Philip Morris Philippines.7 10. Inc. 48.4 10. 42. corn (unmilled).4 8. real estate. National Steel Corporation National Food Authority Phil.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. and various company annual reports. 45. 28.6 1. Consunji Uniden Philippines Laguna.6 12. 30.5 10. 27. Corp.7 13.9 14.9 7. 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. 33. Inc.0 5. 44.8 6.7 10. 49. 50. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters.0 11. Uytengsu/General Milling Group David M.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. Inc. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. Philips Semiconductors Phils. 37. 32. 47. 43.. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. Jollibee Foods Citibank N.25.2 7.0 13. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. 46.6 9.9 7. 39. 26.3 8. 41.3 13.9 6. PSE Databank. 35. 40.5 8. 29. 36. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.8 9. . Amusement and Gaming Corporation Mitsubishi Motors Phils. 34. 31.000 Corporations (1997).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. EAC Distributors Inc.A. W.1 9.5 8. 14.290 53. 9.0 12.

these were dispersed shareholdings. II publicly listed commercial banks affiliated to these groups. . Of course.186 Corporate Governance and Finance in East Asia. such as amendments of the articles of incorporation. and declaration of cash dividends.3. 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. jointly and individually. accounting and auditing. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). Actual control of the banks was still held by the groups. voluntary dissolution. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. determination of compensation to board members. and financial disclosure. although public investors held a majority of shares. 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. 3. corporate mergers or consolidations.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. shareholder voting in general meetings and legal protection of their rights. appointment and compensation of senior executives. issuance of corporate bonds. amendments in the bylaws. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. investments of corporate funds in other companies or purposes. issuance of stocks. The Corporation Code holds members of the board of directors liable. Vol. However. approval of management contracts. business groups had only minority ownership. sale or disposition of a substantial portion of corporate assets. They are likewise liable if they pursue financial interests that conflict with their duty as directors. removal of directors. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. the board of directors plays a crucial role in corporate governance. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation.8 The Board of Directors As the representative of shareholders in a company. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study.

But professional expertise is also an important criterion (28. or representatives of creditors. or a per diem for meetings (18 percent). The longest was 27 years for board chairpersons and 14 years for board directors. appointing senior management. appointed by the Government.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. or percentages of shareholdings (28. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. and determining remuneration for board directors and senior management. More than half of respondents indicated that board directors were elected during the shareholder general meetings. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. . Making day-to-day management decisions was not regarded as an important board responsibility. with a maximum of 36 percent. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). protecting shareholder interests. or the Government without approval by shareholder general meetings. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. In practice. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. According to the ADB survey.7 percent).6 for board chairpersons and 7. board directors were the founder of a company. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average.7 percent). 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. ensuring that a company follows legal and regulatory requirements. 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. 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.9 percent). the average number of years of holding office was 6. in a descending order. a fixed fee plus performance-related bonuses (30 percent).5 for board members.

But the independence of these outside directors is often doubtful. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. or management (15 percent). A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). and nomination committees. audit. however. only 35 percent of responding companies have set up board committees. About half of the active committees were audit committees and the other half nomination committees. large shareholder-dominated companies often view such committees as unnecessary formalities.9 In practice. When the CEO was not the chairperson. or amount of shareholding (15 percent). In some companies. Vol. and reviews the findings of external audits. The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board.188 Corporate Governance and Finance in East Asia. negotiates the audit fees and scope of audits. by tenure and compensation. the chairperson of the board was also the chief executive officer (CEO). the parent company or company bylaws (21 percent). Unlike in Western corporate models. It is also not clear whether the outside directors were elected before or after the financial crisis. Ninetythree percent of the respondents had one or more outside directors. The audit committee selects external auditors. relationship with controlling shareholders (35 percent). 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. In the ADB survey. the CEO 9 The three most common board subcommittees are the compensation. Companies may set up special board committees to strengthen due diligence procedures. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. These committees were established only recently. . The ADB survey shows that in 41 percent of the responding companies. The nomination committee searches and reviews candidates for key management positions. This suggests that large shareholders control CEOs by means other than shareholdings. II Compensation for the chairperson was determined either by the board (54 percent of respondents). namely. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives.

the Corporation Code allows cumulative voting for directors. if the CEO’s contract was preterminated. (ii) contracts with companies linked through interlocking directorship. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. 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.e. and (iii) involvement of directors in businesses that compete with the company. They can vote through proxy. shareholders enjoy a number of rights and protection. and prohibits the removal. But about 27 percent viewed it to be ensuring steady growth of the company. Third. 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. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. i. shareholders may exercise appraisal rights. or (iv) enters into a merger or consolidation with another corporate entity. Fourth. . Second. 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. (iii) invests in another company for a purpose different from that of the corporation. Fifth. 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. Shareholder Rights and Protection Under the Corporation Code. first. including electronic means. of directors representing minority shareholders. The average service length of CEOs was 5. equal to three years’ pay. Companies are not allowed to issue shares with different voting rights.2 years. 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. Among others.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages.. The longest service rendered was 27 years. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. without cause.

Last. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. Regardless of the amount of shares held. There was little chance that a proposal from minority shareholders could ever get approved. minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. Those who did were usually offered below-market values for their shares. because of the dominance of large controlling shareholders. During annual general meetings where minority shareholders could exercise their rights. There was only one case. Sixth. Consequently. In practice. in the Philippines.190 Corporate Governance and Finance in East Asia. SEC proceedings were costly and time-consuming. However. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. Few minority shareholders actually exercised their appraisal rights. the Revised Securities Act has strict provisions designed to deter insider trading. in cases of corporate takeovers. In the case of preemptive rights. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. there were often no real discussions of board proposals or actions. no one has been successfully prosecuted for insider trading. Vol. where SEC made substantial progress in investigation. hostile takeovers are not common because in most companies ownership is concentrated . An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. Being appointees of controlling shareholders. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. that of Interport Resources Corporation. because of poor compliance and enforcement as well as some loopholes in corporate laws. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. a shareholder could file a derivative suit against a director to redress a wrongdoing. The company was dissolved before indictment. 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. In the past. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. II shareholders are allowed to inspect a company’s stock and transfer books. In cases of derivative suits against directors for wrongdoings or actions against insider trading.

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.8 30.2 69. The ADB survey provides further evidence on shareholder rights.0 48.Chapter 3: Philippines 191 in a few controlling shareholders and families.0 63.522 shareholders each. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. About 333 shareholders per company voted by proxy. representing about 24 percent of outstanding shares.4 percent of shareholders but 58 percent of outstanding shares. and their activism in the corporate sector. Yes 100.2 7.6 30.4 70. protection.13 summarizes rights that the shareholders of the responding companies enjoyed. followed by management and banks. Nevertheless. The responding companies had on average 43.2 43.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. the successful hostile takeover by First Pacific Group of PLDT. About 93 percent of the respondents contracted . An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. a company that is widely held but has a large shareholder. Table 3. The brokers or securities companies were the most important proxy voters.900 shareholders per company did not vote during the last annual general meeting.4 No 0. appointed either by the board or shareholders during the annual general meetings. An average of about 4.3 56.0 51.8 56. Table 3. representing 3.8 92. Nominees held about 45 percent of the outstanding shares.7 43.0 36. 1999.

with the longest being 50 years. although closely related. the local standard (i. a hostile takeover case).. revaluation of fixed assets. Nevertheless. These different versions of GAAP. Most major international auditing firms operate in the Philippines. the international accounting standard. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. and consolidation policy. investments in subsidiaries. long-term leases. From publicly listed companies. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more.e. An auditor can choose among three alternative sets of GAAP. 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. vary in their evaluation of some major accounts such as securities and other liquid assets. the US GAAP). Meanwhile. a management discussion of the business. the agency also requires reports on important details about their operations and management. Because of such long relationships. and an analysis of financial statements. On average. as practiced in the Philippines). In two celebrated cases. foreign currency-denominated liabilities. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. intangible assets. independent audits do not guarantee the absence of questionable accounting practices. In practice.192 Corporate Governance and Finance in East Asia. imposing penalties on violators. intra-company receivables and payables.. The Code grants a shareholder the right to inspect business records and minutes of board meetings. the information statement transmitted to every shareholder should contain the audited financial statements. namely. the responding companies have been associated with their present auditors for 13 years. Nevertheless. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. financial reporting standards allow room for interpretation by independent auditors. Vol. . there are many cases of poor financial reporting by large companies. II their annual audit to an international auditing firm. or the accounting standard of a specific developed country (for example. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise.

They allow risk pooling and can achieve economies of scale in management. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. from a minority-controlled to a majority-owned subsidiary. and financing. which are controlled by large shareholders with public investors in a minority position. because of the highly concentrated ownership of Philippine corporations.and medium-sized businesses did not have quality financial statements. e. However.Chapter 3: Philippines 193 Many small.g. Even for widely held public companies.6 billion. arguably.. Pure holding companies can be privately owned. When control rights exceed cash flow rights. 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. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. which are usually controlled by holding companies. Corporate Control by Controlling Shareholders As in many other Asian countries. Publicly available financial information was often of low quality. controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). which are closely held by large shareholders and family members. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management. sometimes did not penalize independent auditors for poorly prepared audited financial statements. and publicly listed. marketing. accounting for 27 percent of the total stock market capitalization that year. the authorities. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. Controlling shareholders usually select member companies that require large . 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. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA).

controlling shareholders of the parent company do not participate in management. II equity investment for public listing. It is majority-owned by Mermac. It has a majority control at 71. Inc.. Public investors collectively hold a minority of 41 percent. of Cebu Holdings (a publicly listed government-owned company). Controlling shareholders gain additional leverage in management control over minority-owed companies. controlling shareholders of the parent company may eventually increase their shares to a majority position. active minority or passive minority holdings. an active minority share at 44. and customers. a family-owned pure holding company. They are operating companies but at the same time have majority or minority share ownership in other operating companies. In a passive minority-owned operating company. especially its management.and minority-controlled operating companies are also holding companies. Honda Cars (Philippines). In an active minority-owned operating company. is privately owned.1 percent of Ayala Land. The first three companies are publicly listed while the fourth. Ayala Land fully owns Makati Development Corporation and holds a minority stake. namely. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. Ayala Corporation’s majority. Ayala Corporation. Depending on the performance of the company. at 47. . In cases of minority ownership. with 59 percent of shares. minority control at 42. They may have a representative in the board.1). Some holding companies are not pure holding companies. and a passive minority investment at 15 percent in Honda Cars (Philippines). This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities.6 percent of Globe Telecom. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate.2 percent. Ayala Corporation is a publicly listed pure holding company. the parent company plays an active role in management.194 Corporate Governance and Finance in East Asia. as an example (Figure 3. Vol. financing.4 percent of Bank of the Philippine Islands. Minority-owned companies may also need access to resources of the group. 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.

04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71.Figure 3. Inc..6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. Inc.96%) Privately-Held Pure Holding Company Public Investors (41.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. Inc. (47.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. . (58.

The Separation of Ownership and Control in East Asian Corporations.44%] / [58.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. First Philippine Holdings Corporation. Expropriation of Minority Shareholders: Evidence from East Asia.44%] = [42.44%] / [25%] = 1.98% x 42. Diversification and Efficiency of Investment by East Asian Corporations. however. P. Joseph P. The control of companies through indirect corporate shareholdings.11 The Lopez family’s control rights over MERALCO was 5. a privately owned company.8%] 5.64% +37. defined as control by large shareholders of an operating company through minority ownership by several companies. Simeon Djankov. The situation offers large shareholders tremendous incentive to move resources 10 For details. 1999b. see the World Bank research papers by Stijn Claessens.76%)] [39. companies in the Lopez Group are large and minority-controlled.14%] / [1. H. Fan. Lang: 1999a.3% x 1. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. See also Stijn Claessens. Simeon Djankov. and a minority-controlled holding company. and Larry H. [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. Vol.7 times Ibid. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. 1998. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.7 times 12 . P. Lang. 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 the double layer pyramid structure of the Ayala group. and 1999c.2).64%) + (37. Benpres Holdings.10 The Ayala family’s control rights over BPI was 1.5%] [39. Generally.196 Corporate Governance and Finance in East Asia. MERALCO.5% x 14.14%] / [6. and Larry H. Rockwell Land. Who Owns and Controls East Asian Corporations? 11 Ibid.5%] / [(88.3% x 5. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. Being in the public utilities sector.12 These examples show that even when large shareholder groups are minority shareholders. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. is illustrated in the Lopez Group (Figure 3.

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 1.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.64% MinorityControlled 14. . Privately-Held Pure Holding Company 88.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.76% Operating Company MinorityControlled 24.7% 62.3% 11. Inc.Figure 3.

The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. and (ii) how the legal framework protects creditor interests and rights. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. Control by Creditors According to the ADB survey.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. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. Suspension of Payments of Debts Under PD 902-A. the data suggest. 3. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. 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. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. Vol. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. whether for working capital or capital expenditure. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years.198 Corporate Governance and Finance in East Asia. However. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan .3. The average company. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management.

4. including the rehabilitation of the corporation. profitable companies from going public. Consequently. the litigation process. bank credit is the main source of corporate financing. a company’s assets are of sufficient value to cover all of its debts. SEC could intervene to avoid asset dissipation. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. 3. The borrower will propose a rehabilitation plan to SEC. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC.4 3. SEC and the court required that the creditors of BF Homes. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. In practice. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. There are no legal or practical limits to the time period of suspension of payments. Under this mode. The first mode is for simple suspension of payments. Inc. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. 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. Commercial banks hold about three fourths of the resources of the financial system. wait for 14 years from the time the company petitioned for suspension of payments in 1984. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver.Chapter 3: Philippines 199 agreement.. a real estate-based business group. 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. under which. 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. Under such circumstances. For example. could take an indefinite period. Publicly listed companies do not represent a cross section of the Philippine corporate .

and less engaged in risky investments. Rising stock prices during the Ramos administration reflected to some extent the business optimism.g. Korea) ($143 billion). however. Even in the real estate sector. the minimum required to qualify as a public corporation. compared with other economies. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. the country experienced double-digit inflation. The market capitalization of the Philippine stock market in August 1997. Equity financing through IPOs was active. inflation. II sector. while interest rates were at high levels and volatile. and convertible securities. especially short-term debt. Interest rates. only 84 had sales large enough to be placed in the top 1. the Republic of Korea (henceforth. Equity instruments include common stocks. The crisis affected the Philippine corporate sector. Most publicly listed companies issue only up to 20 percent of total shares to the public. companies expanded only at a moderate pace. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. The period 1993-1997 was one of lower inflation and declining lending rates. From the 1970s up to the early 1990s. but not to the same extent as it did in other Asian economies..4 billion (or $59 million using the average exchange rate). The corporate sector raised a substantial amount of . 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. is far ahead of the flock. Korea and Thailand). Malaysia. Vol. less exposed to foreign debt. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market.000 companies. Of the 221 companies listed in the Philippine Stock Exchange in 1997. 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. about the size of Thailand’s. was one of the smallest in the region at $47. However. most listed companies are controlled by their five largest shareholders.7 billion. Table 3.5 billion).200 Corporate Governance and Finance in East Asia. The stock market was depressed up to the early 1990s. Philippine companies were less leveraged.14 shows that the average volume of daily trading in 1997 stood at P2. this is because. Foreign funds were wary of the Philippine stock market because of its limited liquidity. and Indonesia ($61. In part. compared with Malaysia ($186 billion). As a result. The Philippine stock market is not a liquid market. They invested in only a few large companies whose shares were relatively liquid. preferred stocks. Foreign portfolio investments also remained small.

545.351.2 61.5 571.3 2.9 2.906.3 314.0 1.7 391.2 925.088.8 1.7 1.1 0.14 Philippine Stock Market Performance.8 102.7 41.1 0.5 26.3 0.5 12. P billion) Gross Domestic Product (current prices.5 1.686.6 1.4 1.171.386.7 0.2 297.1 0. .1 524.692.8 1.2 ($ million) — — — — 6.9 12. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.Table 3.2 3.248.0 0.4 Ratio of Market Capitalization to GDP 0.077.9 608.3 — = not available.2 59.515.5 Year 369. 1983-1997 Daily Trading Volume (P million) — — — — 129.0 2.6 1.0 0.1 0.8 0.3 4.121.3 Market Capitalization (year end.445.6 261.2 0.5 16.9 682.3 158.2 0.4 9.5 72.2 57.5 1.9 1.2 1.7 207.1 88.0 0.0 161.2 1.474.3 59.1 5. Source: PSE databank.421.9 2.251.8 799. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.8 1.4 728.3 0.373.9 114.7 2.

Because existing shareholders wanted to retain their proportionate control over their companies. new equity. The largest buyers have been commercial banks. and debt as sources of corporate financing by using flow of funds analysis. by virtue of their large stakes in the financial system. tight regulations. Under SEC regulations. However. the rights issue was a popular way of raising equity capital. Capital markets cannot provide the market discipline that corporate investors need. Negotiated credits. are in a position to provide such discipline. which ultimately influences the pricing of commercial paper issues. The underwriter. Only a few large companies floated commercial papers because of the limited market.4. The measures used in the analysis are: .. which buy commercial papers either for their own account or for their clients. The picture of the financial system that emerges is thus one of limited capital markets. Debt securities include commercial papers and corporate bonds. However. discounting of receivables. include bank credits. leases. lack of competition among financial institutions. corporate bond issuing was even more limited. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. about 127 companies went public with a total value of offerings of about P134. and high transaction costs. From 1988 to 1997. and the dominance of large commercial banks. moreover. and inventory financing. 3. sells these commercial papers through brokers. Debt instruments include negotiated credits and debt securities. of which 85 percent was raised from 1993 to the first half of 1997. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. asset-backed credits. because business groups often own large commercial banks. which were the principal source of corporate financing in the Philippines.6 billion. The corporate bond market was stunted. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks.2 Patterns of Corporate Financing The study looked at retained earnings.202 Corporate Governance and Finance in East Asia. Only the commercial banks. by volatile interest rates and the absence of a secondary market. a strong regulatory system for bank supervision is imperative. Vol. which in most cases is an affiliate of the issuing company. Corporate bonds are another type of debt securities.

As shown in Table 3.1 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.3 0.3 0.15 Financing Patterns of the Corporate Sector.8 0. it is one minus IDFR.9 0.4 0.1 0.6 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.0 0.3 0. It measures a company’s capacity to finance asset growth by equity capital.5 0.000 Corporations in the Philippines from 1988 to 1997.5 0.8 0.5 0.4 0. On the other hand.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.1 0.5 0. the average SFRF was high at 109 percent. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.3 0.1 0.5 0.8 0.3 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.5 2. By definition.9 0.4 0.9 0.2 0. the SFRT was low at Table 3.5 0. It measures a company’s capacity to finance asset growth by internally generated funds.9 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.0 0.4 0.4 1.2 0.5 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.5 0.2 0.6 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.15.4 0.1 0. . Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. It measures a company’s reliance on borrowings in financing asset growth.000 Corporations in the Philippines. 1988-1997.5 Source: SEC-BusinessWorld Annual Survey of Top 1.6 0.5 0.4 0.1 Average 1.2 0.3 0.7 0. during this period.3 0.2 0.4 0.

Source: SEC-BusinessWorld Annual Survey of Top 1.2 (0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. 1991. implying that internal funds were far from sufficient to finance growth in total assets. In periods of an economic crunch such as in 1989. when it financed 45 percent of it.2 0. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. Corporate Financing by Ownership Type As shown in Table 3. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets.1 a Excludes negative balances.3 0.and foreign-owned.8 0. Total assets grew by 23 percent that year.204 Corporate Governance and Finance in East Asia.7 0. except for foreignowned companies that had a negative new equity financing ratio. II only 19 percent. 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. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. for all three types of companies—publicly listed. privately. Companies financed fixed assets from internal sources in hard times. with debt providing 93 percent of the financing requirements. the level of corporate leverage increased. 1988-1997.5 Privately-Owned 0.000 Corporations in the Philippines.3 0. Vol. .9 0. reflecting the capital flight caused by political instability in the early 1990s. the SFRF was higher.3 0. Retained earnings were the least important. In 1997. As a result. debts were the most important source of financing. and 1997. In all the years. On Table 3.6 0.16 Corporate Financing Patterns by Ownership Type.3 0.5 Foreign-Owned 1. except in 1991. internal funds were not a significant source of financing growth in total assets.0) 0.16. There were significant year-to-year variations. This was mainly caused by the declining contribution from retained earnings. retained earnings declined and few new equity investments flowed into the corporate sector.5 0.

0 13.4 2.8 46.4 100.2 100.3 10.2 51.0 9.3 11.0 38.8 26.9 24.5 12.2 42.1 9.5 9.4 10.3 12.9 3.8 3.4 100.8 100.0 10.5 16.7 7.6 26.9 16.0 53.4 100.3 12.1 13. It presents a composition analysis of assets and financing sources for the period 1992-1996.7 13.7 100.0 8.1 10.3 13.7 4.Chapter 3: Philippines 205 average.7 23.5 41.1 50.3 51.000 Corporations in the Philippines.9 16.8 51.0 9.9 100.7 13. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.9 38.7 2.1 15.8 16.1 7.3 10.6 48. 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. Foreign-owned companies relied more heavily on debt financing. publicly listed companies relied more on new equity financing than privately.0 9.3 4.17 Composition of Assets and Financing of the Publicly Listed Sector.0 1995 1996 13.8 17.4 3.5 27. The sector built up its short-term debts.8 0. especially bank loans.2 3.and foreign-owned companies.2 3.4 12.4 2.7 2.2 100.4 100.8 0.6 48.0 1994 19.8 3. .0 6.0 100.9 16. 1988-1997.4 41. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.8 39.9 12.3 12.0 10.6 0.9 0.6 43.4 43. contributing 90 percent of growth in total assets.3 48.2 12.0 12.6 37.5 0. significantly Table 3.8 4.9 4.8 38. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.17.1 49.0 Source: SEC-BusinessWorld Annual Survey of Top 1.0 9.0 1993 14.

206 Corporate Governance and Finance in East Asia. the average SFRF of business groups was higher compared with that of independent companies.18 Financing Patterns by Control Structure.3 0. Further.3 0.45 in 1996. 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. The normal standard liquid position is a current ratio of 2 or higher. II in 1996 and became more vulnerable to the financial crisis in 1997. for independent companies. 1988-1997.13 was at 1. indicating that many publicly listed companies were likely to be in a tight liquidity position. . On average. compared with an average of 54 percent for independent companies. As shown in Table 3.6 Independent Company 0. the easier access to external credit. group companies usually financed their investment in member companies by equity rather than debt. Table 3. Vol. The traditional measure of liquidity. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.1 0.9 0. their inherent ability to pool risks. respectively. and economies of scale in fund raising.18. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.2 0.000 Corporations in the Philippines. as opposed to 94 and 30 percent. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded.5 0.3 0. the current ratio. For these two reasons. Group companies were generally more profitable than independent companies.5 0. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.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.

medium-sized companies used more debts.19 Financing Patterns by Firm Size.5 Medium 3. averaging 61 percent of growth in total assets. Large companies’ IDFR of 0.Chapter 3: Philippines 207 independent companies.4 Small 0.8 0. The corresponding ratio was 0.08 and SFRT of 0. 1993 with 96 percent. equity financed 42 percent of incremental asset growth.19).6 0. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.2 0.5 0. with an average of 3.47.3 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.9 0.000 Corporations in the Philippines.6 0. These years were 1991 with 110 percent.5 Excludes negative balances. and 1997 with 131 percent.88 for large companies (Table 3.50 (Table 3. On average.55 was substantially higher than the small companies’ 0. 1988-1997. With assets growing at a fast pace during this period.1 0. There was also increased reliance on debt financing.20). Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.3 0.76 for small companies and 0.06. compared with 55 percent for large companies and 47 percent for small ones. Table 3. Large firms consistently increased their reliance on debts from 1994 to 1997.2 0. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.3 0. Excluding . 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.2 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets. Source: SEC-BusinessWorld Annual Survey of Top 1.

when debts declined.5 0.58 and SFRT of 0.6 a Excludes negative balances.4 Construction 0.5 0.2) 0. During the crisis year.27.5 Utilities and Real Estate Services and Property 0. Table 3.4 0. increasing to 0. achieving an average SFRF of 3. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. The effects of the crisis of 1997 were adverse. the incremental equity ratios of the industry were high. Vol. The construction sector was a heavy user of debt financing.4 0. Excluding 1997 when fixed assets declined.91. Up to 1997.3 0. SFRF for the sector averaged 0.5 (0. 1988-1997. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997. the manufacturing industry financed 57 percent of its total asset growth by debt. While this level is considered prudent. The sector had the highest leverage among all industries that year.1 0.3 0. Since the real estate boom coincided with that of the stock market.4 3. .7 0. II 1991.208 Corporate Governance and Finance in East Asia.47 two years later.6 0. while SFRT averaged only 0. The real estate industry financed its growth by substantial equity funds. ranging from 41 to 118 percent.4 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994.3 0. Equity financed an average of 62 percent of total asset growth. the total debt ratio was much higher in 1996 at 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1.000 Corporations in the Philippines. with an SFRF as low as 0. Incremental equity financing amounted to an average of 44 percent of total asset growth.79 and in 1997 at 0. many of the leading real estate companies successfully went public during that time. Source: SEC-BusinessWorld Annual Survey of Top 1.3 0.04. The situation improved beginning 1994.6 0.6 0.32.20 Financing Patterns by Industry. the industry generated internal funds.29. debt financed about 78 percent of asset growth in real estate. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. In the eight years preceding the crisis.

measured by the percentage of shareholdings of the largest five shareholders. ROE. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.21. ROA. was regressed against measures of profitability and of financial leverage. creditors bear the consequences. Financial Leverage. ROE.Chapter 3: Philippines 209 3. at the same time. while if it fails.230 Leverage 0. 14 See for example Michael Jensen (1993). and leverage. Journal of Finance 48: 831-880. As shown in Table 3.860 Leverage = the ratio of total assets to total equity. and financial leverage are all positively and significantly related to the degree of ownership concentration. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.3 Ownership Concentration.21 Ownership Concentration.00036 2. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Using the PSE database. the degree of ownership concentration. ROE = return on equity.009 5.00125 2.00056 1. Exit. ROA = return on assets.14 Large shareholders may borrow excessively to undertake risky projects.004 3. alternatively.421 0. knowing that if an investment turns out to be successful they could capture most of the gain. Profitability. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. as the dependent variable. . The Modern Industrial Revolution. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.769 0. Source: Author’s estimates based on the PSE databank. more profitable.130 ROA 0. Table 3. and the Failure of Internal Control Systems.4. ownership concentration = the total shareholdings of the top five shareholders. 1992-1996. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant.008 5.287 0.

more than half (52 percent) of exports were semiconductors. Commercial and industrial activities in the country were largely oriented to domestic markets.210 Corporate Governance and Finance in East Asia. with commodities accounting for the balance. Manufactures accounted for about 85 percent of exports. and intermediate goods. but its share had been declining by 4 percent per year since 1995.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. Although much lower than those of other Asian countries.5 3. the country’s GDP growth pace indicated that it did not have a “bubble economy. Net trades in goods and services averaged a deficit of 4. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). foreign investments in the country have been low. and agriculture at 21 percent. In 1997. Vol. industry at 34 percent. their growth gathering momentum only beginning in 1992. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. which averaged 4. notably remittances of overseas workers. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. II 3. The largest contributors to GDP were services at 43 percent.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. Exports were growing at about 20 percent per year in the three years preceding the crisis.5 percent per year from 1992 to 1997. In sum.8 percent of GDP from 1995 to 1997. an overexpansion of capacities. the country was less dependent on foreign private capital. Net investment inflows were $3. with a narrow exporting industry base.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. Compared to other East Asian crisis-affected countries. raw materials. The export sector had a very narrow breadth. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. Historically.5. Garments was the second largest export sector at about 9 percent. After a . the economy still showed vestiges of its import-dependent and substituting character. Because of limited local capital. The country experienced balance of payments surpluses but these were due to transfers. 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.

The lessons from debt restructuring became the basis for the Government’s economic policies.5 percent. a positive balance of payments from 1992 to 1996. From 1993 to 1997. while sales grew by only 20 percent per year. Profitable operations since 1992 had allowed it to build equity. the Government sought stability and achieved this in 19921997. Closer analysis. depended on the quality of the corporate sector’s investments. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. The corporate sector was in a relatively stable financial condition around the time of the crisis.3 percent.6 billion as of March 1997. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. During this time. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. fueled also by successful IPOs during the stock market boom of 1993-1996. 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. resulting in stability in the short-term debt to reserves ratio.1 percent.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. adjustments were focused on the quantity and quality of the banking system’s corporate loans. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. the Government restructured its debts into longer tenors with a maximum of 25 years. assets grew at a compound annual rate of about 31 percent. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. average ROE was 13. an average inflation rate of 7. After hovering in the range of 100 to 127 percent. and a relatively healthy banking system. . 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. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. In the Philippines. Eventually. From 1988 to 1996. the country and the corporate sector had no access to foreign currency debts from the international financial market. an average Treasury bill rate of 13. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. which. in turn. unlike their counterparts in the region.8 percent. however. Total debts were only 52 percent of assets or 108 percent of equity. a government fiscal surplus from 1994 to 1997.

22 Foreign Investment Flows.101 billion or 196 percent of net FDI in 1996. But portfolio investment amounting to $406 million flew out of the Philippines. 1997 = 29. It financed 26 percent of corporate capital growth. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.718 30.” 3.212 Corporate Governance and Finance in East Asia.485 145.609 1.073 (406) 121. Sources: Bangko Sentral ng Pilipinas and SEC.7 Note: Peso-dollar exchange rates used are: 1995 = 25. mitigated the effects of the pullout and liquidation of investments in the aftermath. 1995-1998 Item Net Foreign Investments ($ 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 1.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.5 billion in 1995.300 1.0 1998 739 555 328 69. precisely. It rose to $2. Table 3. growing by about 34 percent per year from 1994 to 1997. . Most of this leverage happened during the boom years in the region.47.22). or 114 percent of net foreign direct investment (FDI). Debts financed a large part of this expansion.71. Data for 1998 cover only January-August.101 92. 1998 = 41.06. Vol. but to a lesser degree. These patterns in investment and financing are similar to those of other countries in the region. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.22. 1996 = 26.303 23. In 1997.074 2.4 1997 762 1. 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. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.749 26. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. the other immediate impact of the crisis was that on foreign investment flows. Net foreign portfolio investment amounted to $1.0 1996 3.5. net FDI remained stable at more than $1 billion.517 1.650 32. In sum. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards.

in turn. ROE at 6. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. The real problem of the corporate sector during the crisis was the rise in interest rates. they were willing to restructure and renegotiate existing loans by corporate borrowers. The resources of the financial system that year totaled P3. meanwhile. which held about 75 percent of the assets of the financial system in 1997. depended on the liquidity and capital position of commercial banks. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. and leverage increased to 149 percent compared with 109 percent in 1996. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources.2 percent in November 1997. With the increase in borrowings and reduced liquidity.2 to 28. Although corporate borrowers were not highly leveraged. the sectors with the highest outstanding loans had reduced their credit exposures. Loans outstanding of commercial banks declined by the first quarter of 1998. new borrowings financed asset growth. lending rates also came down. Loan calls. Because of weak internal fund generation. Companies deferred investments in new fixed assets. the commercial banking sector’s capital remained strong at 17. By October 1998. When the Treasury bill rates eased in March 1998. Average bank lending rates climbed to their peak of 25. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past.513 billion. Lending rates were well above the 20 percent level from July 1997 to March 1998. ranged from 11 to 13 percent from 1993 to July 1997. sparking a rise in interest rates on corporate loans.7 percent in January 1998. and the wholesale and . the corporate sector became vulnerable to loan calls and high interest rates. in varying degrees for each sector. then rose to a high of 22.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997.2 percent was barely above inflation rate. with commercial banks holding P2. albeit at current market interest rates.3 percent of assets. Net profit margins were at a 10-year low at 4. The interest rates on Treasury bills. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Because commercial banks were strongly capitalized.9 percent. By March 1988. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation.369 billion.

This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. This allowed the Central Bank to convince the banks.9 percent of bank loan portfolios. and set up a hedging facility for borrowers with foreign currency-denominated loans. These figures show that adjustment problems were industry-specific and that the real estate industry. including (i) a regulatory limit of 20 percent on banks’ loans to the .6 percent in June 1998.214 Corporate Governance and Finance in East Asia. But the Philippine banking system had gone through worse crises in the past. single-digit NPL ratios began only since 1989. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. 3. 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. and the financial system.3 percent in December 1997. set limits on overbought/oversold foreign exchange positions of banks. by 12 percent. as with its counterparts in other Asian countries. the fiscal position. The Central Bank adopted other measures to strengthen the financial system. and its experience of low.5-6 percent. II retail trade sector. was a problem sector.5 percent by September 1998. The move retained the liquidity position of banks but lowered their cost of reserves. the ratio increased to a high of 11. Still. These peaked at 14. However.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues.5. As for nonperforming loans (NPLs). Vol. and subsequently went down to 13. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. 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. thereby reducing overall intermediation costs. real estate loans averaged 11. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. In March 1997. through the Bankers’ Association of the Philippines.

consolidating business units. bank loan rates have also come down. In the case of PLDT. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. (PAL). the largest telecommunications setup in the Philippines. subcontracting and outsourcing. was known to have a policy . changing technologies. the country’s flag carrier. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. (v) improving disclosure requirements on the financial position of banks. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. the Government kept inflation below 10 percent. With prudent monetary management. Responses of the Corporate Sector The corporate sector’s financial position. PAL. Large companies with heavy loan exposures such as Philippine Airlines Inc. and the legal framework for reorganization and liquidation conditioned its response to the crisis. First Pacific Corporation. Average Treasury bill rates have cooled since mid-1998. Financially strong companies were able to survive the crisis by effecting such internal restructuring. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties.Chapter 3: Philippines 215 real estate sector. The economy avoided a recession in 1998 and achieved 3. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. and giving up noncore businesses. its accessibility to foreign capital. the Asian crisis opened a unique opportunity for foreign investors. The policy directions and actions taken by the Government appear to have ushered in recovery. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. With its weakened financial position. took more action. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. 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.6 percent growth in 1999. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. In response to calls for lower bank intermediation costs. The acquiring company.

When Cojuangco took over. One mode was the outright purchase of shares in the open market. By itself. When companies are highly profitable. however. the Soriano family.6. the stock price of PLDT was buoyant during the takeover period. controlling shareholders can capture these profits by excluding public investors from ownership. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. 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. concentrated ownership of companies is not equivalent to weakness in corporate governance. eventually took over PLDT and announced a restructuring plan for the entire group of companies. using some or all of these means. In a legal process that ended in his takeover of management. is whether there are sufficient safeguards to prevent controlling shareholders from . Corporate governance is conditioned by the high ownership concentration of these large companies. Consequently. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years.6 3. 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. A second method was to purchase the shares of other large minority shareholders. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. II of investing to control companies that are dominant players in their industries.1 Summary. at a premium over the market price to reflect the value of management control. Conclusions. Its stock price and returns to shareholders had stagnated. Ownership is highly concentrated and a few dominant players control major industries. The question. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. Vol. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. 3. SMC is another widely-held company managed by a minority shareholder.216 Corporate Governance and Finance in East Asia. Although considered the prime industrial company in the Philippines. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. First Pacific. the Cojuangcos.

Privately-owned companies. were the least profitable. foreign companies were the most profitable but highly leveraged. minority shareholders need to be protected by external control mechanisms. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. Ownership of publicly listed companies is highly concentrated. ownership of banks by business groups. With large shareholders in control. medium companies showed higher profitability than large and small ones. Financial institutions are not significant shareholders. Performance was. By ownership structure. influenced by industry characteristics. By control structure. 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. By size. Returns to capital exceeded inflation rates. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders. passive independent auditing. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. Analysis of corporate financing by ownership . Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. while the largest 20 shareholders control more than 75 percent of shares.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. to some extent. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. The result is that corporate governance depends only on internal controls. and the lack of market for corporate control. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. oligopolistic market structures. the most numerous in the corporate sector. an underdeveloped capital market. The five largest shareholders have majority control of an average publicly listed company. Leverage was within Asian norms but above developed country standards. an ineffective insolvency system. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings.

Ownership concentration was positively related to both returns and leverage. and leverage were all positively related to the degree of ownership concentration. A commercial bank is an important part of most business groups. 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. family-based shareholders gain control by such means as the setting up of holding companies. Even in cases where the group owned only a minority share of a commercial bank. After controlling for industry effects. and sustained growth. . as typified by the Ayala Group. A business group is an effective business organizational model for achieving leadership in industries. ROA. The difference between management control and ownership rights is usually substantial. and centralized management and financing. superior profitability. Vol. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. Large companies owned or controlled by business groups tend to dominate their industries. with the foreign-owned companies found to rely more on borrowed funds. 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.218 Corporate Governance and Finance in East Asia. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. and the extent of supervision of outside institutions such as independent auditors and SEC. Large. the bank usually accounted for a large share of each group’s net profits. 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. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. selective public listing of companies in the group. Business groups with pyramiding structures heighten the issue of corporate governance. II type gave similar results. ROE. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. The pyramid model is useful for centrally managing smaller companies.

rather than the banks that lent millions of pesos. 3.2 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. 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. with recently restructured public debt. That is. resulting in the banks’ accelerated restructuring of troubled debts in this sector. Still. There are systemic risks involved in highly concentrated ownership. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years. adversely affecting companies’ operations and financial position. low inflation. strong capital position built on IPOs in a buoyant stock market. SEC’s quasijudicial functions. are to be removed and transferred to courts. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. decide on the financial future of a troubled debtor. mostly by highly leveraged companies and speculative investors in real estate. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. and sound overall creditworthiness.6. 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. SEC officials.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. The Central Bank imposed strict limits on real estate lending. decisions by large sharehold- . The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. including suspension of payments. the government budget in surplus. Specific actions recommended are described below. Under the new Securities Regulation Code enacted in 2000. a strong international reserves position. As the crisis wore on in 1998. and a market-oriented policy environment. there were sharp rises in the number of bankruptcies and petitions for debt relief. For example. This law is flawed in concept because it supplants a market-based credit agreement with a political process.

SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. 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. Vol. Another measure would be to impose a statutory limit on the number of directorships that one can accept. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent.220 Corporate Governance and Finance in East Asia. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. they serve to curb the powers of controlling shareholders. The adjustment should be made over a fixed period of time. Clear legal accountability is a precondition for successful shareholder activism. inadequate disclosures. To strengthen the board. II ers often cause wide volatility in stock prices and invite reaction from creditors. 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. and self-dealing. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. depending on the size of the company. (ii) require disclosure of material changes in ownership. It has suffi- . This may limit current practices of appointing prominent individuals and family members as directors. 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. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. To help ensure this. to 25 percent.

the board can easily muster the needed majority to approve the deal. and disclosure standards. in areas of supervisory functions of the central bank. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. Because ownership is generally concentrated in five shareholders. They need legal empowerment such as higher majority voting requirements. raising the current two-thirds majority to a three-fourths majority. For example. 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.. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks. in particular. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. Finally. prudential measures and regulations. and related interests. (ii) set strict limits on lending by banks to affiliated companies. e. Impose severe penalties for any attempt by banks to circumvent this regulation. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. or prohibit cross-guarantees by companies belonging to affiliated groups.Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements. officers. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. and of banks in nonfinancial companies in order to avoid connected lending. reporting. fit and . limit. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders.g. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. (iv) require banks to follow international financial accounting. directors. and (v) closely monitor.

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. Investment and venture capital funds meet this description. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. and lending to DOSRI. management. II proper rule. Presently. If institutional investors are present. foreign ownership of banks. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. 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. institutional investors can be a driving force in providing market discipline to management. and external auditors. The current law should expand class action suits to include management and . Vol. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. 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.222 Corporate Governance and Finance in East Asia. Two measures should be adopted to promote shareholder activism. Institutional investors impose market discipline by voting on strategic corporate decisions. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. In developed capital markets. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. Its priority is to protect prospective fund investors from unscrupulous fund managers. By supporting the establishment and operation of institutional investors. This way. institutional investors lead public investors in providing market signals to companies. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. transparency.

and Credit Information Bureau that can be the starting point of this effort. and dividend decisions. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. entry . And by issuing Government Treasury securities in longer tenors. Legal provisions for class action suits should cover self-dealing by directors. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. Securities market development efforts should coincide with strict regulation of the commercial banking sector. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. These groups have an incentive to gather technical expertise. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. SEC should allow minority shareholders to be represented by activist groups. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. leadership. 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.Chapter 3: Philippines 223 auditors. compensation contracts. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. There are existing institutions such as Dun and Bradsreet. their directors and management. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. information disclosures. 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. and the external auditors. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. the Government could develop the market for future issues of corporate bonds. guarantees.

Many large companies remain privately owned. Audited financial statements contain basic information about a company’s financial position and performance. Penalties for poor conduct of auditing by independent . Efforts to reduce graft and corruption. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. Vol. improve enforcement of the rule of law. PSE and SEC need to build a liquid and efficient market. and provide quality basic services should also be heightened.224 Corporate Governance and Finance in East Asia. Current disclosure requirements of SEC are not rigorous enough for public investors. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. and publicly listed companies trade barely the minimum number of shares required for public listing. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. II and exit barriers. Lack of liquidity deters institutional investors. 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. so that small. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. and various other forms of protection.and medium-scale companies can become more competitive relative to large companies. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. 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. The Government should also continue to improve infrastructure. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public.

and Liquidation. Instead. 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. and liquidation of troubled companies should be made a priority of the Government. and transferred these to courts. For that matter. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. including the resolution of intracorporate disputes. and implement those standards and penalties rigorously. reorganization. Reorganization. Improving the Legal Framework for Suspension of Payments. suspension of payments and private damage actions. SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. violators were made to pay only nominal penalties. The law on suspension of payments replaces a market-oriented solution with a political process. . review the system of penalties on professionals involved in a company’s violation of disclosure rules. Reforming the legal framework for suspension of payments. SEC and PICPA need to formulate more specific disclosure standards.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. it creates a moral hazard problem. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. the new law needs to be effectively implemented and enforced. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation.

1997. Agency Problems. Expropriation of Minority Shareholders in East Asia. and Larry H. Simeon Djankov. Lang. World Bank. H. H. Simeon Djankov. 693-728. Quarterly Journal of Economics. Emilio. and Corporate Diversification. and Clifford Holderness. II References Abonyi. . and Simeon Djankov. P. Large Shareholders. Stijn Claessens. Monitoring and the Value of the Firm. Institute of Southeast Asian Studies. The Philippines: Onward to Recovery. Vol. Pedro. 1988. 1998a. and Larry H. P. The Separation of Ownership and Control in East Asian Corporations. 1998b. and Larry H.. May. edited by Toida Mitusuru and Daisuke Hiratsuka. and Larry H. World Bank. Antonio. July. World Bank.226 Corporate Governance and Finance in East Asia. Demsetz. Claessens. Journal of Finance 2 (1). Thailand: From Financial Crisis to Economic Renewal. 1998. Vol. Stijn. 1999. Jr. P. 1989. Joseph P. Alba. Stijn. Simeon Djankov. 1985. Denis. Joseph Fan. Fan. Joseph P. Equity Ownership. Lang. Working Paper. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. October. Ownership Structure and Corporate Performance in East Asia. Claessens. World Bank. P. Harold. Barclay. The Structure of Corporate Ownership: Causes and Consequences. Diversification and Efficiency of Investment by East Asian Corporations. and Atulya Sarin. Simeon Djankov. 1999. Bangko Sentral ng Pilipinas. 1998. and Fausto Panunzi. Private Benefits from Control of Public Corporations. Lang. Philippine Macroeconomic Prospects: The Next Ten Years. Dennis. Stijn. Asian Development Bank. Discussion Paper. David J.. Claessens. 1997. Simeon Djankov. P. Tokyo: Institute of Developing Economies. Diane K. and Kenneth Lehn. Journal of Political Economy 93 (6). Claessens. 1999. M. March. Lang. 1998c. Lang. Joseph P. Working Paper. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Michael. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. 1994. George. Dennis Gromb. Stijn. Journal of Financial Economics 25: 371-395. Burkart. Fan. World Bank. Claessens. Fan. XXIX. Working Paper 2088. and Larry H. H. Key Indicators of Developing Asian and Pacific Countries 1998. Stijn. Asian Industrializing Region in 2005. Manila: Asian Development Bank.

Journal of Financial Economics 3: 305-360.. Quarterly Journal of Economics 106: 33-60. 1958. Michael. Corporate Structure. 1984. Corporate Governance: Emerging Issues and Lessons from East Asia. Stein. 1976. 1990. The Cost of Capital. Journal of Financial Economics 5: 147-175. International Corporate Governance. 1998. and William Meckling. Scharfstein. Anil Kashyap.. Douglas. and the Failure of Internal Control Systems. 1977. David S. 1986. Lufkin. 1993. 1983. American Economic Review 85: 567-85. November. Robert H. Hart. Prowse. Gestner. The Market for Corporate Control: A Scientific Evidence. Euromoney Books. Corporate Finance and Takeovers. Journal of Financial Economics 11: 5-50. Journal of Finance 45: 321-350. Corporation Finance. 1994 and Investment Guide 1997. World Bank.Chapter 3: Philippines 227 Diamond. Stephen. 1995. Harris. and John Moore. Stephen. F. Franco. Internal versus External Capital Markets. Jensen. 1991. Jensen. Jensen. Michael. The Quarterly Journal of Economics. Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. and the Theory of Investment. Journal of Finance 48: 831-80. and Merton Miller. and Richard Ruback. and Artur Raviv. American Economic Review 76: 323-29.). Exit. and Jeremy C. Modigliani. Hoshi. Financial Intermediation and Delegated Monitoring. Review of Economic Studies 51: 393-414. Joseph C. Myers. Theory of the Firm: Managerial Behavior. Philippine Stock Exchange Fact Book 1997. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. Jensen. Prowse. Stuart. and David Scharfstein. 1995. . American Economic Review 48 (3): 261297. Agency Costs of Free Cash Flow. 1990. Oliver. and David Gallagher (eds. Liquidity and Investment: Evidence from Japanese Industrial Groups. 1990. Takeo. Michael. Capital Structure and the Information Role of Debt. Michael. Determinants of Corporate Borrowing. Milton. Agency Costs and Ownership Structure. Journal of Financial Economics 27: 4366. 1994. The Modern Industrial Revolution.

Journal of Finance L11: 737-783. 1997. 2. DC. 1996. A Survey of Corporate Governance.228 Corporate Governance and Finance in East Asia. IFC/WB. Ajit. Journal of Finance LII. Journal of Money. David. Singh. Some Conceptual Issues in Corporate Governance and Finance. Mimeograph. No. Credit. Joseph E. Asian Development Bank. Journal of Political Economy 94: 461-88. and Robert W. Technical paper No. . How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. Shleifer. Internal Capital Markets and the Competition for Corporate Resources. 1998. Stephen. Andrei. 1. The Structure of Ownership in Japan. Stiglitz. No. Stein. and Banking Lecture 17. 1985. Vishny. Large Shareholders and Corporate Control. Jeremy C. Vol. Andrei. Journal of Finance 91: 1121-1139. 1991. 1997. Shleifer. 1998. Washington. Credit Markets and the Control of Capital. Webb. II Prowse. World Bank. November. 1. March. East Asia: The Road to Recovery. 1992. Washington. May. DC. and Robert W. Vishny.

For the period 1994-1996. The banking system. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). But it also laid bare weaknesses in both the financial and corporate sectors. Republic of Korea (henceforth. Korea). Faculty of Business. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. The corporate sector also contributed significantly to the crisis. . The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. As a result. the Thai baht came under pressure from speculative attacks. and Philippines all depreciating significantly. It was inefficient in financial intermediation. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. Chonburi. The fixed exchange rate policy. with Thai corporations overutilizing short-term foreign currency-denominated loans. Malaysia. both of ADB. 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. David Edwards. 1 Associate Professor. the Thai Government conceded and adopted a floating exchange rate regime. had been plagued with prudential problems for a long time. Asian University of Science and Technology. magnified the impact of these problems on the economy when the crisis hit.4 Thailand Piman Limpaphayom1 4. and Lea Sumulong and Graham Dwyer for their editorial assistance. short-term private debt obligations grew to about 60 percent of total private sector debts. the banking system merely validated the financial risks.1 Introduction In May to July 1997. but also the stalling of East Asia’s “economic miracle. Thailand. heralding not only a financial crisis in the country. In the prelude to the 1997 crisis. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. with the currencies of Indonesia. The majority of these debts were not properly hedged. poorly regulated and sheltered from competition. the Stock Exchange of Thailand for its help and support in conducting company surveys.” After mounting an aggressive defense of the currency. Thai corporations were collectively overexposed to exchange rate risks.

2. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Section 4. Section 4. the Government increased tariffs on products that could be produced locally. This study examines these and other factors that might have weakened corporate sector governance in Thailand. as well as its legal and regulatory framework. .230 Corporate Governance and Finance in East Asia. Section 4. The First and Second Plans (1961-1971) Under the first two plans. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). while new industries were encouraged to reduce the need for imports.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.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. To protect domestic industries.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. The National Economic and Social Development Board was created to plan the country’s economic and social development. Import tariffs on machinery and heavy equipment were removed. The country initiated national economic development planning in 1961 when the economy was growing rapidly.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. 4. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. Vol. and a family-based corporate ownership structure. Section 4. The study then considers policy recommendations with emphasis on corporate governance improvement. with government policy providing support but avoiding direct interference. its growth and financial performance.2 4.

it proceeded with its development plan for the industrial sector. The results were increased exports. however. The Third.4 billion from overseas and increased taxes on numerous items. Inflation levels were low. capital inflows. Industrial sector growth was also rapid and many industries (tires. textiles. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. Unemployment. Consequently.Chapter 4: Thailand 231 During this period. Budget deficits remained a major problem during the Fifth Plan.5 percent in 1973 and 24. the Government borrowed $6. resulted in increases in the current account deficit. the current account registered a surplus in 1986. External factors. the government’s debt burden escalated. including a weakening of the dollar. As a result. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy.15 billion per year or 4. became a major problem as domestic investment declined.6 percent per year. the industrial sector grew at a faster rate than the agricultural sector. remaining high until 1981. with the agricultural sector the major contributor. Thus. processed steel. however. and increases in world food and oil prices. especially foreign aid from the United States. helped offset these deficits. However. lower than anticipated due to a worldwide economic recession. The decline in imports was steady. Average growth for the period was 4 percent per year.4 percent of GDP. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. the value of the baht remained stable. with the devaluation of the baht in 1984 a major step in this direction. Inflation reached 15. leaving the Government no choice but to resort to overseas borrowings. Fourth. The Government had to shift emphasis to restoration of economic stability. an improved trade balance. gross national product grew by about 7 percent per year. averaging 1. The focus shifted to export promotion. chemicals.3 percent in 1974. including luxury goods. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. To close the fiscal gap. At the same time. The average budget deficit reached an all-time high of $2. . and automobile assembly) emerged. Budget deficits also increased throughout the Fourth Plan. and reduced current account deficits. canned foods.

5 to 13. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. an oversupply of housing emerged.8 percent. By 1995.6 percent target of the Seventh Plan. .2 percent target. The manufacturing sector became a dominant force in the economy. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. from only $31 billion in 1992. compared with the 8. respectively.6 percent. the bulk of domestic investments went to speculative ventures such as real estate. while exports expanded considerably. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan.5 percent. the property sector began to collapse in 1996. The country’s high ratings in the international capital market. On top of its predominantly “borrowed” nature. Growth rates during 1987-1991 ranged from 9. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. China—went to export-oriented manufacturing industries. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. property development.2 percent per year.7 and 11. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. Vol. The exchange rate was steady at around B25 to the dollar.4 percent targets.8 percent. Average annual growth in real GDP was 8 percent. better than the 5. Europe.232 Corporate Governance and Finance in East Asia. invited a deluge of capital seeking profitable investments. increasing its share in total export value from 42 to 76 percent. and Hong Kong. United States. lower than the target of 8. From 1989. Growth of exports and imports averaged 14. Singapore. The country also attracted a large amount of foreign direct investments (FDIs).2 and 13. with private foreign debt reaching $92 billion by the end of 1996. and the stock market. combined with its liberal financial policies. Private sector investment grew at an average annual rate of 7 percent. Most of the FDIs—originating mainly from Japan. Thailand became a debtor’s market. compounded by a slump in property sales. Inflation was 4. rather than to productive activities. compared with the 14. reaching an annual inflow of $2 billion in 1991. averaging 10.

And because the Government considered the banking system vital to the development of the economy. the Bank of Thailand and . the corporate sector’s main source of funding was the banks. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. In 1978.2. which was amended in 1979 and 1985. on account of an overvalued baht that weakened export competitiveness. In his report. Foreign banks were barred from competing directly with domestic banks. However. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. its policy had always been to protect domestic banks. the capital markets didn’t play a significant role until 1975. The deficits caused the Government to rely on even more external borrowing. Sidney M. a policy that held throughout the first six economic development plans. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975.3 percent in 1996. prepared a comprehensive report entitled “A Capital Market in Thailand. many companies considered the Act too restrictive and a hindrance to growth. Before the capital market emerged. the Government amended the “Announcement of the Executive Council No. placing all publicly listed companies under regulation. with growth shrinking from 23. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare.Chapter 4: Thailand 233 Toward the end of the Plan period. the signs of an economy about to falter were there. a former Chief Economist from the US Securities and Exchange Commission. Under the 1962 Commercial Banking Act.8 percent in 1995 to 1. 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. SET officially became “the Stock Exchange of Thailand” in 1991. In 1972. 4.” which later became the master plan for the development of the Thai capital market. the Government passed the Public Limited Company Act. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. which raised the debt service ratio.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. Robbins. In May 1974. In 1969. Exports went into a tailspin.

Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Externally. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. the Government was under international pressure to deregulate the financial sector. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. to cater specifically to its . 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. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. However. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. the financial and banking laws were generally ineffective. the World Bank had recommended such a move. increased financial market activities. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. At the end of the Sixth Plan. Thai banks gained access to a variety of funding sources from around the world. and new financial instruments. With the liberalization of financial markets. Vol. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. Earlier. The regulatory measures were inadequately designed and poorly enforced. II the Ministry of Finance had full authority to supervise all commercial banks.234 Corporate Governance and Finance in East Asia. In the 1990s.” The Government also granted financial institutions overly generous bailouts. Thailand’s capital market entered a new era with improved legislation and regulation. Laws were enacted to stimulate growth of the corporate sector. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. it usually relied on “moral suasion. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. While the Bank of Thailand had the regulatory power to influence business practices.

9 16.0 Paid-up Capital (B billion) 1.394. Insurance.0 19. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4.3 trillion have been registered with the authority (Table 4. 4.4 trillion in registered capital and B791 billion in paid-up capital. Social and Personal Service Total Note: The data for 2000 is as of October 2000.6 1. in that order.1 78.6 2. and Restaurants and Hotel Transport. and wholesale/ retail trade and restaurant/hotel sectors.6 23. however.2.291. Worldwide. Ministry of Commerce. The majority of the companies are in manufacturing. Gas. the country became recognized as an economic development model for other emerging economies. Storage.1). 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.5 50. and Communication Financing.5 791. Forestry. and Business Service Community. and Fishing Mining and Quarrying Manufacturing Electricity.9 1. Thailand. The result was a corresponding growth and development in Thailand’s capital markets. finance.Chapter 4: Thailand 235 fast-growing neighbors. the financial sector is the largest.9 34.9 261.2 11. Source: Department of Commercial Registration. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.6 350.1 30.1 trillion and paid-up capital of B1. about 661 companies with total registered capital of B2.2 Type of Business Agriculture. and Water Construction Wholesale and Retail Trade.0 110.3 83. Real Estate.0 21. Financial deregulation and liberalization were key to realizing that vision. with B1. Hunting.101.5 111.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act.1 Public Companies Registered. In terms of capital. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. .

6 — = not available.1 2.8 billion. While a rebound was apparent beginning in 1998. The stock market also became an invaluable source of funds for corporations.9 37.5 1. Domestic and offshore debt issues reached B54.1 54.1 599.2 5. Securities and Exchange Commission of Thailand.3).7 9.5 1. the year before the crisis struck.9 1998 1999 15.6 7.7 136.6 39.0 20. Vol. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.0 1994 82. the value of public offerings rose steadily.1 — — — 6.7 27.2 40.7 billion and B27. The 1997 crisis battered the primary market for securities. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. Market capitalization.3 194.8 201.3 22. 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 1.4 96.3 6.2 25.7 billion in 1996. These peaked at B89.2 12. allowed Thai financial institutions and corporations to obtain funds overseas. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.8 151. The development of the corporate sector closely followed the development of capital markets. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.5 — — 56.3 1996 1997 65.5 billion and B1 billion the previous year.7 5. The signing of Article VIII with the IMF.6 174. respectively.3 31. After the passage of the SEA of 1992.8 1995 64. reducing the value of offerings to a little more than a quarter of the previous year’s level.0 0. meanwhile. Table 4.8 — 26.4 277. the capital market became instrumental in the rapid growth and development of the corporate sector.4 51.7 7.236 Corporate Governance and Finance in East Asia. moreover.2). reaching a precrisis peak in 1996 (Table 4.1 286. The number of listed companies and securities steadily increased until 1996 (Table 4. II B261 billion. from only B20. Source: Key Capital Market Statistics.2 Public Offerings of Securities.6 8. reached .4 34.5 39.9 31.

Foreigners accounted for an increasing proportion of SET’s turnover value. resulting in their inability to fulfill debt obligations. Throughout the 1990s. however. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . While the decline in gross profit margin was not as sharp. its high point in 1995 at B3.4 percent in 1996. The key financial ratios of all companies listed on SET bear this out (Table 4.133 1. not all public companies are listed on the SET. was the ominous deterioration in the key financial ratios of publicly listed companies. The financial leverage of all companies declined until 1994. By the early 1990s. From 10. when long-term debt grew as Thai corporations began to borrow heavily to finance growth.201 2. return on equity (ROE). the highly liquid financial system continued offering cheap funds to sustain corporate sector investments.114 1. their share rising from 17 percent in 1993 to 43 percent in 1997. Side by side with this surge of financing for corporate growth.535 1.301 3. The upward trends for ROE and ROA continued through 1989.4).325 3. The trend reversed in 1995. Source: Securities and Exchange Commission of Thailand.683 1.268 2.193 2.560 1. gross profit margin rose until 1991 before falling in 1992. ROA dipped from 10.565 2.5 at its peak in 1987.360 1.4 percent to 5.8 percent. had been on the rise throughout the 1980s. Corporate profitability.303 930 855 1. the averages for all three profitability ratios took a downswing all the way until 1996. in the end.Chapter 4: Thailand 237 Table 4. pulled down by active public offering activities.6 trillion.1 by 1996. then stalled in 1990. the companies could not generate enough net returns from their assets and equity.281 832 373 356 482 Due to listing requirements and other reasons.3 Statistical Highlights of the Stock Exchange of Thailand. corporate profitability had been declining.3 percent in 1989 to 3.610 1. 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. But instead of shifting to a low gear. Meanwhile. ROE similarly fell from 21. and gross profit margin. as measured by return on assets (ROA). the average times interest earned (TIE) was down to 5. however.

7 5.2 10.2 27. and footwear had the lowest at 11 percent.0 29. which fell from 16 percent in 1991 to just under 6 percent in 1996. Overall.2 6.5 15.7 12.9 77.8 11.2 35.3 12. The downtrend in corporate profitability.5 38. Vol.3 91.2 10.6 36.4 9. clothing.6 41. Despite the availability of the equity market.1 242.0 145. They were generally more efficient in managing their assets and .9 8.4 5.2 49.4 Key Financial Ratios of Publicly Listed Companies.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.6 125.4 34.4 24.5 50.2 64.0 117. Among the crisis-hit countries.8 5.7 5.6 27. 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. was also distinct in the region. Thailand’s ROE. these companies opted for debt.4 119.7 54.7 80.2 215. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.4 7. clothing.0 63.8 8.6 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.9 144.7 5.4 4.1 120.7 12.6 168.1 16.8 51.9 14.0 3.1 16.1 9.6 12.2 10. the textiles.4 26.3 10.1 114.4 18.4 44.7 27.7 34.0 7.1 60.4 12.7 27. Korea and Thailand had the highest debt-to-equity ratios. II Table 4.7 35.8 151.5 9.4 7.4 51.0 125.8 54.9 7.5 51. and footwear industries also experienced losses.1 52.9 140.7 21.8 25. Severely affected by global competition throughout the decade.8 5.7 20.2 27.9 27.4 3. A major reason for this was the rapid rise in asset prices.7 15. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.9 66.9 7.5).0 139. resulting in higher collateral values for borrowers.6 7.2 161. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. US.4 12.238 Corporate Governance and Finance in East Asia.7 59. which was particularly significant in the two years preceding the crisis.7 4.8 14.7 12. Hotels and travel showed the highest ROE of 15 percent while textiles. was felt across industries.8 88.4 47.5 52.7 12.4 28.5 63.9 39.1 44.3 8.3 4.5 30. practice of heavy borrowing.6 138.4 139.9 51.

3 15. In sum.3 43.5 Average Key Financial Ratios by Company Size.7 14.3 25.2 10.7 6.0 83. 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 6.0 48.8 10.2.8 47.6 61.3 88. capital despite the higher gross margins of small companies. weaknesses became evident.5 7.4 116.8 6.2 121. by the 1990s.5 94. Although stable in the 1980s.6 7.4 8.9 20. .5 87.2 18.5 6.6 6.1 13.1 6. For instance. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. US. total asset turnover declined after 1989. However.3 164. although the performance of listed companies in the late 1980s was strong. the law disallowed cumulative voting.8 6.1 29. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.8 26. the overall activities of listed companies.2 12. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies. Cumulative voting.1 5. They also tended to use more financial leverage than small companies as their total DERs show.3 135. measured by total asset turnover. it was thought.3 49.6 12.1 25.6 5.6 10. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.9 13.4 Legal and Regulatory Framework Before 1992.3 23.Chapter 4: Thailand 239 Table 4. 4.3 49. also deteriorated.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.7 10.2 134.6 31.8 62.3 52.6 30.4 52. which would be disruptive to company management. could lead to a high turnover in the board.8 142.1 Small Medium Large 5.6 30. During the 1990s.3 176.0 20.

The legal and regulatory framework for the corporate sector also includes provisions related to insolvency.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. and the punishment for management misconduct was also lightened considerably. Vol. As the succeeding sections point out. II Another issue was the proportion of shareholding by top shareholders. This will be discussed in Section 4. that creditors had generally little influence on the management of corporations. coupled with weak corporate governance. As it turned out. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. Cumulative voting was made optional. Fortysix companies responded. relaxed the contentious provisions of the 1978 Public Limited Company Act. the exit of these provisions appears to have contributed to the 1997 financial crisis. 4. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. The provision discouraged original family owners from registering their companies. The Public Company Act of 1992. and external monitoring and control of corporations were also weak. for instance. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. but not all questions were answered.5. concentrated ownership. as a group. However. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. An Asian Development Bank (ADB) survey conducted for this study shows.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. The protection of minority shareholders was inadequate under the Public Company Act of 1992. adopted to promote the development of publicly listed companies. .240 Corporate Governance and Finance in East Asia. The law prohibited the largest shareholders. played an important role in bringing about the financial crisis. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector.

3 28. respectively.0 7. Indonesian.0 3.4 6. and minority shareholders to stake their claim in the control and regulation of these companies. But with their increased reliance on new varieties of equity and debt instruments.1 7.3 7.9 52.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.2 4. on average.3 5.4 5.9 3.7 percent. In contrast.7 7.6 68. creditors.3 16.3 11. China firms have the highest single shareholder ownership concentration at 35.4 6. Source: Comprehensive Listed Company Information Database. 56. one would expect the public.6 28. 33.2 11.7 6. Most large Thai corporations listed on SET started out as family businesses.9 52.5 Average for 1990-1998 period.China have the least concentrated ownership.9 percent of shares of a company.6).3 percent.4 26.8 11. 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.0 7.3 percent and 18.9 54.4 4.9 3. Table 4. .0 5.0 53. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.1 5. and Hong Kong.9 11.7 11.1 12.1 5. with the largest shareholder on average controlling 10. Unfortunately.1 11. there were only slight variations in the pattern.9 52.2 56.9 6. with the top three shareholders accounting for almost 50 percent (Table 4.4 10.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.9 4. Ownership Concentration Between 1990 and 1998. this was not the case. Ownership was most concentrated in the packaging. and 28. these companies obtained funding solely from banks or from their own retained earnings.0 3.1 4. In the past.2 4.1 5.2 4.1 3.1 percent of control rights.8 5.3 7. Stock Exchange of Thailand.9 55.4 26. Across industries.7 12. Thai.8 32.5 28.0 56.6 4.9 26.5 9.4 percent of outstanding shares.Chapter 4: Thailand 241 4. the top five shareholders of each of publicly listed Thai companies held.4 26.6 27.6 57.3. 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.

800 0.242 Corporate Governance and Finance in East Asia. results show a significant positive relationship between ownership concentration and financial leverage. On the other hand. ** at the 5 percent level. II agribusiness. Based on a regression analysis.7).080 6. owning 26.001 0.001) 0. US.022*** 0.003 0.7 Statistical Relationships between Corporate Profitability. year.029 3.116) Debt-to-Equity (1.533)*** Debt-to-Assets (0.647 Note: The regression included dummy variables for industry.034*** 0. *** at the 1 percent level.037 0. * Denotes significance at the 10 percent level.058* ROE (0. Leverage.005** 0. with a top-five ownership concentration of at least 60 percent. as measured by debt-to-equity and debt-to-asset ratios.001*** 0.115 9. Ownership Concentration. and ownership types. including those that are publicly listed . It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. Through these holding companies. Company size is significantly related to ROE and leverage. Vol. 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. Table 4.169*** 0. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.7 percent of outstanding shares on average (Table 4.8). founding families maintain effective control of entire groups. 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. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.072) (0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.031 3. and building and furnishing industries.090 0.

5 0. Although holding companies set up affiliate firms. one of the founding members.6 28.5 percent.8 23.6 percent of outstanding shares.2 18.8 28.1 4.6 1. The top 10 shareholders include a holding company owned by the Tejapaibul family.5 1.3 percent of outstanding shares.5 Government Other 0.7 — 1.3 1. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.3 0.1 0.6 1. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.4 20.2 1.2 5. a joint venture among three families.9 0.5 2.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.9 6.7 0.7 5.4 22.3 27.9 18.3 — = not available. In 1994.0 17.7 1. unlike in Japan where crossshareholding is common.4 1. .6 25.1 1. operates five of the most successful shopping malls in Thailand.5 NBFIsa 6.7 Bank 2.5 26. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28. Stock Exchange of Thailand.5 0. including finance and investment companies.0 3. the company increased its registered capital and became a public company listed in SET.9 19.6 1. Typically.8 1. the company.3 20. in SET. Established in 1980 with a registered capital of B300 million. with 29. These individuals usually hold important management positions in concerned companies.3 27.5 Individuals 13.8 0.2 7. The ADB survey indicated that listed companies held shares in an average of 11 companies. individual members of the Chirathivat family aggregately hold 25. a company listed in the real estate sector of SET.0 19. Source: Comprehensive Listed Company Information Database.3 1. The largest shareholder is Central Holdings Company.0 18.5 0.2 1.5 5. a NBFIs denotes nonbank financial institutions.4 1. the affiliate firms rarely hold shares of their parent companies. This practice is illustrated by Central Pattana. Individual family members also hold a significant amount of outstanding shares.4 1.Chapter 4: Thailand 243 Table 4.3 27.5 1. owned by the Chirathivat family.9 7.6 5. averaging about 18.1 1.9 15.3 1. In addition.

Nonbank financial institutions hold an aggregate 5. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. duties.5 percent of total outstanding shares. By owning 62 percent of voting shares. they account for 80 percent of total outstanding shares.3. There was a trend of rising government shareholdings throughout the period 1990 to 1998. Across industries. . where the top three shareholders are the Ministry of Finance. 1. However.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. the top 10 shareholders consist predominantly of members of founding families and their holding companies. 4.244 Corporate Governance and Finance in East Asia.. qualification. Except in the hotel and travel service sector. The Government holds. the Government’s role in public companies is expected to decline. commercial banks account for only 1. and responsibilities of directors of public companies. Although the list of top shareholders of publicly listed companies includes financial institutions. the predominance of individual family members and holding companies in the top shareholder list remains valid. has the Ministry of Finance as its only large shareholder with 92.5 percent of total outstanding shares of listed companies.1 percent of total outstanding shares of listed companies.9 percent of outstanding shares. Only a handful of companies have the Government among their large shareholders. and a state bank. with the envisioned privatization master plan. the Petroleum Authority of Thailand. Thai Airways International Plc. In effect. on average. Moreover. Another example is Bangchak Petroleum Plc. Together. they exercise limited influence in operations because of the restricted size of their shareholdings. 3 Discussions in this section are based on results of company surveys by SET and ADB. II another of the company’s founding members. only one tenth of listed companies have commercial banks on their top-five shareholder list. the Government owns the majority of the shares. both conducted in 1999. roles. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. In such cases. For example. these shareholders are able to control the company. On average. Vol.

In five other companies. In their business conduct. and to comply with the laws and articles of association. meanwhile. Generally. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. Some companies (36 percent) had five to six main board members holding seats in their executive boards. Although 28 percent of the chairpersons came from the ranks of independent outside directors. while 30 percent of respondent companies held board meetings monthly. Many companies have a formal policy on corporate governance and business ethics. . Nineteen companies stated that selection was based on professional qualifications. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. selection was based on relationships with controlling shareholders. the majority (71 percent) had board chairs who were also members of top management teams. while 15 percent of respondents went beyond the requirement. but not in 22 others. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. The ADB survey indicated.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. an executive board consists of senior management and some main board members. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. 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. Unless stipulated in public companies’ articles of association. directors may be imprisoned or fined. 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. directors are required to act with care and honesty for the company’s best interest. In addition. Meanwhile. directors shall be elected at the annual general shareholders’ meetings (AGSMs). Most companies (83 percent) satisfied SET’s requirement of having two independent board members. If found in violation of these provisions.

Fourteen other companies had profit-related incentive schemes in addition to fixed fees. In one company. not an independent assignment. Chair. All respondents confirmed the use of external auditors. Half of the companies in the SET survey had a separate remuneration committee. Companies already with audit committees did not have independent outside directors as audit committee members. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. 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. These committees were mainly responsible for determining compensation for senior and regular staff. Audit Committees and Accounting Standards Since January 1999. In 25 companies. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. Three companies allowed their management to determine the chair’s compensation package. II Compensation of Directors. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. however. 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. Also. Vol. the work of this committee was often considered part of the executive board’s responsibilities. 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. the remuneration packages had to be approved during AGSMs. However. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. the auditor is not .246 Corporate Governance and Finance in East Asia. with 41 firms admitting the use of services of international auditing firms. Where different.

Relationships between firms and external auditors are generally long-term. and executive committees. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. According to the ADB survey. However. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. SET. averaging about 14 years. The Act. SET’s rules and regulations closely follow this Act. For instance. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. remuneration. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. shareholders can claim compensation in cases of negligence or dishonesty by management. (iii) Because the chair is frequently also part of the top management team. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. In the majority of these companies (38 out of 46 respondents). stipulates the proper conduct of shareholder meetings. and the Bank of Thailand— are not clearly defined. although recently. The Act also holds directors liable for any damage to shareholders. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. (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. there are also significant gaps in the system of shareholder protection. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. As a result. likewise. there is the danger that top management may be capable of unduly influencing the board’s decisions. (i) No standards are enforced in the content and timing of notices for shareholder meetings. Forty-four companies indicated that they had proxy voting in place. as well as the registration and holding of shares. At least 28 responding companies had the following . debentures. with 13 companies allowing proxy voting through mail. While safeguards are in place. most responding companies have rules and regulations intended to protect shareholders. shareholders have access to reliable information at no cost.Chapter 4: Thailand 247 independent from the company. SEC. or other financial instruments. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms.

66 percent of total outstanding shares. however. . Only a small number of shareholders attended the latest AGSMs. On paper. 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. In effect.248 Corporate Governance and Finance in East Asia. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results.3. minority shareholders are assured adequate legal protection. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. In theory. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. While stimulating the growth of the sector. Although the attendees held. it would be difficult for minority shareholders to gather the shares needed to take action. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. given their importance in providing finance and their stake in companies. representing only about 28 percent of shareholdings. 4. on average. Vol. Banks would be obvious candidates to implement these mechanisms. takeover of the company. In practice.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. But the exercise of these rights requires even higher shareholding levels. such protection has been insufficient. the only group of shareholders that can exercise rights is the top five shareholders. But with the ownership concentration of Thai companies. 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. did not vote in previous AGSMs. they comprised only 8 percent of total shareholders. Almost 82 percent of shareholders. and insider trading. and mandatory disclosure of related interests and significant shareholders’ transactions. and call an extraordinary session. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions.

Only three companies thought otherwise. while 18 said none of their creditors required collateral. Actual bankruptcy proceedings took more than five years on average. creditors do not always require project feasibility studies or business plans in granting loans. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. Under a weak bankruptcy system.Chapter 4: Thailand 249 Historically. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. Apparently. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. other than losing control. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. such as that seen in Thailand before the crisis. which could cause a delay by at least a year. Normally. while loans for fixed investment were also more likely to be supported by collateral. However. 17 indicated that only some of their creditors had such a requirement. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. . borrowers seldom lose control to creditors even when they default and become insolvent. a company’s reputation and its long-term relationship with creditors sufficed in many instances. 11 experienced rejection after the crisis started. There were many options. In the end. they resort to borrowing. however. when insiders want to expand their company’s operations without losing control. Debtors had many handles to stall the bankruptcy process. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. as the ADB survey confirmed. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. For 20 of the 46 responding companies. the majority believed that creditors had little influence on company management and decision making. including procedural disputes. to solve debt repayment problems. Most companies reported that banks were more likely to require collateral. Leverage allows the assets and operations of the company to grow without diluting corporate control. creditors’ collateral requirements were tightened after the crisis.

with a significantly lower total tender offer value of B8. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. however. In 1996. Since the introduction of the Public Limited Company Act of 1978. Such efforts would serve to strengthen external discipline on controlling owners. There are detailed requirements regarding such notification. SEC was later made responsible for regulating corporate takeovers. According to the SEA of 1992. its main role is to ensure transparency and fairness. The market for corporate control has not been active in Thailand. there are two categories of merger and acquisition activities with associated regulatory measures. In 1994 and 1995. The second category is the tender offer. It will take years. The first category is the acquisition of shares in the open market. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. there were only six tender offers. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. of shareholders: (i) all shareholders must receive tender offers. Vol.250 Corporate Governance and Finance in East Asia. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. and failed to provide managers with strong incentives to perform efficiently. whether directly or indirectly. there were 41 cases of tender offers. if the purchase of shares implies a change in the directors or business activities. 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.3 billion (Table 4.9). Recently. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. before the extent to which the bankruptcy framework has been strengthened becomes clear. with a total tender offer value of B42. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days.3 billion. only a limited number of successful mergers of public companies have taken place. In this case. Although merger and acquisi- . SEC has no authority to either approve or reject tender offers. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value.

tion activities increased after 1997.6 17.3 60. if any.3 11. trading by mutual funds in SET represented less than 10 percent of total trading.1 84. But instead of opting for an active role in the market for corporate control.2 8. Even when companies offer ESOPs. While the Thai mutual fund industry compares well to those in other developing countries in the region. Employee Participation in Corporate Governance There has been little. Because of the current crisis.2 7.3 6.9 Merger and Acquisition Activities.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. but the average shareholding is smaller than 1 percent of total outstanding shares.0 B billion 4.1 19. not with a view to becoming involved in actual management. but employees have never been represented in the board of directors since their shareholdings are minimal.8 81. it remains small.7 11.4 23. Source: Securities and Exchange Commission of Thailand.7 Purchase Value Number of % of Tender Offer Value Companies 84. they have mostly been concerned with short-term gains.2 6.5 6.0 55. Provident funds for government workers and workers in public enterprises have been established only recently. most of these were forced mergers or related to rescue packages.9 3. employees are even less willing to accept common shares as a form of compensation or benefit.2 6. Since 1994. . Pension funds are perhaps even weaker in Thailand.1 58. Twenty-nine firms indicated that employees held shares of their companies. employee participation in corporate governance in Thailand.1 75. employees regard the plans as monetary incentives. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. Eleven of the 46 responding companies in the ADB survey offer ESOPs. Few companies offer employee stock option plans (ESOPs).Chapter 4: Thailand 251 Table 4.

II 4.372.0 8.906. In 1996.1 3.. Vol.325.485.161. The Banking System Until recently.775.9 2.0 SET Market Capitalization 1.477. there were 29 commercial banks. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.4. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market. the next four largest banks accounted for 63 percent.5 trillion. the banking sector was highly concentrated.268.6 2.0 424. The bond market played only a marginal role in corporate financing.979.663.825.5 4.5 6.3 5.1 5.912.8 3.119.360.669. although its role increased in the wake of the crisis.564.8 941.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4. and Bank of Thailand.390.4 4. The country’s largest bank.133.4 4. The share of domestic banks in the banking system’s total assets was 80 percent.193.6 6.171.1 Domestic Debt Securities Outstanding 215.1 6. Bangkok Bank Ltd.4 3.10 Size and Composition of the Thai Financial Sector.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.3 546.10) shows that Thailand is a highly bank-dependent economy.0 339. total assets of commercial banks amounted to B5.1 3.5 4.430. .0 3.2 262.037.4 1.4 519.3 1.1 7.300. Thai Bond Dealing Centre.252 Corporate Governance and Finance in East Asia. 15 of which were domestic banks. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.559.6 1. Table 4.2 2. accounted for 28 percent of the banking sector’s total assets.5 Outstanding Loans from Commercial Banks 2.5 5.230.

the stock market entered its first boom period in 1986. In 1995. also made it unattractive to raise capital from the equity market. self-regulatory organization under the . The Equity Market During the first few years of its operations. and 20 new foreign banks.2 trillion. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. Banking activity peaked in the mid-1990s. and almost all capital account transactions were deregulated. the SET index declined. After that. was set up by 74 members with an initial capital of B500 million. The number of listed companies also quadrupled between 1981 and 1993. Some 347 companies were listed in the same year with a total market capitalization of B3. Benefiting from rapid economic and industrial growth. reaching 355.8 in 1998. SET immediately recovered due to the strength of the Thai economy. the market rose steadily and reached a record high in the fourth quarter of 1993. 12 existing foreign banks. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. Many company founders did not want to release even a small portion of corporate ownership and refused to go public.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. BSDC is a nonprofit. BIBF banks also enjoyed tax incentives on their operations and profits. Despite the worldwide market crash in 1987. and property have accounted for the bulk of trading volumes.3 trillion. an over-the-counter market. Through the years. The lack of supply of quality shares was a big problem for SET at that time. owning 70 percent of the country’s second largest bank. banking. the Bangkok Stock Dealing Center (BSDC). SET is organized into 32 major industries. Licenses were granted to 15 Thai banks. Because borrowers carried the exchange rate risk. In the following years. In 1993. due to their close ties. Turnover value reached B2. Easy access to commercial bank loans by family business groups. The Government removed controls on capital and dividend repatriation in 1991. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. finance. In contrast. SET was not very active. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations.

turnover value was negligible and the BSDC Index remained flat throughout 19961998. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. If the issue is oversubscribed. In 1996. also acts as a clearinghouse. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. the two classifications were merged. and securities registrar.254 Corporate Governance and Finance in East Asia. financial projections. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. After initial public offerings. Vol. but dropped the following year to B122 million. to assist in the public offering process. with each facing different listing requirements. SET. It separated the primary and secondary markets to promote more flexible and effective supervision of both. The company should then appoint a financial adviser. Turnover value was B1. If approved by SEC and the SET Board of Governors. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. Before 1993. In 1998. In July 1990. According to the SEA of 1992. approved by SET. lottery drawing must be used to ensure fairness. and (ii) a minimum of 300 shareholders. The primary market is supervised by SEC. Company applicants must have an established history of operating under substantially the same management. Listed companies were those that had (i) paid-up capital of at least B20 million. and pro forma balance sheet and income statements. II jurisdiction of SEC. securities deposit center. which consist of SET and BSDC. The allocation procedure is nondiscretionary. Consequently. each holding no more than 0. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. Only one security was listed in BSDC in 1995 and two more in 1996. securities can be traded in the secondary markets.8 billion in 1996. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. The listing application should be submitted concurrently to SEC and SET. the BSDC was dissolved in 1999. . there were two kinds of companies in SET—“listed” and “authorized” companies. stock trading can commence within five days.5 percent and collectively owning at least 30 percent of paidup capital. 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. however. SET established new requirements for initial public offerings. so now only listed companies are traded in SET. among other functions approved by SEC.

was also instrumental to the growth of the corporate debt market. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. The recent financial crisis. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. . In 1996. A turning point of the corporate debt market was the enactment of the SEA of 1992. it represented only 9 percent of GDP. To gain some perspective of the size of the bond market in Thailand. the first bond rating agency in Thailand.11). in 1994. 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. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions.9 billion. Upon its founding in 1942. it accounted for a small share of the entire financial sector. The bond market in Thailand started in 1933. However. 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 Government issued more bonds to finance industrial development projects and perennial deficits. while secured debt instruments accounted for just above 10 percent. the Bank of Thailand assumed responsibility for regulating the bond market. 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. compared to 110 percent in the US and 74 percent in Japan in the same year. which encouraged limited companies and public companies to issue debt instruments. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. and the Government did not issue new bonds during 1990-1997. Investors had limited knowledge of debt instruments. however. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. Beginning 1961. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. The budget surpluses of the 1990s eliminated the need for new bond issuance. The Thai Rating Information Services.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. the size of the corporate debt market rose to B132. Four years after the passage of the SEA. The proportion of domestic convertible debt instruments increased until 1995.

1 141.4 — — — 1. .5 — — 32.6 — — 0.9 0.8 31.7 95.0 27. 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 — — — — — — 400.4 49.7 5.5 — 39.9 5.6 billion.5 138.7 132.3 140.5 — — — — 1.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.7 — — — — — — — 77. then declined substantially in 1996 and 1997.5 37.1 61.1 289.5 10.3 — 14.8 2. II Table 4.3 6.0 33.7 — — 40.2 2. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.7 5.0 — 5. a surge attributed to capital inflows encouraged by high returns on Thai bonds.4 — 26.1 — — 6. total offshore debt offerings had plunged by 68 percent to a mere B28. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.6 19.4 57.7 7.4 7. Vol.0 — 5.4 billion.8 47. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.4 — 9.7 821.256 Corporate Governance and Finance in East Asia.7 28.0 5.7 0.2 — — 50.9 20.1 6.3 8.1 8.1 21.5 — 0.3 50.9 40.1 55. turnover value had reached B51.3 46.3 — — 3.9 329.0 0.1 41.0 86. By 1995.7 — — — — — 4.2 45.1 — — — 29. the year the crisis unraveled and the baht was floated.1 107.7 0.2 89.3 29.1 121.9 37.3 22.9 30.5 43.0 281.11 Offerings of Debt Securities.3 13.1 59.1 12.0 7.8 167.2 28.0 17.9 37. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.4 110.5 5. this had climbed to B200.6 — 0.5 55. The following year.1 315.7 538.5 billion.3 46.8 191.1 10.2 57.0 26.2 43.0 60. Total offshore debt offerings peaked in the run-up to the financial crisis.8 55.5 — — — 3.0 — 26. by the end of 1997.0 333.7 90.2 39. However.3 3. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.

Chapter 4: Thailand 257 compared with investment in equities. these comprised 31 percent. and marketable securities holdings. For the construction industry.2 billion as a result of the default of debentures due to the Asian crisis. The average for all industries was only 22 percent. Longterm loans accounted for about 20 percent of total liabilities. turnover value plummeted to B106. with equity levels remaining high despite an increase in debt. There was also little change in the trend in retained earnings within the seven-year period. they also had a relatively small proportion of equity and .4. 4. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. judging by their relatively low levels of retained earnings. Turnover fell further to B72.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. a trend most apparent in the leap between 1991 and 1992. In 1997. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. Equity financing remains an important part of listed companies’ long-term financing. while for the property development industry. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. In addition. Across industries. Companies in construction and property development seemed unable to generate internal funds. short-term loans accounted for more than 40 percent of total liabilities. In any case. steadily easing up between 1990 and 1996. At lower than 5 percent of total liabilities. Construction and property development industries tended to have high proportions of long-term loans and debentures. From 1990 to 1996.12). The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result.1 billion in 1998. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. significant variations can be noted. The proportion of accounts receivable also declined steadily. cash balances. these accounted for 33 percent of total liabilities. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. In the same year. Retained earnings accounted for about 30 percent of total equity financing. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996.

3 14.6 8.0 100.3 25.2 42.3 48.6 51.9 3.8 25.258 Corporate Governance and Finance in East Asia.9 40.4 17.6 13.0 10.3 12.7 16.9 16. were highly leveraged.6 50.9 17.8 35.0 1.1 50.2 15.2 16.6 0.3 14.12 Common-Size Statements for Companies Listed in SET.1 5.4 8.4 2.2 1.9 12.4 49.8 9. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.4 17.0 100.5 0.2 2.0 14.0 100.7 15.2 17.3 49.4 21. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.8 10.9 43. US.6 21.0 100.4 14.2 1.8 37.0 51.0 100.9 18.6 18.7 52.2 2.7 1.3 18.6 10. Printing and publishing companies had lower financial leverage than companies in other industries.5 1.3 34.3 1.4 43.2 3.5 43.9 14.7 18.9 38.3 38.5 1.9 6.6 100.9 14.2 22.9 10.9 50.7 14.5 11.2 35.4 49. II Table 4.2 17.7 36.8 3.13).2 2.9 0.4 7.1 49.5 9.1 18.5 37.7 0.2 17.0 100. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.3 17. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.8 46.6 38.5 14.4 48.2 43.6 2.9 14.9 17.8 9.2 45.3 18.2 2.0 10.9 15.0 13.8 14.0 100.0 100.1 36.0 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.3 1.9 14.6 0.7 9.0 6.3 21.6 12.6 0.6 15.1 17.6 14.8 1.0 7.1 2.2 17.8 7.3 50.6 100.8 34.0 2.7 7.5 9.6 36.8 37.0 48.2 16.0 100.2 1.3 6.7 50.5 1.7 17.9 14.0 15.0 100.8 17.7 16. The level of total liabilities for the group characterized by high ownership concentration .0 100. Vol.8 19.8 8.6 11.0 100.3 2.9 2.8 20.6 22. medium.3 34.2 12.6 6.9 20.9 49.9 6.2 43.0 100.1 7.0 100.2 34.4 6.8 6. compared with the 44 percent general average.6 0.1 13.0 12.8 21.

6 0.8 13. was 53 percent of total assets compared with 49.2 8.0 41.6 2.7 19.1 44.3 100.4 37.5 21.3 1. .2 45.6 22.3 1.4 18.3 16. 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.6 15.0 14.1 49.2 0.8 12.9 0.9 16.0 100. 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 2.6 47.9 50.7 12.5 11.5 18.0 16.2 14.1 36.9 100.7 percent for medium ownership concentration companies and 49.2 22.Chapter 4: Thailand 259 Table 4.0 100.0 6.5 13.0 6.4 1.4 3. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.9 36. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.13 Common-Size Statements of Public Companies by Ownership Concentration.6 14.9 7.4 7.8 37.0 Low 1.7 17.0 Medium 2.2 11.6 100.0 7.4 49.4 13.1 53.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.3 35. US.6 9.0 19.9 21.3 8.4 50.8 13.1 18.9 2.4 35.5 100. For the high ownership concentration group.

6 7. and maintenance of the existing ownership structure. While further detailed investigations are necessary.9 63.2 68. US.7 66.4 139.8 percent in 1990 to 52.6 41.5 38. Such deterioration of financial positions during the period was a common feature of listed companies. More important.7 11. and rights issues. The TIE ratio declined from its peak of 7. was the headlong deterioration of firms’ ability to meet their interest payment obligations.9 51.0 145.1 16. Short-term debt accounted for most of the increase.2 49.4 44. especially from 1994 to 1996.5 52. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing. .8 65.8 5.3 31.4 12.4 7.2 35. 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. Public companies relied more on short-term debt financing in the period before the financial crisis.3 61. bond issues. however. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.14).1 44.0 25. 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 in 1996. thus rendering them more vulnerable.4 5. bond issues overtook loans from commercial banks as the second preference.7 percent in 1996.7 12.260 Corporate Governance and Finance in East Asia. minimization of transaction and interest costs.7 28. After the crisis. these firms more easily increased their leverage.0 28. Table 4.6 125. The ratio of total debt to total assets increased from 50.0 50.1 144. the choice of financing is determined by the company’s liquidity considerations. followed by bank loans.1 64.4 51. As a result.14 Financial Ratios of All Listed Firms.7 12.1 52.8 65.6 138.1 31.7 34. Generally.8 151.7 in 1994 to 5. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.1 23. Vol. however.1 16.9 14.7 34.1 31.15.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.7 5.9 140.8 51.9 7.

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.6 30.3 42. From 45 percent of total net capital movements in 1985.8 29.8 66. and a preponderance of short-term debt liabilities.7 percent from 1991 to 1996.9 percent in 1997.4 percent to 46 percent during the same period. The composition and term-structure of this debt.15 Financial Ratios of Listed Companies by Ownership Concentration.2 49.2 percent in 1986 to 251.4 52.4 13.8 28. This decline was accompanied.0 64. Nonbank private debt increased from 27.2 124.5 126. From only 34 percent in 1986. continued to slide from 1985 to 1997.4 27.5 percent between 1985 and 1990 to 8. unhedged foreign exchange liabilities.8 Medium 7. Additionally.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.Chapter 4: Thailand 261 Table 4. . the proportion of short-term debt increased from 15. Their average annual growth rate declined from 28. US. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. however.5 34. peaking in 1994 at 84 percent. such as direct equity and portfolio investment. on the other hand. 4.6 11.5 4.5 148. is even more telling. 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. private debt accounted for 84. The proportion of external debt as a percentage of GDP consequently increased from 42. debt-creating capital inflows rose to 65 percent in 1990.8 49.8 percent in 1986 to 52 percent in 1995.8 14. The proportion of nondebt-creating capital flows.1 High 6.16).4 63.5 percent of external debt in 1996 (Table 4. 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.5.

1 23.5 14.5 19.8 13.9 3.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.3 37.9 43.3 0.7 13.0 8.6 18.7 20.4 — — — — — — — 1.Table 4.4 2.1 95.1 12.1 30.2 32.3 0.1 2.1 5.9 6.8 0.3 0.3 0.2 15.2 14.16 External Debt.3 105.0 11.3 12.0 13.8 3.7 0.5 16.7 10.9 10.3 3.3 0.9 5.9 10.7 109.9 1.7 23.4 5.9 1.2 0.3 0.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.3 10.6 — 0.4 3.0 0.9 11.9 6.3 — — — — — — — 6.2 10.7 2.6 7. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.3 16.0 3.9 31.0 21.3 7.3 20.2 2.2 2.9 7.8 31.4 10.1 64.6 52.8 12.5 4.8 3.8 108.4 15.3 0.9 100.5 1.1 0.2 2.1 0.1 0.6 Total 18.9 3.9 4. .2 0.7 24.3 0.5 12.5 12.9 0.0 6.1 Source: Bank of Thailand.3 2.5 4.3 3.4 18.9 29.1 0.1 34.9 35.9 13.8 10.0 11.1 22.2 0.6 1.0 4.7 1.

suggesting that serious investors have not returned to the market. trading activity at SET had been on the downturn.6 in December 1996. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. from its peak in 1995. With easy access to foreign funds. reaching 45 percent of total outstanding credit in December. After that. the number of newly registered companies dropped to a 10-year low in 1998. If lending rates remained high. It hit a 10-year low in the second quarter of 1998. Most of these foreign debts were not properly hedged. and drastic decline in the number and capital of newly registered companies. according to the Bank of Thailand.360. the SET Index stood at 1. At the end of 1994. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. On average. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. Similarly. and (iii) bankruptcies.17). The value of public offerings sank in 1997 to B56. outstanding credit also declined throughout the second half of 1998.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. Trading volume has since been thin. exposing the companies to disaster when the baht started tumbling on 2 July 1997. leaving domestic investors with large capital losses. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. Foreign investors retreated from the market. 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. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. the index declined to 1. and poor business confidence on the other. The effects of the crisis were felt across all industry sectors. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. Due in part to liquidity problems on the one hand. Meanwhile. banks would be recording more of such NPLs.281 in December 1995 and to 831. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. . closures. based on the three-month past due definition. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation.6 billion from the 1996 level of B201 billion. Aside from the problem of NPLs. the liquidity problems faced by the corporate sector are likely to continue for some time. Even before the crisis.

the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.095 14.264 Corporate Governance and Finance in East Asia.2 billion for balance of payments support and buildup of the country’s reserves. Ministry of Commerce. Thailand.5.977 Source: Department of Commercial Registration. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.112 9.066 19.224 4.410 5.334 4.134 31.307 4. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.052 36.096 22.797 4. Vol.792 7.902 3.407 28.933 25.409 6. The IMF financial package was a credit facility of $17. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.105 4.777 11. The price-to-earnings (P/E) ratio deteriorated from 19.17 Number of Newly Registered and Bankrupted/Closed Companies.6 in 1997. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. It also explains the higher dividend yield ratio. II Table 4.2 Responses to the Crisis Initially.695 3.677 Bankrupted/Closed 2. 4.288 35.312 25. the Government was left with no choice.080 9. .5 at the end of 1994 to 12 in 1996 and further to 6. A steady price decline over the past few years has dragged down the ratio of market price to book value. But when assistance from other sources did not materialize.925 12. As part of the assistance package.218 3.904 20.201 24.915 37.410 37.

The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. however. The old law allowed only creditors to file bankruptcy suits. only two companies emerged intact from the suspension. Regulatory Response by the Government The IMF program. Many believed that the process was inefficient. follow through with a civil or bankruptcy suit. The Bank of Thailand also improved banking standards. and Credit Foncier Businesses. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. and if necessary. also aimed at institutionalizing legal and regulatory reforms.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies. increase profitability. secured creditors had to obtain the court’s approval before starting proceedings . creditors seldom succeeded in obtaining payment against bankrupt borrowers. loan provisioning. debtors could drag out the process for many years. the Civil and Commercial Code. IMF relaxed these key conditions. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. As it turned out. For example. drawn up with World Bank and ADB assistance. The assets of the other companies were liquidated by auctions. Strict loan classifications. and the Act Regulating the Finance. and did not recognize debtor-initiated bankruptcy declarations. In early 1998. Under the old bankruptcy laws. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. There were many options for solving debt repayment problems. These include repeal of the Commercial Bank Act. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. While no definition for “insolvency” could be found in the bankruptcy law. and restore solvency. it was widely interpreted as “having debts more than assets. By invoking procedural loopholes. Securities. and worked on revisions to the Secured Transaction Law. Creditors could negotiate to reschedule debt repayments. and income recognition were implemented.

The amendment added reorganization provisions to the Bankruptcy Act of 1940. (iii) shareholders regain their legal rights. The reorganization process is successful if (i) the debts shall have been discharged. The model for Thailand’s amended bankruptcy law was the US Chapter 11. which means that a debtor could continue in business while the reorganization program was being implemented. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. Companies need . the judges and court officers have yet to learn and master the new bankruptcy procedure. In effect. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. (ii) management of the company reverts to the borrower. To make matters worse for creditors. In Thailand.266 Corporate Governance and Finance in East Asia. The amended law also introduced the concept of automatic stay. The original Bankruptcy Act dealt only with liquidation and composition. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. Under the old Bankruptcy Act. In 1999. If the process fails to revive the business. Chapter 11 is the main tool in restructuring bankrupted companies in the US. time consuming. The amended legislation also includes voluntary bankruptcy as a new feature. and expensive process. There are other potential problems. 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. II for the recovery of debt through the realization of any collateral. For one. but it is a complicated. thereby allowing court-supervised corporate restructuring. Vol. it covers only the court-supervised reorganization of distressed companies. Enforcement of the new law is bound to be ponderous and lengthy. 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. and (iv) the debts shall have been settled within a five-year period. 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. But more important. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. the amended law limits the rights of secured creditors. the company shall be declared bankrupt and liquidation of assets shall follow. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment.

minority shareholders’ rights are not adequately protected. The result. Replacing the Public Limited Company Act of 1978. 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. Under the new law. In case the board of directors does not comply. 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. only tangible assets were the norm. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration.g. Still pending Parliament approval is the amendment to the Secured Transaction Law. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting. Without the necessary corporate restructuring. Consequently. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. The amendment also remedies the slow process of executing or disposing of assets in a public auction.Chapter 4: Thailand 267 to solve the problems (e. the court. shall have the power to call the extraordinary general meeting. SEC also examined the possibility of an amendment to the Public Company Act of 1992. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. Most important. corporate governance) that caused the bankruptcy in the first place. .” as opposed to the more appropriate criterion of “ability to pay when the debt falls due. In the past. has not been satisfactory.. namely “liabilities exceed assets. after determining the legitimacy of the request. 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. however. the test for insolvency still uses the balance sheet criterion. and (ii) processing of default cases within four to six months of filing of a court claim. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. questions have been raised regarding the appropriateness of the 1992 Act.” The Foreclosure Act Amendment was likewise passed in 2000. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders.

the main problem is overlooked. The regulators are drafting a proposal to amend the provisions on related transactions. The proposal clearly delineates duties of care and loyalty for directors of public companies.268 Corporate Governance and Finance in East Asia. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. the controlling shareholders have the exclusive domain to appoint or exercise management. vis-a-vis the minority shareholders.e. Where equity will come forward. Otherwise. the dominance of controlling shareholders. But as demonstrated. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. i. and determine voting results on virtually any matter. claiming that it creates fragmentation in the board of directors. 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. which.. subject only to approval by the board of directors. The proposal for the amendment of the Public . in turn. minority shareholders have no chance of being represented in the board. Most companies decide against cumulative voting. it permits directors. disrupts the company’s management and decision making. Because of high ownership concentration. Vol. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. This may be true in countries where publicly traded companies are widely held. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. But because this is the assumption embedded in the regulation. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. 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. they face the prospect of being unable to compete for the scarce funds available in the equities market. with the approval of the board. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. this is not so in publicly traded companies in Thailand. without cumulative voting. In addition. 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. Consequently. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. who are also the managers. In the absence of such a stock market boom now. However. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms.

methods. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court.6 trillion. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly.1 trillion of outstanding credit. Within three months. the Government introduced debt restructuring-related measures to help resolve bad debts.6 trillion) have agreed to cooperate with CDRAC’s restructuring process.1 trillion in outstanding credit. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy.764 debt restructuring cases involving B1.068 cases involving B475 billion are undergoing restructuring. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. The first bankruptcy court in Thailand opened on 18 June 1999. the court had more than 80 cases for disposition. In response. accounting for B1. accounting for B1. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. the number of cases has abated. 322. Considerable progress has been achieved on this front.767 cases involving outstanding credit of B2. Another 77. personal consumption. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. Cases for which negotiations were unsuccessful. although since then. However. CDRAC’s target debtors comprised 10.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. Commercial banks initiated 74 percent of these cases. This point is crucial because compared with . contributing to the unprecedented rise in the corporate sector’s bad debt. As of November 2000. only 7. as well as those that did not cooperate with CDRAC’s restructuring process. Some 82 percent of these cases have been successfully restructured. where bankruptcy procedures are swift and effective. 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. with the majority of the debtors coming from the commerce. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies.147 cases (B1.8 trillion had been completed. In addition. will be settled by the courts. and procedures for debt restructuring. and manufacturing sectors. In particular. By October 2000.

4. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand.6. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. despite the weakness of their disciplinary powers.1 Summary. behavior. The . and performance during this period helps understand the causes of the crisis. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. Examination of corporate ownership. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. and even Indonesia. Such improvements in disclosure standards are part of the efforts of SET and SEC. to push companies to harmonize their accounting with international standards. and promoted key industries through incentives. 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. 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. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. Conclusions. Vol. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. 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 1997.270 Corporate Governance and Finance in East Asia. The study covers the period 1985 to 1996. For this reason. II Malaysia. the Government protected certain corporate sectors through tariffs and regulation. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. 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. Philippines.6 4. In the next three decades.

foreign debt in the Thai corporate sector increased continuously. even after the development of capital markets. After 1992. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. The SEA of 1992 also marked the beginning of an active bond market in Thailand. the overall pattern of ownership concentration seems to have been stable for the past 10 years. at a time when most of them were already experiencing declining profits and high leverage. the overall corporate sector was seriously affected.000 from the previous year’s level.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. Nonbank private corporations accounted for most of the increase. the increase in long-term debt more than compensated for the drop. the Public Company Act of 1992 and the SEA of 1992. . One of the major findings is the high ownership concentration among Thai companies listed on SET. the numbers of bankruptcy cases and company closures reached alltime highs. 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. At the same time. the corporate sector entered a new era with the enactment of two major pieces of legislation. the top five largest shareholders hold about 56 percent of total outstanding shares. The number of newly registered companies in 1997 dropped by almost 10. During 1992-1997. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. reaching its peak in 1996. On average. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. Although there are some variations across industries. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. Although there was a decline in short-term foreign debt. Subsequently. In 1995 and 1996. The study examined the impact of ownership structure on corporate governance and financing patterns. At the onset of the 1997 financial crisis. Meanwhile. the profitability of publicly listed companies abruptly declined and their financial leverage increased. In 1992. Because most of these debts were not hedged. there was a marked increase in the number of public corporations. The impact of the crisis was felt across all industries. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. Thai companies were vulnerable to exchange rate risks. Consequently. the number and value of public offerings of securities accelerated. Minority shareholders.

the mutual fund industry has entered the picture but with limited roles and activities. through the use of holding and affiliated companies. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. there is a clear lack of outside monitors for these publicly listed but family-controlled companies. II although larger in number. The key laws. The implications of ownership structures that are concentrated to such a high degree are serious. In the past. Financial institutions hold a very small proportion. The rules in both Acts governing . The absence of external market controls on the management of publicly listed corporations is dangerous. Institutional investors in Thailand. hold only a small portion of total outstanding shares. Consequently. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. the government pension fund was the only major institutional investor.272 Corporate Governance and Finance in East Asia. protect the interests of all shareholders of public companies. These laws stipulate rules and regulations concerning the activities of all public companies. The investing public holds the rest of the outstanding shares. With financial institutions playing limited roles in the capital market. All these. they have little influence over management decision making and control. Vol. Recently. the Public Company Act of 1992 and the SEA of 1992. Thus. 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. Among the five largest shareholders of Thai companies listed on SET. Individuals and insiders hold the second largest proportion at about 19 percent. The highly concentrated ownership structure weakens the protection of minority shareholder rights. contribute to the lack of external controls on the corporate sector through the capital markets. the existing legal and regulatory framework suggests otherwise. Nominally. foreign and domestic. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. averaging 46 percent. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. are not active. along with a highly concentrated ownership structure. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits.

laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. key reforms that will strengthen the regulation of financial institutions. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. . The second issue involves the protection of shareholder rights. these companies tend to become overleveraged. the main challenge is not how the board can control management to maximize shareholder value. Ownership concentration appears to have little impact on corporate profit performance. an aim that can be achieved mostly through legal reforms. Rather. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. In this third area. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. Specifically. The third issue involves creating external market controls through better regulation and development of the capital markets. For example. before the crisis. However. making them vulnerable to economic shocks. but is significantly related to financing patterns. The ownership structure of Thai listed companies also significantly affects company behavior. because there are shared interests between the controlling shareholders and key management personnel.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. Consequently. moreover.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards.6. posed formidable barriers in the minority shareholders’ exercise of their rights. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. Certain provisions. In view of this. For instance. 4. because there is no separation between ownership and management. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management.

Only then will these agencies be able to act promptly and effectively. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. It is important that the roles and responsibilities of each agency are clearly defined to the public. There is also supposed to be separation of ownership and control. voting only on major decisions. In reality. this is a problem in Thailand. Under the current system. The best approach may entail establishing a single. Once the roles and responsibilities are clearly defined. If the principal shareholder is in fact chair of the board. the supervisory agencies also need to be empowered to enforce the laws. the supervisory system is fragmented and not as effective as it should be. . and increase the participation of institutional investors are imperative. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector.274 Corporate Governance and Finance in East Asia. In this setting. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. Vol. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. Consequently. If this were the situation. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. The owners of a firm rely on a board of directors to supervise the managers. and SEC) are involved in corporate supervision. with control delegated to professional managers. in 1975. three major government organizations (the Ministry of Commerce. he/she often has the decisive vote. and after the enactment of the SEA in 1992. SEC was established as another supervisory agency. the Ministry of Commerce had the sole supervisory responsibility. The board therefore plays a pivotal role. SET. As in other crisis economies in the region. in most of Thailand’s publicly traded firms. II encourage market competition. This is due to the historical development of the Thai corporate sector: before 1975. SET was mandated to supervise listed companies. activate the market for corporate control.

requiring cumulative voting for the election of directors. they should be monitored and regulated. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. regulators must increase transparency and step up enforcement. increasing penalties for directors engaged in misconduct. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. Because these holding companies control a number of large public companies in Thailand. 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. there has been much progress in this area. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. and . SEC is exploring the possibility of amending the law toward this direction. This move is expected to be unpopular among founding family members and original owners. accountability. Through an amendment in the Public Company Act. the Government can change the shareholding limit for controlling shareholders. To ensure a level playing field. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. and a prohibition of connected transactions by directors or management.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. transparency. 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. The situation prompts two specific recommendations. The second recommendation is to dilute ownership concentration through the use of regulatory power. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. 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. Since the Asian financial crisis. The slow improvement in the legal framework has likewise obstructed progress in this area.

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. the power of the capital market to discipline inefficient management is almost nonexistent. while a strong domestic debt market will also offer protection from foreign exchange risk. Further. in turn. In the stock market. However. Vol. Accounting standards have also been under review. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. The first step is to establish an active secondary Government bond market. . Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. especially in the area of connected lending. will lead to the emergence of a reference yield curve. The same goes for improvements in the bankruptcy system. aimed at ensuring that banks finance only creditworthy projects. This may not be possible without reforms in the banking sector itself. which. II responsibility among companies. Capital Market Development and Regulation Another important issue concerns the development of capital markets. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. A well-developed domestic debt market will provide corporations with an alternative to bank financing.276 Corporate Governance and Finance in East Asia. there is a need to increase market disciplinary power through market competition. In an environment of highly concentrated ownership. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. it will be difficult to improve corporate governance in Thailand. Without a strong and efficient capital market. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. for instance.

PACAP-Thailand Database. The University of Rhode Island. Thai Accounting Standards. The Stock Exchange of Thailand. 1995-1999. The Stock Exchange of Thailand. 1998. Thailand. 1995. The Stock Market in Thailand. The Securities and Exchange Commission of Thailand. Fact Book. . Bank of Thailand Monthly Bulletin. 1995-1999. Kingston. Bank of Thailand. US. Ministry of Commerce. Department of Commercial Registration Database. Bank of Thailand. Bank of Thailand Quarterly Bulletin. Pacific-Basin Capital Markets Research Center. The Thai Bond Dealing Centre. 1997. 1997. Key Capital Market Statistics.Chapter 4: Thailand 277 References Annual Report. 1997-1999. The Securities and Exchange Commission of Thailand. 1995-1999. The Stock Exchange of Thailand. Bond Market Development in Thailand.

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