Corporate Governance and Finance in East Asia
A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand
Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank
© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term country does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines
List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51
2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance
53 53 55 55 60 62 65
iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214
v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226
4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References
229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277
Indonesia Table 1. 1993-1997 Table 1.19 DER and ROE of Publicly Listed Companies by Sector.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.10 Anatomy of the Top 300 Indonesian Conglomerates. 1996-1998 2. 1992-1998 Table 2.4 Development of the Stock Market.21 Nonperforming Loans by Type of Bank.11 CharacteristicsoftheBoardofCommissioners Table 1.7 Growth Performance of the Top 300 Conglomerates.16 FinancingPatternsofPubliclyListedNonfinancial Companies.5 Financial Performance of Publicly Listed Companies by Sector. 1997 Table 1.1 Growth of the Banking Sector.13 Presence of Board Committees in Listed Companies Table 1.12 CharacteristicsoftheBoardofDirectors Table 1.14 Banking Sector Outstanding Loans.15 V alue of Stocks Issued and Stock Market Capitalization. 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
. 1996-1998 Table 1. 1992-1999 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 1986-1996 Table 1. 1990-1997 Table 1.2 KeyMacroeconomicIndicators Table 2. 1992-1999 Table 1.vi
List of Tables
1. 1992-1997 Table 1.3 Subsidiaries of the 30 Largest Chaebols Table 2.2 Foreign Capital Flows. 1992-1995 Table 1. 1992-1997 Table 1. 1992-1997 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.1 Listed Firms with Positive Economic V alueAdded. Republic of Korea Table 2. 1993-1999 Table 1.18 GDP Growth by Sector. 1990-1998 Table 1. 1988-1996 Table 1. 1992-1997 Table 1. 1996-1999 Table 1.4 Growth Performance of Publicly Listed Companies by Sector.20 ROE of the Banking Sector.6 GrowthandFinancialPerformanceofState-Owned Companies.
23 Table 2.16 Table 2.vii Table 2.11 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.20 Table 2.14 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.6 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.22 Table 2.10 Table 2.13 Table 2.18 Table 2.26 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127
. 1995-1997 Ownership Composition of Listed Companies. 1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio.21 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.15 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.5 Table 2.28 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.27 Table 2.7 Table 2.12 Table 2.30 Private Capital Flows to Korea.19 Table 2. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.17 Table 2.9 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.29 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols.25 Table 2.8 Table 2.24 Table 2. 1997 Ownership Concentration ofAll Listed Firms. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 1994-1998 Financing Patterns of the Top 30 Chaebols.
14 Philippine Stock Market Performance.21 OwnershipConcentration.33 Net Profit Margins of Chaebols.31 Table 2.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3. 1988-1997 Table 3. andAffiliated Banks of Selected Business Groups. 1997 Table 3. 1983-1997 Table 3. Leverage Table 3. 1978-2000 Table 4.1 GDP Growth of SoutheastAsian Countries.20 Financing Patterns by Industry.11 TotalandPerCompanySales.1989-1997 Table 3. 1997 Table 3. 1985-1997 Number of Firms with Dishonored Checks. 1997 Table 3.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.17 Composition ofAssets and Financing of the Publicly Listed Sector.32 Table 2.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.12 Control Structure of the Top 50 Corporate Entities. Flagship Company.2 Public Offerings of Securities.19 Financing Patterns by Firm Size. 1988-1997 Table 3. 1997 Table 3.viii Table 2.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3.000 Companies.2 Growth and Financial Performance of the Top 1. 1988-1997 Table 3. 1990-1999 Table 3.13 ADB Survey Results on Shareholder Rights Table 3. 1989-1997 Table 3. 1992-1996 Table 3.15 Financing Patterns of the Corporate Sector. 1992-1999
.SectorOrientation.Profitability andFinancial . 1989-1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType. 1995-1998 4. 1989-1997 Table 3.22 Foreign Investment Flows. 1989-1997 Table 3.1 Public Companies Registered. Thailand Table 4. 1988-1997 Table 3. 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. 1986-1998 Nonperforming Loans of General Banks.3 TheCorporateSectorandGrossDomesticProduct.18 Financing Patterns by Control Structure.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. The Philippines Table 3. 1997 Table 3.
ix Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1992-1999 Offerings of Debt Securities.10 Table 4.8 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.14 Table 4.12 Table 4.7 Table 4. 1990-1998 Merger and Acquisition Activities. Leverage. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.2 Figure 3.6 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.11 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand.3 Table 4. Ownership Concentration. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.13 Table 4.1 Figure 3.4 Table 4. 1993-1999 Size and Composition of the Thai Financial Sector.1 Figure 1. 1992-1999 Common-Size Statements for Companies Listed in SET. 1990-1996 Financial Ratios of All Listed Firms. 1985-1999
237 238 239 241 242 243 251 252 256 258 259 260 261 262 264
List of Figures
Figure 1.16 Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.15 Table 4. 1990-1996 External Debt.5 Table 4.9 Table 4. 1985-1996 Average Key Financial Ratios by Company Size.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197
Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADBs financialsectorworkinitsdevelopingmembercountries.
Arvind Panagariya ChiefEconomist
Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.
ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholdersmeeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter
xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation
Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
On the other hand. and responses to the financial crisis. followed by finance (-26. The construction sector was the worst hit. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. or Thailand. However. 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. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. All sectors. except utilities.5 percent. patterns of financing. When the crisis hit the country. To facilitate even easier access to credit. Foreign creditors. Foreign debt reached more than $100 billion. this left the Indonesian economy extremely vulnerable. and
. contracting by 36. Section 1. 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. This study reviews the Indonesian corporate sector’s historical development. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies.6 percent) and trade (-18 percent).3 looks at patterns of corporate ownership and control. In this setup. particularly those with large foreign loans. patterns of ownership and control. In many instances. no doubt. Malaysia. these controlling families had political connections that allowed their companies to enjoy special privileges. II
rate reached 58.2
Corporate Governance and Finance in East Asia. how it has affected corporate financial performance and financing.2 presents an overview of the Indonesian corporate sector. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea. Section 1. and analyzes their importance to the corporate sector in Indonesia. the currency composition and term structure of corporate foreign indebtedness were causes for concern.5 percent. placed a high premium on these political connections in assessing the chances of being repaid. and how it contributed to the crisis. It analyzes the weaknesses of corporate governance in Indonesia. highly leveraged companies. were the ones most affected. short-term loans were used to finance long-term investments. Vol. These banks were allowed to operate even if they violated minimum capital adequacy requirements. prior to the financial crisis. The study also identifies family-based companies and corporate groups. posted negative growth. the Indonesian economy seemed to be in generally good shape. regulatory framework.
Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. In the early 1970s.Chapter 1: Indonesia 3
profiles the corporate sector’s governance characteristics. However.4 analyzes corporate financing patterns. in the course of the fight for nationhood from 1942 to 1950. Up until the mid-1960s. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.
1. Despite the oil revenues. and tobacco industries.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. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution.2 1. Subsequently. 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. substantial volumes of private investment entered the scene.and large-scale companies were dominated by state-run industrial concerns. while Chinese and indigenous entrepreneurs ran some large businesses in trading. Section 1.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. medium. textiles.
.2. Section 1. Not all items in the questionnaires were answered by the respondents.2 Section 1. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. how it was affected by the crisis.5 examines the corporate sector during the financial crisis in terms of its role. The industries that emerged were highly import-dependent and reliant on tariff protection. 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. and its response.
the dilution of corporate ownership. Last. 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. By 1987. In 1992. the value of manufactured exports overtook the value of oil and gas exports for the first time. During this period.2. 1. Second. But until the end of 1988. wood. the Government shifted its industrial policy toward the promotion of labor-intensive exports. the Indonesian industrial sector was quite diverse.
. mostly nonbank financial institutions and stockbrokers. produced consumer goods. Partly as a result of various government policies. Generally speaking. But these proved counterproductive because they limited the potential for capital gains to prospective investors. and related products) had shares in total exports that were rapidly increasing. II
the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits.4
Corporate Governance and Finance in East Asia. which dominated their respective sectoral outputs and markets. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. Vol. many founding owners of companies were reluctant to go public and dilute their corporate ownership. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. there were also many rapidly growing large-scale companies and business groups or conglomerates. the number of firms quoted in the stock market was only 24. a distinct industrial elite started to emerge. Third. A number of underwriters emerged.2 The Capital Market
The Government reactivated the stock exchange in 1977. exports of nonoil products (particularly textiles and footwear. In the 1980s. 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). even when new shareholders do not threaten the control exercised by the original owners. The equity market remained largely unappealing due to a number of factors. and employed the bulk of the industrial labor force. These were families with strong links to the political elite of the New Order. potentially subjects companies to greater regulatory scrutiny. First. While most of the companies were small. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates.
reduced restrictions on foreign exchange transactions. Through the years. with a total value of Rp16. However. The initial banking sector reform was introduced in 1983.5 trillion.Chapter 1: Indonesia 5
At the end of 1988. the number of listed companies in the stock exchange increased substantially. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs).
. the number of private domestic banks increased. The dominance of state banks started to erode. These included the opening of the banking industry to new entrants. Interest rate regulations on state banks and credit ceilings in general were removed. the controlling shareholder of these SOCs is still the State. Consequently. and increased access of domestic banks to international financial markets. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. Partly as a result of these reforms.3 The Banking Sector
Despite the development of the stock market. to date. 1. The Government also allowed foreign investors to buy up to 49 percent of listed shares. which up to then was channeling oil revenues to priority sectors. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. began to face competition. with a total value of more than Rp8 trillion. Thus. the banking sector has been and still is the major source of credit for the corporate sector. But in terms of assets per bank. Conglomerates carried out 210 out of 257 IPOs.1 shows that from 1994 to 1998. six SOCs had issued equities in the market. In 1988. During this period. from 24 in 1988 to more than 300 in 1997. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. Since 1977. companies could no longer enjoy low-interest credit from state banks. private domestic banks dominated the sector in terms of number and total assets. more significant reforms were introduced. However. which were previously constrained to 4 percent per day. However. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. Table 1. the banking sector has undergone many reforms. The banking sector. the capital market played an increasing role in raising long-term funds needed by the corporate sector. state-owned banks were still among the biggest.2.
7 27 37.3 30 7.1 240
. But the banking system proved incapable of performing its intermediation function.8 10 19.1 10 47.9 39 18.8 29 6. Because regulation was weak. The other banks among the top 10 were state banks.8 10 37.9 10 11.5 27 88. the 10 largest were all affiliated with major business groups.5 165 308. Of these.6 7 7.1 Growth of the Banking Sector.8 391.6 164 144 130 92 387. and Bank International Indonesia (ranked 9th). Bank Danamon.3 27 51.9 27 113.9 304.3 201.5 7 9.7 351.9 762.9 31 9.4 789. 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.2 10 14.3 10 17.6 7 12. banks could earn profits even when they did not gather and process information about risk.8 31 10.5 7 7 7 5 15.8 27
200. BCA. while BUN has been closed down by the Government.4 34 12.9 291. II
Table 1.4 10 35. Bank Danamon (ranked 7th).6
Corporate Governance and Finance in East Asia.8 166 248. Both BCA and BUN have shareholders linked to the former President Suharto.8 27 147.2 161 214.9 248.6 34 14.5 528. Vol.4 239 222 208 173
Assets and liabilities were concentrated in the top 10 banks.0 234
1994 104.5 27 66.6 240
141. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group). In terms of assets.
1993 100. Among private domestic banks. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). 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.
01 (2. especially through bank loans. In 1994.01) (0.88) — — — — — — 8. such as metal goods. foreign creditors were eager to provide financing to Indonesia. Increasingly.74 5. 1990-1998 ($ billion)
Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998
1. Source: IFS CD-ROM.2 Foreign Capital Flows. FDI flows were strong.
.09) (0. they still amounted to a large sum for the economy to absorb.4 Foreign Capital
The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs). Until the onset of the crisis. and footwear.33 (13. Most FDIs came in through joint ventures with business groups having strong political connections. IMF. 1. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. September 2000. From the mid-1980s until July 1997. when the financial crisis hit Indonesia.87 7.40) (0. as shown in Table 1.09) 1.09 1.48 1. But FDIs were only one form of foreign capital inflows to Indonesia. In effect.15)
— = not available. the Government allowed foreign investors to own 100 percent of an Indonesian company. Table 1.88 4.Chapter 1: Indonesia 7
Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way.10 5. foreign investment also had a strong presence in the services and infrastructure sectors.81 3. November 2000. Successive policy deregulation facilitated FDIs in various light manufacturing industries.59 billion in 1996.2.63) (1.11 3.00 2. except in certain strategic sectors. textiles.59 4. there was a phenomenal growth in direct borrowings by Indonesian corporations. 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. In the 1990s.50 (0. Net FDI flows increased to $5.2. Indonesia received capital inflows averaging about 4 percent of GDP. initially from Japan and the Republic of Korea.78 2. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). Between 1990 and 1996.
an interesting question is whether standard measures of corporate profitability and performance also indicated the same. Private borrowers preferred foreign loans since these were relatively cheaper. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. Between 1989 and 1992. This increased to 30 percent by the end of 1993. Vol. and conglomerates.
. In the 1990s. Consequently. The external corporate debt owed to foreign commercial banks was $67 billion.4 trillion in 1997. plus 4 percent for the depreciation of the rupiah. From 1987 to 1996. participation in the Indonesian stock market was exclusive to domestic investors. increasing the total trading value from Rp8 trillion in 1992 to Rp120. the average borrowing rate for dollar loans was 9 percent. of which two thirds were rupiah-denominated.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. Domestic corporate debt was about $50 billion equivalent. The following section looks at the growth and financial performance of the corporate sector. In September 1997. 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.8
Corporate Governance and Finance in East Asia. In November 1998. but declined to an average of 25 percent during 19951997. 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. 1. II
Up until the late 1980s. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. 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. Due to data constraints. state-owned companies (SOCs). foreign investors began to dominate daily trading. the analysis focuses only on publicly listed companies. foreign banks became a significant source of financing for the corporate sector. total corporate debt reached nearly $118 billion. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. the average foreign ownership of listed companies was 21 percent. The Government relaxed this restriction in 1988. with the onset of the Asian crisis. especially the short-term ones.2. By the end of 1997.
publicly listed companies as a group contributed less than 10 percent to GDP.8 percent between 1992 and 1996.5 34.0 12.Chapter 1: Indonesia 9
Publicly Listed Companies Table 1.4 1997 7. 1993.4 31. the average DER increased to 310 percent from 230 percent the
. 174 firms.1 220.7 3. Source: JSX Monthly (several publications).5 3.1 4.2 1995 37. Note: The number of firms is not identical for each year.7
— = not available. but turned negative in 1997. a Value added was assumed to be 30 percent of total sales. When the crisis battered Indonesia in 1997. Asset turnover was above 30 percent until 1996.3 shows the growth and financial performance of Indonesian publicly listed companies. 1995. 226 firms.9 37.5 34.3 3.4 1993 45.1 percent in 1997 when the crisis began to buffet Indonesia.8 220.7 — 250.0 10. Table 1.3 Growth and Financial Performance of Publicly Listed Companies.2 7.4 1996 18. averaging 3. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.6 1994 50.6 3.4 percent.4 38.0 12. but dropped to 1.7 percent in 1997. 1994. Despite such rapid growth. 250 firms.6 percent in 1997. ranging from 220 to 250 percent between 1992 and 1996. b Asset turnover is defined as sales over assets.0 3.
Average return on equity (ROE) of listed firms was 11. In 1997. although the contribution increased over time.9 310.1 0.0 6. Return on assets (ROA) was also relatively stable during 1992-1996. there were 204 firms.6 24.8 230.0 33. total sales of listed companies grew at an annual average rate of 31 percent.2 30. 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 — 3.0 1.5 37. and 1992. During 1992-1997.0 11. 246 firms. but declined to 0.6 48.3 6. 1996. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. but fell to 24.0 64. 248 firms. The growth of listed companies was sustained by continuing investments.0 12.5 240. while total assets grew at 43 percent.8 6.
previous year. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. and trade) even posted
. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. although asset turnover was slow. the dominant sector was the finance sector. Also. the mining sector had the highest ROE. Meanwhile. in terms of growth of sales and assets.10
Corporate Governance and Finance in East Asia.4). real estate. consumer goods. finance. indicating its reliance on equity to support growth. the property sector was severely affected by the crisis.73 percent in 1992 to 1. the mining sector ranked first. miscellaneous industry. ROA of all sectors dropped in 1997. Overall. For instance.64 percent in 1997. mining. From 1995. basic industry and chemicals.5 presents the financial performance of listed companies by sector. meanwhile. and services. due mainly to the domination of the International Nickel Company of Canada. Table 1. The finance. infrastructure. followed by agriculture (Table 1. However. the mining sector had the lowest DER. investment. investment. only two sectors (mining and finance) showed a consistently increasing trend from 1992. In terms of share of value added to GDP. miscellaneous industry. helped in part by the relatively strong demand for consumer goods. During those years. Before the crisis. trade. and property. The same applied to the trade sector.2 in 1997. In terms of sales and asset levels in 1997. still posting a positive but lower ROE. property.3 percent between 1992 and 1996. when the property sector was booming during 1993-1997. The consumer goods sector ranked second in terms of ROE. property. averaging 17. and trade. real estate. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. This sector was less affected by the crisis. the banks eagerly provided credit to property development companies. Four sectors (basic industry and chemicals. and building construction. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. ROE fell drastically because the sector had one of the highest DERs. the companies in the sector did not operate with a high leverage. averaging 21. increased from 0. Vol. The finance sector’s contribution to GDP. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged.7 percent during 1992-1996. But the sector’s ROE fluctuated a lot. and services. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. with ROE falling to -11. which operated in nickel and copper mining in 1992 and 1993. When interest rates increased. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks.
.1 32.2 5.7 34.0 0.9 54.1 1.4 1.4 64.3 (203.5 53.9
1994 (75.7 (82.5 23.7 — 36.7) 26.1 0.0 22. Investment.2 41.7) (113.4 103.4) 8.2 59.7 90. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.1 1.1 35.0 0.5 0.8 28.0 43.4 170.7 0.5 0.8 66.5 68.7 133.5) 49.7 — — 11. Constn. Source: JSX Monthly (several publications).1 28.2 11.4
1993 155. 1992-1997 (percent)
Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.8 (76.8 1.0
58. Industry Consumer Goods Industry Prop.1 0.2 14.9 64.6 (41.4) 6.6 22.2 13.5 61. Real Estate.0 1.5 9.9 (7.1 0.9 59.6 26.0 18.7 62.6 24.7 21.7 40.7 24.0 0.3 0.1 1.1 0.4 (149.5 1.1 (11.1 — 39.3 31.0) 46.5 45.5 28.6 135.3 31.1 71.0 (28.6 (0.8) 0.9 53.7 112.9 0.5 (11.3 92.9 1.8 50. Industry Consumer Goods Industry Prop.9 0.6) 19. Real Estate.3 0. and Bldg. Real Estate. Industry Consumer Goods Industry Prop.3 0.5 1.5 95. Infrastructure Finance Trade.9 54.0 16.0 68. and Services
— = not available.6 0.9 25.1 42..3 17.7 54.4 44.9 123. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.7 17.1 0. and Bldg.1 0.4 30.6 1. Constn.6 0.1 0.8 27.7
1995 51.4 Growth Performance of Publicly Listed Companies by Sector.1 1.2 0.3 0.
1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.1 0.0 24.4 43.9 8. Real Estate.6 51.9 14.3) 39.3 0.5) 6.2 41. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.4 1.4 1.0 0.8 51.0 0.6 85..4 0.Table 1. Infrastructure Finance Trade. Investment. Infrastructure Finance Trade.1 67. Investment.8 24.2) 0.6 0.7) 17.8 32.3 340.3 51.8 0.5 1.5 92.4 30.8 29.6) 25.6) 119.6 28.7 0.3 1.5 (8.7 28. Infrastructure Finance Trade.6 133.9 31. Industry Consumer Goods Industry Prop.6 83.5) 13. Constn.6 15. and Bldg.1 23.0 (192.4 21.5 13.2 35.0 31.7) (27.1 0.9 36. and Bldg. Investment.8) (12.8 1.6 0. Constn.0 (20.8 62.3) 53.4 31.1 16.0 0.1 1.7 43.2 0..4 38.1 (41.1 0.4 77.
1 7. Real Estate.0
1997 230. Industry Consumer Goods Industry Prop.0 180.9 4.4 13. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc. Investment.0 190.0 100.7 4.3 17. Investment. Industry Consumer Goods Industry Prop.4 35.1 2.0 50.5
1995 80.8 8. Investment.5 13.0 110.9 87. Constn. Infrastructure Finance Trade.1 65. Real Estate.2 8.0 70.3 17.2 3.3 18. Industry Consumer Goods Industry Prop.5 5.7 12.2 7.2 111.1 9.0 100.0 110.0 680.3 7.8 5.0 39.7 10.6 (11.0 150. 1992-1997 (percent)
Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.5 Financial Performance of Publicly Listed Companies by Sector.6 19.9 41. Real Estate.1 (3.3 1.8 3.1 4.8 20.0 100..6 23. Industry Consumer Goods Industry Prop.0 630. Infrastructure Finance Trade.7 4.7 10.2 15. Infrastructure Finance Trade.5 19.9 40.
1992 20.8 16.0 210.4 6.4) (1.0 70.7 1.1
1996 100.9 42.5 7.0 8.0 9.0 180.4 79.7 13. and Bldg.9 38.8 81.7 61.0 150.0 190.6 1.0 110.0
14.0 220.0 17.4 46.7 12.3 33.2) 7.7 5.. and Bldg..2 (4. and Services
Source: JSX Monthly (several publications).3 0.0 12.0 650.0 66.0 3.5 11.0 560.5 4.9 10.0 380. Infrastructure Finance Trade.1 8.4 4.2 53.9 7.0 100.8 67.8 11.7 5.5 14.3 38.0 15.2 6. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.4
.2 3.0 120. and Bldg.0 110.6 (2.1 1.1 6.7 10.0 110.5 43.6 8.8
382.0 86.0 110.7 9.8 168.3 5.0 180.8 479.8) 8.6) 18.0 (0.1 10.1 10.0 11.0 8.4 20.0) 7.9 29.0 150.0 110.1 63.7 46.0 170.0 160.1 4.3) 5.4 17.4 5.8 44.0 190.0 650.0 160.3 73.3 7.4 6.0 3.0 120. Constn.5 56.0 700.7 8.0 80.0 69.0 120.1
1994 80.0 90.7 71.1 9.0 140.Table 1.1 4.0 80.2 30. Real Estate.4 13.6 13.0 130.0 80.7 4.9 38.0 120.7 12. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.6 14.4 1.6 18.0 160.9 17.2) 15.4 35.8 25.6 8.6) 36.0 70.2 23.7 1. Constn.7 26.2 7.1 (5.0 46.2
1993 130.1 13.0 60.9 14. and Bldg.2 13.6 74.5 4.1 11..5 17.4 71.8 11.2 11.4 46.2 39. Investment.7 (3.3 13.3 64.1 3. Constn.1 89.7 8.0 19.6 13.8 9.0 140.1 10.
Chapter 1: Indonesia
negative ROA.3 trillion. but dropped dramatically to 4. growth of net profits and assets was erratic. Trade had the highest ROA of 39. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. respectively. there were 165 state-owned companies (SOCs)3 in Indonesia.4 percent the following year. and finance company (four companies). This was due to large sales by the National Oil Company (Pertamina). much lower than that of companies listed in the stock exchange. the ratio decreased from 8. SOCs actively operated in various sectors4 under the supervision of “technical” departments.7 percent.1 percent in 1992 to 28. Assuming a fixed ratio of value added to sales.
.6). the Department of Finance supervised 30 SOCs. insurance (11 companies).7 percent in 1990 to 6 percent in 1996. and basic industry and chemicals sectors had relatively stable ROA before the crisis. banks (seven companies).8 percent between 1992 and 1995 (Table 1. SOCs diversified into many businesses.6 to 8. the subsidiaries and affiliates number 459 with total assets of Rp343. there were 58 SOCs with subsidiaries and affiliates. However. but it continuously declined from 370 percent in 1992 to 250 percent in 1995.7 to 7 percent for publicly listed companies. While asset turnover rates of publicly listed
SOCs are those in which the State has at least a 51 percent equity interest. SOCs’ sales growth fluctuated during 1990-1996. This was relatively high compared to the 3. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). registering an average annual rate of 10 percent. Just like private companies. increasing from 21.3 percent in 1995. SOCs’ ROE ranged from 6. The finance and miscellaneous industry. which collectively had the largest assets. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. indicating SOCs’ declining contribution to GDP. These growth rates were low compared to those for listed companies during the same period. For instance. ROA had been at high levels from 1992 to 1995. Asset turnover rates were lower relative to those of publicly listed companies.1 percent in 1993. Six SOCs were listed in the Jakarta Stock Exchange. Similarly. Taken together. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. By 1995. The DER was slightly higher than for listed companies. State-Owned Companies At the end of 1995. averaging 24 and 31 percent. between 1993 and 1995.
1995 25.2 percent in 1997 (Table 1.6) 260.1 19.1 12.0 6.7 13.4
1993 16.3 250.4 16. 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. the contribution of conglomerates to GDP increased from 12. Source: Indonesian Data Business Center.4 percent in 1994.6 28.2 23. Assuming a constant ratio of value added to sales.8 11. Source: Indonesian Data Business Center.5 percent in 1995.7). 1990-1997 (percent)
Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.3 30.0 8.4 13. a Value added was assumed to be 30 percent of total sales. Their total sales increased from Rp90.0 28.2 18.6 28.
.3 12. but climbed to 30.6 percent in 1994.
1992 — 7.5 3.4 13.1 30. but dropped to 11.7
1994 (9.7 Growth Performance of the Top 300 Conglomerates.1 trillion in 1990 to Rp234 trillion in 1997. a Value added was assumed to be 30 percent of total sales. mostly private companies.0 7. Vol.1 32.5
Conglomerates This study used available data on the top 300 conglomerates in Indonesia.0 12.1) 5.8 21. b Asset turnover is defined as sales over assets.4 13.6 Growth and Financial Performance of State-Owned Companies.1 6.8 12. these conglomerates owned 9.14
Corporate Governance and Finance in East Asia.2
— = not available.7 16.0 17.766 business units.4 7. In 1997.2 — 370. Table 1.7 (2.8 percent in 1990 to 13. SOCs’ asset turnover rates showed a downward trend from 32.0 8.0 24.1 310. II
companies consistently declined over time.4 percent in 1992 to 28. Table 1.
The BOC. This guards against shady intercompany dealings within a group of companies. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. and consolidations.2. commissioners. and the board of directors (BOD).Chapter 1: Indonesia
1. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. and the attendance should at least be two thirds of total shareholders. For instance. and the accountant. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. The company charter details the issues that need shareholder meeting approval. If the BOC does not perform well. tasked with supervising the firm. The law replaced an earlier statute that was based on the Dutch system. the Government promulgated a number of laws and regulations to protect investors. shareholders lose control. acquisitions. however. For example. For mergers. except in strategic issues stated in the law. By international standards. the decision to use certain company assets as collateral for bank credit might need BOC approval. as representative of shareholders. mergers. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. the legal and regulatory framework of the corporate sector was far from adequate. The law also holds the directors and commissioners jointly responsible for decisions made by the company. For instance. such as the appointment (or replacement) of directors.6
Legal and Regulatory Framework
During the 1990s. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). an approval needs the majority (50 percent plus one) vote. In general.
. and declaration of bankruptcy. tasked to provide direction to the company. is the only shareholder mechanism for monitoring and controlling the BOD. The meeting decides on important issues.
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. (v) preemptive rights on new share issues. (xvii) mandatory independent board committee. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. (vii) the right to call an emergency shareholders’ meeting. investment managers. and other supporting agencies. It also regulates reporting and auditing procedures. The law is supplemented by Government regulations. brokers. (vi) one share one vote. and administrative and legal punishment. (viii) the right to make proposals at the shareholders’ meeting. (iii) proxy voting by mail. consolidations. (ii) proxy voting. (ix) mandatory shareholders’ approval of interested transactions. (xiii) mandatory disclosure of nonfinancial information. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. such as custodian banks and the securities registration bureau. Vol.16
Corporate Governance and Finance in East Asia. Controlling shareholders have no vote on the matter. (x) mandatory shareholders’ approval of major transactions. (xvi) independence of auditing. (xi) mandatory disclosure of transactions by significant shareholders. (xii) mandatory disclosure of connected interests. (xv) mechanisms to resolve disputes between the company and shareholders.
. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. II
acquisitions. (iv) cumulative voting for directors. and bankruptcy. the decision should be approved by three fourths of the shareholders present. Because of such requirements. insider trading (including market rigging and manipulation) investigation. securities companies. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. investment advisors. underwriters. It regulates the requirements of investment companies. 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. transparency requirements. and guidelines promulgated by the head of capital market supervision. A tender offer is also required for acquisitions of up to 20 percent of listed shares. and the attendance should at least be three fourths of total shareholders. decrees of the finance minister. and (xviii) severe penalties for insider trading.
creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. etc. capital adequacy.. For instance.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.
1. or 20 shareholders. Banking regulations also set lending limits. 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. A Commercial Court was also set up to deal with bankruptcy cases. holding companies. for instance.Chapter 1: Indonesia
Bankruptcy Law Despite loan covenants.3. 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. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. families. whether they are individuals. It reveals characteristics of controlling shareholders.
. or financial institutions. the viability of a project). amended in October 1998. states that a bank is not allowed to provide credit without collateral. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. net open positions. Discussions on corporate ownership cover listed companies and conglomerates. The two most important elements of ownership structure are concentration and composition. the Banking Law (1992). the collateral could take the form of nonphysical assets (e. five.1 Corporate Ownership Structure
Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). A new bankruptcy law was passed in August 1998.g. 1. It aimed to protect creditors by providing easier and faster access to legal redress. Ownership concentration is usually measured by the proportion of shares owned by the top one. However.
7 1996 48.9 14. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.5 16. issued 93.0 2.1 0.5 1997 48.2 1.6 13. and basic industry and chemicals sectors than in others. consumer goods.8 68.2 11.0 1.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table).1 1.9 0.5 Average 48. The percentage owned by each of the five largest shareholders was 48. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48. Vol.6. 1993-1997 (percent)
Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.8 68.2 67.18
Corporate Governance and Finance in East Asia. The pattern of ownership concentration changed little over this period. for instance.6 4. Rig Tenders Indonesia (shipping services) issued 51.9
Source: The Indonesian Capital Market Directory.9 percent of total outstanding shares.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. When a company goes public.7 3. II
Publicly Listed Companies Table 1. Meanwhile. the controlling shareholders usually act as standby buyers.9 2.0 67. On average. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. When a company makes a rights issue. 3.3 1995 47. 2.8. This is because a few companies in the transportation sector issued high proportions of shares to the public. the five largest shareholders owned 68. and 0. Zebra Nusantara (taxi services).
Table 1.9 2. mining.4 2.0 4.1 13.6 percent.6 68.0 0.1 4.7 1994 48.6 3.6.5 12. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. the founder usually continues to own the majority of shares through a
. 13.8 1.5 72. respectively. This preserves the pro rata share of existing shareholders.6 3.8 Ownership Concentration of Publicly Listed Companies.9. Table 1.4 percent.5 percent.0 0.
Investment.4 54. and the efficiency of the judicial system.4 4. and only 0.9 0.Chapter 1: Indonesia
fully-owned limited liability company (Perseroan Terbatas). Claessens et al.2 46.4 44. (1999) also found.6 1.1 1.6 percent of total market capitalization while the top 15 families control 61. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in
. Infrastructure. and Transportation Finance Trade.6 2.1 percent) of Indonesian publicly listed companies were in family hands. in a cross-country study.1 0.6 percent were widely held. Real Estate.3 0.9 Ownership Concentration of Publicly Listed Companies by Sector.5 58.2 0. In terms of capitalization.1 1.4 11.6 0. is strong. (1999).4 1.5 4. that the correlation between the share of the largest 15 families in total market capitalization. two thirds (67.1 0.1 2..8 14. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.7 1.7 percent of the market.
First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54. on the other.1 1. In fact.3 48.2 2. Industry Consumer Goods Industry Prop. and Services Average
Source: The Indonesian Capital Market Directory. as well as the existence of corruption. 1997 (percent)
Sector Agriculture Mining Basic Industry and Chemicals Misc. the top family controls 16.7 4.3 36.7 13. 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.. Indonesia has the largest number of companies controlled by a single family.9 44.2 10.6 9.5 1.1 2.7 9. the rule of law. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.3 14.1 13.7 6. which shows that in 1996.6 8.1 2.9 50. Constn.1 11. Util.0 5.2 15.2
This is confirmed in Claessens et al.1 1.9 3. Table 1.9 44.3 0.3 2.4 6. and corruption. and Bldg. on the one hand.9 1.
the Government allowed foreign investors to buy up to 100 percent of listed shares. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. Indian. This may indicate that the New Order Government. From 193 in 1988. During 1988-1996. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits.20
Corporate Governance and Finance in East Asia.
. or other ethnic groups. However. Vol. and Padang. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. But these benefits are few and often dubious compared to the high costs of concentration. In September 1997. the proportion of foreign ownership declined from 27. ethnicity. numbering 162 in 1988 and 170 in 1996. II
the small number of families and the tight links between companies and the Government. Batak. their number increased to
In 1997. In Indonesia. it rose to 30 percent. The nonindigenous businesspeople are usually Chinese. Sundanese. the legal system is less likely to evolve in a manner that protects minority shareholders. resulting instead in a decline in the proportion of foreign investor ownership. was able to create a favorable environment for business development.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. Among the top 300 conglomerates. However. Coordination is easier because informal communication channels exist. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. 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. political affiliation.5 Conglomerates Table 1. In 1993. most were established during the New Order Government.55 percent in August to 25. the onset of the crisis negated this development. conglomerates established before 1969 dominated in terms of sales. and family origin. with all its regulations. foreign ownership increased to 21 percent. Indigenous businesspeople include the Javanese.42 percent in December. but later declined and steadied at around 25 percent. accounting for 64 percent of total conglomerate sales in 1988-1996.
more than five times its 1988 level. Meanwhile.4 31.8 28.2 48. For instance.6 54.6 34.3 134.10 Anatomy of the Top 300 Indonesian Conglomerates.9 77.7 89.5 22.8 30.4 15.3
20.7 28.7 49.7 24.4 57. Conglomeration Indonesia 1997.6 77.
204 in 1996.4 32.8 38.9 trillion.9 14.4 trillion in 1996.4 81.7 64.9 35.5 106.4 86.4 59.4 69.6 114.1
95.1 33.6 12. 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
9.0 44.1 percent of total
.0 31.1 42.7 106. due to their “go public” activities. Their total sales also increased from Rp38.4
22.2 33.3 120.4 52.8
12.5 120.4 18.1 58. In 1996.0
15.2 23.2 12.2 29.1 46.6 trillion in 1988 to Rp137.3 43.Chapter 1: Indonesia
Source: Indonesian Business Data Centre.9
13.8 68.8 25.4 68.2 159.9 137.3 101.7 40.6 17.3 80.4 19.1
25.1 179.3 36.6 95.1 41.8 36.9 42.2 30. its sales reached Rp1.1 87.2 76.0 58. the number of mixed groups declined from 86 in 1988 to 68 in 1996. While they supplied 20.9 billion.0 28.4 31.1 52.9 47.1 46.0 116.4 16.4 48. sales of the Bakrie group before it went public in 1990 were only Rp369.8 57.0 58.4 37.4 59.1 103.9 73.8 49.0 18.5 21.
Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). In November 1997. or have resulted from alliances between entrepreneurs and officials. But only a handful of these companies are listed in the market. their contribution declined to 13. Out of 174 companies.22
Corporate Governance and Finance in East Asia. and Fast Food (restaurants). there were 175 groups that originated from a family business. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. But listed companies within conglomerates were few. In 1997 and 1998. collectively controlling
sales in 1988. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. average sales of official-related conglomerates reached Rp1. compared with the less than Rp700 billion of a nonofficial-related conglomerate. In 1996. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo).2 trillion. and Wisnu Suhardhono of Apac-Bhakti Karya. Some of them later became public companies by listing in the stock market. which is the largest conglomerate in Indonesia. The Salim group. 117 are jointly owned by the family and 57 are owned by individual family members. Vol. The Suharto family is the largest stockholder in Indonesia. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. Bambang Rijadi Soegomo. for instance. Bank Indonesia. including Indofood Sukses Makmur (food industry).7 percent in 1996. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. In 1996. Only about 13 percent were formed by official or ex-official families. Most of the top 300 conglomerates were established by ordinary citizens. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. Prudential credit analysis tends to be ignored. owns four groups with many subsidiaries and affiliate companies. Indocement Tunggal Prakarsa (cement industry). and Ibrahim Risyad of the Salim group.and officialrelated groups. Djuhar Soetanto. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Conglomerates were also classified into nonofficial.
Some of the groups related to officials have a unique share ownership structure. Semen Cibinong. Both are listed companies and members of the Salim group. If the family members cannot actively manage the companies as directors. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). Cross-holdings between financial and nonfinancial firms potentially create more serious problems. In so doing. many of whom. continue receiving some kind of protection and special treatment. But it is difficult to obtain data on cross-shareholding among firms. While the source of the
. This is because cross-owned banks had to consider not only their own interests.. or both. In 1996. for instance. The Salim Group is also in part controlled by the Suharto family. He or she could either be the biggest shareholder. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders.1). they still control the work of the directors. served in some government function (see Figure 1. and hence. Although some groups employ professional managers. but those of the entire group. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. Indonesian law allows cross-shareholdings. 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. Although they are not actively involved in the daily operations of the companies. with no restrictions. as well as other relatives and business partners. families mostly manage the groups and make strategic decisions themselves. besides Suharto himself. or someone very close to and trusted by the controlling shareholders. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. the controlling shareholders are able to maintain their special relationship with officials. Cases in point are the Bank Papan Sejahtera and Bank Niaga.Chapter 1: Indonesia
assets worth $24 billion (Claessens et al. they maintain their position as commissioners. The families retain control of the companies through ownership. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. The BOC chairperson often represents the controlling party of the company. management. 1999).
Who Controls East Asian Corporations? Financial Economics Unit. (Feb. and Larry H. Simeon Djankov. Financial Sector Practice Department. World Bank.
. 1999).Figure 1. P. Lang.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
17 firms with control over 20%
Bimantara Group (son Bambang)
8 firms with control over 20%
Kabelindro Kiani Murmi Sakti
Source: Stijn Claessens.
2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia
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.Chapter 1: Indonesia
problem is inconclusive.
. the BOC has the right to obtain any information concerning the firm. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange.3. role and protection of minority shareholders. This is based on the Dutch system. As the owners’ representatives. one possibility is that legal lending limits had been violated. 1.2 Management and Internal Control
A company’s internal organizational structure determines how shareholders control management. Shareholders are at the top of the organization. Therefore. seek an audience with directors. including the boards. the BOC supervises the work of directors. the directors. Figure 1. request a shareholders’ meeting. and accounting and auditing procedures. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. The managers execute the BOD’s decisions and lead employees in their departments. management and managerial compensation. and. The BOD leads the company and makes strategic and operational decisions. if necessary. both controlling and minority.2.
Corporate Governance and Finance in East Asia, Vol. II
Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
Chapter 1: Indonesia
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
Corporate Governance and Finance in East Asia, Vol. II
Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
Chapter 1: Indonesia
provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
Corporate Governance and Finance in East Asia, Vol. II
Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were
The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. at a large profit. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. This used to be a common practice in companies associated with the Suharto regime. They then replaced the BOD and later sold the bank. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced.6 In this case. except for publicly listed SOCs. the Government took over NPLs and put them under IBRA management. the owner of Tirtamas group. Since the NPLs reached up to Rp300 trillion. However. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. appointment of management.
. In these two latter cases.
Later in March 1999. 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. State ownership for listed SOCs ranges from 25 to 35 percent. The bank was reported to have high NPLs and had broken the legal lending limit. it was common for the Government to invest in certain private companies.Chapter 1: Indonesia
external acquisitions. or direct subsidies. with the minister’s approval. In the massive restructuring of the banking sector that commenced after the crisis. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. Most Indonesian state companies are 100 percent owned by the Government. the bank was liquidated. which was acquired by Yopie Wijaya in 1995. Before the financial crisis. The Government appoints the BOD and BOC of these firms. to Hashim Djojohadikusumo. Wijaya and his friends bought shares of the bank on several occasions until they gained control. IBRA found itself tasked with managing large amounts of assets in the private sector. In April 1999. Bank Niaga was under a recapitalization program. For instance. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. a state-owned insurance company may invest its funds in a private firm. the acquiring interest was apparently seeking economic profits. One famous takeover was Bank Papan Sejahtera. restrictions on market entry. who was acquiring his second commercial bank. Control by the Government Government control could be in the form of state ownership.
2 71.4 56.4.1
Corporate Financing Financial Market Instruments
Prior to 1977.3 9.4 trillion in 1998.6 3. including bonds.4 24.8 193.32
Corporate Governance and Finance in East Asia.9 trillion in 1992 to Rp487. the share of private national banks in outstanding total loans increased to 44. Vol. 1992-1999 (Rp trillion)
Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total
Source: Bank Indonesia.4 86. stocks.5 7.9 150.9 234. new instruments have been introduced to the corporate sector.0 487. remain the major financing instrument for the corporate sector.4 1. However.6 292. bank credit surged from Rp122.7 50. Since then.2 27. because of the restrictions discussed below. equities became available to the corporate sector.5 42.3 188. companies considered alternatives to bank loans.
68.5 108.7 112. jointly providing almost 90 percent of loans until 1997.0 168.6 6. however.6 4.14 Banking Sector Outstanding Loans. II
1.7 122. Private national banks and state-owned banks were the biggest domestic creditors.5 80.14. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).9 378. and others offered by nonbank financial institutions or finance companies.2 5.4 225.3 60. Table 1.6 percent in 1997.6 150. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. Bank loans.1
Equities In 1977. this market was not well developed. From 34.3 66.
.9 153. Data from Bank Indonesia show that from 1994 to 1997.7 18. private national banks overtook state banks as the dominant credit source.0 3. Bank Credit As shown in Table 1.1
220.3 111.4 percent in 1992. when the Government reactivated the stock exchange.3 14.0 93.2 6.0 6.6 48.
shooting up to 18.1 10. credit cards.7 14.6 123. Prior to 1995.8 48.6 310. In 1988. The ratio reached 8.7 15. factoring.4
1996 1997 1998 50. thus increasing the role of the capital market in raising long-term funds.Chapter 1: Indonesia
Some companies went public. i.5
1995 35. and net open position).6 301.6 91. however.0 206.g. Table 1. legal lending limit.2 16.4 207. and consumer credit.. In 1995.1 18. the Government issued regulations to supervise and promote prudential practices in finance companies.
1992 1993 11.1 17.7
9.e.. the stock market has gained a bigger role in corporate sector financing (Table 1.0 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. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. when foreign investors were not yet allowed to purchase listed shares.15). 1992-1999 (Rp trillion)
Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization
Source: Bank Indonesia.9 406.5
Financing by Finance Companies Finance companies first emerged at the end of 1980. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity.15 Value of Stocks Issued and Stock Market Capitalization.
.6 859. It gradually increased again starting in 1991. capital adequacy ratio. They were not.1
1994 26. finance companies were increasingly used as channels for the inflow of foreign loans. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. offering services such as leasing. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.7 percent in 1997.5 333. Overall.0 15.9
76. allowed to accept deposit accounts from the public. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.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. During the 1990s.
2 26.2 Patterns of Corporate Financing
Table 1.1) 23.0 39.3 37.6 23.7 22.9 16.6 12.6 100.0 1991-1996 16.8 7. This is in contrast to the lower share of borrowings during the same period. short-term borrowings were greater than long-term debts. 1.0
— = not available.4 8. In the second half of the 1980s.3 (0. While banks had some exposure to these instruments. respectively.4 23. Table 1. 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). Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.6 8. which are unsecured negotiable promissory notes with a maximum maturity of 270 days.0 1986-1996 17.1) 23.
.5 percent and 36.5 (0. Thus in November 1995.0 100.5 11.3 16. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases. they were not rated by a rating agency. 1986-1996 (percent)
Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. at 81 percent of total borrowings.0 3.34
Corporate Governance and Finance in East Asia.3 14. otherwise it would be classified as a loss in the banks’ books.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.6 100. have been popular in Indonesia since 1990.5 21. Vol. II
Commercial Papers Commercial papers. 1996. In terms of composition.4.16 Financing Patterns of Publicly Listed Nonfinancial Companies.4 13. averaging 26.8 17.5 — 26. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).8 percent. PACAP Research Center.
Two telecommunications companies. All companies in the cement industry suffered from foreign exchange losses. in the context of Indonesia and some other countries.4.1 trillion. rising from Rp54.
.3 percent during 1991-1996. the pattern changed. Hence. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. Indofood registered losses of almost Rp1. was due largely to a rapid rise in long-term debts. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. 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.2 trillion (mostly foreign exchange losses). The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.3 Corporate Financing and Ownership Concentration
It has been suggested. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. the corporate sector’s high leverage. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. respectively.17 compares the DER of listed firms by degree of ownership concentration. Corporate debts grew over time. For instance. while Semen Cibinong’s losses reached Rp2. The results indicate that firms with higher ownership concentration tend to have a higher DER. Bank loans also surged when the banking sector was liberalized in 1988. also suffered from foreign exchange losses but managed to post profits of Rp0. with longterm debts increasing rapidly. which managed to post significant profits due to low exposure to dollar-denominated loans. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market.9 trillion.2 trillion. that ownership concentration may be associated with heightened risk-taking by companies. They also do not want to dilute corporate control and are more likely to finance growth with debt. These liabilities grew significantly because corporate expansion was largely financed by debt. Indosat and Telekom. which was masked by the rapid growth in investments. This amount doubled in 1997. Table 1.Chapter 1: Indonesia
In the 1990s. 1. Most corporate charters require commissioners to approve debt issues or sign debt agreements. corporate debts accounted for 39.6 trillion and Rp1. except Semen Gresik (an SOC). reaching Rp229.4 trillion in 1993 to Rp112. Of the various financing sources.9 trillion in 1996.
Corporate Governance and Finance in East Asia.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. aided
.0 1. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.0 386. Vol. and high ownership concentration among families with political affiliation. Table 1. Source: Author’s estimates. the private sector borrowed heavily in unhedged dollars. II
However. to maintain control of the company. As a result.358.0 351.5. 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.
1. 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. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. In addition. The test of the difference between the two means found the t-value of 1. 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.56 significant at the 10 percent level. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.1
The Corporate Sector in the Financial Crisis Causes of the Financial Crisis
Many intertwined factors led to the crisis. the borrowings swelled. Controlling parties rely on external financing to maintain their equity share and. decisions on debt are made with the implicit endorsement of owners. Between 1987 and 1996. heavy reliance of companies on bank credits to finance investments.5 1.
Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. The supervising agency was caught unprepared. As a result. A lot of short-term foreign funds were used to finance long-term investment projects..
.e. It was doubly difficult to exercise supervision when groups with political clout owned the banks. It was only in 1995 that some regulations on the activities of finance companies were contemplated. did finance many viable ventures. only created to serve the companies to which they lent. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group.Chapter 1: Indonesia
by the lack of an existing mechanism to supervise and monitor foreign transactions. It is not known if these regulations had an effect on nonbank intermediaries. 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. This often led to the violation of prudential credit management practices. averaging about 4 percent of GDP. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. The large supply of foreign funds. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. 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. In the process. to circumvent these banking regulations. 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. However. the level of corporations’ foreign debt could not even be ascertained. many firms became highly leveraged. 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. However. after all. those with high DERs) established their own banks. The Government later specified the legal lending limit and the net open position that banks had to follow. Conglomerates that had difficulty in getting loans (i. A director at Bank Indonesia revealed that in 1995.
banks did not lend on the basis of the soundness of the project. This fact was usually not disclosed in financial statements. and in the process maintain control of the company. In early 1998. This was often the case in the banking industry. of which $64. and power generation) require huge capital. Vol. politicians.5 billion was owed directly by corporations. Families retain control by keeping the majority percentage of outstanding shares. total private sector foreign debt stood at $72. Projects involving massive capital investments and long-term operating deals (in telecommunications. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. where private banks are usually in the hands of big businesses. partly because they used nominee accounts to register ownership rather than set up a holding company.
. Corporations were certain that they could roll over short-term loans when these fell due. II
By mid-1997. toll roads. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. most often to people who were close to the ruling regime. or both. and investing shares among nonfinancial companies within the group and in other groups’ companies. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. Collusion between big businesses and the political elite was widespread in Indonesia. as they had done so in the years before the crisis. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. there was also almost universal confidence that the economic growth would continue indefinitely. In many cases. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies.38
Corporate Governance and Finance in East Asia. They enhance their control over companies through cross-shareholdings.5 billion. but on the basis of who the borrower was. by setting up their own banks. Since the Government could not afford to undertake these projects. contracts were granted to the private sector.
0) (15.18 GDP Growth by Sector. and building construction.3 12. DER and ROE were calculated per sector. much higher than the 307 percent registered in December 1997.6 8.7) (8.9 3.2 8.4 7. except utilities.8) (13.8 0.7) 2. Forestry. and Fisheries Mining and Quarrying Manufacturing Electricity. and Business Services Other Services GDP 1996 3.1 6.6) (0.4) (0.370 percent.0 5.6 12.2 (1. and Water Supply Construction Trade.6) (3. The consumer goods industry reported the lowest ROE.6 13. The construction sector was the worst hit. 1996-1999 (percent)
Sector Agriculture. Table 1.0 2.1 5.1 (1. and 128 companies reported a total loss of Rp46.1) 1.0) 1999 2.8) (11. 53 companies reported negative equity of Rp6.0 3. and Restaurants Transport and Communications Financial. followed by property.58 trillion (meaning their losses were greater than the paid-up capital).7) (2.8 1997 1. Only 86 companies reported profits.52 trillion. Hotels. real estate. This continued in 1998.6 4. Most sectors showed significant increases in leverage. Sectors with lower ROE generally had higher DER.7 6.2
Impact of the Financial Crisis on the Corporate and Banking Sectors
Impact on the Corporate Sector Table 1.18 shows that growth in most sectors significantly fell in 1997. followed by the finance and trade sectors.1) (26.5) (18.
The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. Real Estate. indicating a rapid rise in
. when all sectors. Livestock. Gas.3
Source: Central Bureau of Statistics (Biro Pusat Statistik. as shown in Table 1.8 8.6 (36.7 1998 (0. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.8 7.24 trillion for the first six months of 1998. posted negative growth rates. BPS).4) 2.4 7.3 11.5. The average DER was found to be 1.4 5.19.Chapter 1: Indonesia
Third.1 (92.8 percent in 1996.0) (78.0 219. foreign exchange losses came about with the use of unhedged foreign debt.0 111.0 108.21.2 13.
rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. First.4) 18.0 1998 186.1) 7.0 307.0 65.1 (3. the NPL ratio had reached more than 60 percent. The huge losses suffered by most companies were caused by three factors.0 105.2) (264. 1996-1998 (percent)
DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.0 72. Financial and banking analysts estimate that by September 1998.0 108.7) 6. Impact on the Banking Sector Table 1.1 1.7 1. and would have kept on increasing if interest rates had not declined.1)
Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 12.
. but annualized to approximate full year values. several publications. losses in operation were due to declines in sales and increases in the cost of imported inputs. small foreign banks enjoyed the highest profits.19 DER and ROE of Publicly Listed Companies by Sector.0 631.6) (115.0 177.0) 10.0 1. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.1 (5.9 12.5 8.0
ROE 1996 1997 1998a
14. a Actual data for 1st semester only.370.8 (373.20 reveals that the banking sector’s ROE decreased significantly in 1997. as shown in Table 1.2 23.5 percent in April 1998.0 158.0 2.8) 36.0 1. the NPL ratio rose to 25.7 percent in July 1998. from only 8. Vol.0 193.0 163. Mostly suffering from a liquidity squeeze.6 (11.271.0 205.0 2.0 1997 234.2 (4. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.0 635.0 1. Source: JSX Monthly.0 177. II
Table 1.4 (6. As the rupiah weakened and interest rates increased.625.0 92.0 697.40
Corporate Governance and Finance in East Asia.4 5.3 7. This figure further increased to 47.6) 15.8 17.0 229. Second.0 191. private banks posted negative ROEs in the same year.1 30.0 864.4) 8.395.097.0 97.1 (124.
81 13.2 37.1 13.6 6.1 30.9 Regional Foreign and Development Joint Venture Banks Banks — 9.47 20.70
1995 7.6 — 13.20 ROE of the Banking Sector.7 106. coupled with negative spreads (deposit rate was higher than the credit rate).69 14.91 21.1 274.
State-owned banks initially had the highest NPL ratio.21 Nonperforming Loans by Type of Bank. Source: The National Banking Association.2 48.07
1994 14.1 1.15 20.24 15.Chapter 1: Indonesia
Table 1. In July 1998. 1992-1997 (percent)
Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total
— = not available.3 361.7 — 1.20)
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 331.09 (11.43 10.7 29.
.44 15. 230/1998. private national banks overtook State-owned banks when their NPL ratio jumped to 57.72 16.9 percent.12 15.3 22. put pressure on the banking sector.2 — 8. The high and increasing NPLs.1 198.28 5.84 27.68
8.1 47. 1996-1998 (Rp trillion)
State-Owned Banks — 140.9 11.50 9.5 128.8 187.2 1.2 8.
1992 7.24 (4.2 — 19.5 31.38) 11.30 5.0 — 4.2 8.73 30.5 2.0 — 32.09 11.9 297.6 — 4.3 445.45 —
1993 15.25 22.8 14.8 8.86 11.3 Private National Banks — 179.39 13.5 222.34 16.67 8. however. July No.9 — 11. 227/1998 and October No.89 27.4 7.7
— = not available.8 11.2 10.37 19.07 13.06 20.5 57. Source: Infobank.45 21.0 622.2 47.0 129.8 3.7 4.5 34.6 — 1.
Astra International (automotive).3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997.42
Corporate Governance and Finance in East Asia. In June 1998. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Corporate debt accounted for 46. The scheme encourages negotiation between creditors and debtors. 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. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.7 billion of foreign exchange debt. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements.7 percent ($64. only a
. Aside from being described as overly complicated. II
1. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. Since September 1998.5. Unfortunately. and Ciputra (property business). the committee launched the Jakarta Initiative. by mid-September 1998.000/$1) in debt from domestic commercial banks. none of the 2. On 9 September 1998.000 eligible firms had signed up for the scheme. a more comprehensive scheme to tackle domestic and foreign corporate debt. Vol. particularly in terms of debt resolution. companies were not servicing their debts. a number of prominent companies. few companies were in a position to resume interest payments. While the process of restructuring was in progress. In November. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. Thus. assembling the legal and policy framework to facilitate corporate restructuring. about 80 percent of which was private. In addition.4 trillion of domestic debt and $6. However.2 billion debt. 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. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. the Government and private sector formed a committee to help corporates deal with the crisis. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. such as Garuda (a national flag carrier). By end-November. have been subject to restructuring deals under the initiative.6 billion) of Indonesia’s total external debt in March 1998. the scheme failed. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps.
Debtors. lay off workers. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. 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. Astra International. as well as general commercial disputes. In the banking industry. for equity infusion. For instance. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process
. especially in preventing unjustifiable delays in the adjudication of bankruptcy. and sell noncore businesses or nonoperating assets. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. under which the latter would become one of the bank’s shareholders.Chapter 1: Indonesia
few companies reached agreement with their creditors on this. consolidate business units.. some companies attempted to restructure their businesses on their own. Bank Niaga also negotiated with some of its creditors. When credit from the banking sector became unavailable and interest rates increased significantly. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. Moreover. plantations. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). A Commercial Court was set up to handle corporate restructuring and debt settlements. Meanwhile. mining. and mining equipment. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. Standard Chartered. i. 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). Rabobank and Citibank. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. with the requirement that adequate compensation and protection will be provided to such creditors during that period. Bank Bali agreed on a debt-to-equity swap with its creditor. the companies’ financial performance deteriorated. a publicly listed company operating in the automotive industry.e. forcing them to cut costs.
Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. 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 bias in favor of debtors has retarded the pace of corporate restructuring. the measure had only a minimal impact. companies were allowed to sell shares only by issuing stock rights. in consultation with IMF and the World Bank. and recapitalization of state banks. collusion. since the market reflects the condition of the economy. To push bankruptcy reforms. II
to achieve liquidation of the company. including procedures for handling operational issues and processing bankruptcy cases. Capital Market Reform In the capital market. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. (ii) the resolution of nonviable private banks. There will be changes in the implementation of the bankruptcy law. the Court’s early record has been a disappointment. is also reviewing the Bankruptcy Law. Previously. with only 17 cases filed as of November 1998. 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. and nepotism (anti-KNN) was signed in 1999. However. (iii) the merger. reform. Vol. The Government. Rather. and (v) a strengthened banking supervision system. Realizing that they undermine investors’ confidence. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. In the longer term.
. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public.44
Corporate Governance and Finance in East Asia. The Government has also been concerned with the issue of capital controls. However. the Government did not impose restrictions nor did it attempt to regulate capital flows. legislation against corruption. The Court has also declared only two companies bankrupt.
Bank Indonesia has announced a recapitalization program for potentially viable private banks. A new central banking law. and Recommendations Summary and Conclusions
Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. providing Bank Indonesia with substantially enhanced autonomy. Banks deemed ineligible for recapitalization will be closed. Other Regulatory Reforms To push corporate restructuring further.
1.Chapter 1: Indonesia
In 1997. The importance of this legislation may need to be emphasized. The merger process will be finished within two years.6 1. and Bapindo) will be merged into one bank named Bank Mandiri. improvement of rules and prudential regulations. the Government established IBRA to supervise problem banks. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. and follow-up action on bank restructuring. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. However. The four state banks (BDN. In particular. Liquidity support given to troubled banks should be repaid in four years. The Bank Indonesia 21st package includes recapitalization.6. It has also drafted regulations to remove obstacles for converting debt to equity. or sold (after transferring NPLs to the AMU). To overcome these problems. it is doubtful whether pure holding companies are able to enter into swaps. BEII. In October 1998. depositors will be fully protected by the Government. Conclusions. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision.1
Summary. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. was enacted in 1999. merged. Some 175 groups that originated from family businesses controlled
. To obtain a clearer picture of the banking sector. the Government required banks to be audited by international external auditors. BBD.
Financing Patterns Controlling shareholders opted to use debts to finance expansion. the majority remains family-controlled. when barriers to entry in the banking sector were lifted.1 percent of publicly listed companies in Indonesia.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. Therefore. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. However. Rapid growth in investments masked the corporate sector’s increasing leverage. meanwhile. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. When the Government regulated the legal lending limit and the net open position of banks. while a single family controlled 16. These figures show the extent of power wielded over the corporate sector by a small number of families. however. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion
. On average. But because foreign creditors were reluctant to lend long term. These banks also obtained cheap offshore funds. not all of the conglomerate-affiliated companies are publicly listed. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. Indonesian companies borrowed short term. families control 67. However. II
53 percent of total assets of the top 300 Indonesian conglomerates. banks were unwilling to provide credit to highly leveraged companies. allowing them to maintain their equity shares and. 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.46
Corporate Governance and Finance in East Asia. The restructuring and resolution of financial distress may. corporate debts grew over time. Foreign creditors. lacked the information necessary to allow them to assess projects’ risks and chances for success. As a result. retain ownership control of companies. Companies relied heavily on bank credit. Among those listed in the Jakarta Stock Exchange. On the one hand. thus.7 percent. Vol.
the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative).24 trillion in the first half of 1998. Impact of the Financial Crisis Prior to the crisis. were the most adversely affected. and strengthen prudential regulations and supervision of the financial sector. As the rupiah weakened and interest rates increased. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. the corporate sector was in quite good shape in terms of growth and profitability. ROE dropped from 1. The Government and the private sector responded with measures to mitigate the negative effects. Meanwhile. the consumer goods industry was the worst hit. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. On the other hand. corporate-initiated debt restructuring
.1 percent in 1997 to -124.1 trillion in 1997 from Rp13. When the crisis hit Indonesia. DER increased to 307 percent in 1997 and further surged to 1.Chapter 1: Indonesia
without diluting their control.1 percent in 1998.21 trillion in 1996. particularly those with large short-term foreign loans. Bank Indonesia extended emergency loans to many banks. facilitate debt restructuring. Sales of conglomerates as well as those of publicly listed companies were increasing. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. and registered a net loss of Rp39.370 percent in 1998. NPLs rose and capital adequacy ratios fell. the highly leveraged companies. although at a declining rate. The financial crisis led to the closure of several dozen banks. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. At the height of the crisis. followed by the property sector. Total profits of publicly listed companies dropped to Rp3. and the rapid decline in equity due to losses. the high domestic interest rates that prevailed from 1998. To restructure the corporate sector. The Government introduced reforms to improve bankruptcy procedures. financed by issuing nearly $80 billion worth of bank restructuring bonds.
improving the legal and regulatory framework for bank supervision. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. and protecting creditors’ rights. The Government should ensure that all laws and regulations are effectively enforced. II
measures included internal business restructuring (e.. but it is not clear whether in practice these standards are in place. Vol.g. but inadequate protection to minority shareholders from the dominance of large shareholders. If the role of a limited number of families in the corporate sector is so large and the Government is either heavily involved in or influenced by business. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank
. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts. (ii) delineating the functions of the board of directors and commissioners. Most companies claim to have adopted international standards of accounting and auditing procedures. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders.48
Corporate Governance and Finance in East Asia. Specific recommendations include protecting the rights of minority shareholders.6. 1.2 Policy Recommendations
The Government should introduce measures to address the weaknesses in corporate governance identified in this study. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. In particular. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. and (iii) strengthening transparency and disclosure requirements. 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.
Because foreign creditors are faced with more information asymmetries than domestic creditors. the Court has been slow and ineffective in processing bankruptcy suits. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. However. and liquidation of corporate assets. When finance companies were used to channel offshore loans in lieu of commercial banks. recapitalization. the Government lost monitoring and control powers over foreign fund flows. with necessary legal sanctions for violations. in contrast to the Republic of Korea and Thailand. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. Consequently. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. orderly restructuring. This is a significant factor in
. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. Protecting Creditors’ Rights To protect creditors’ rights. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. One way is to set limits on lending activities by banks to affiliated nonfinancial companies.Chapter 1: Indonesia
financial institutions. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. Banks should be required to provide data on such transactions and charged penalties for noncompliance. The Government should also continue strengthening the monitoring system for foreign exchange transactions. The regulatory framework was also weak in supervising and monitoring foreign transactions. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. In the first place. it has been difficult to implement standstills. most of banks’ NPLs resulted from credit to companies within the same group. Further.
despite the smaller level of capital inflows (as a percentage of GDP).
. Only when creditors have the confidence that their rights are protected will they resume financing companies. Vol. II
explaining the greater depth of the crisis in Indonesia. The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing.50
Corporate Governance and Finance in East Asia.
Letter of Intent of the Government of Indonesia to the IMF. Who Controls East Asian Corporations? Financial Economics Unit. Michael Krill. John Wiley and Sons. various publications. Economic and Financial Statistics. 1998. Manuscript. 1995. 1997. Risks. 1996. Indonesian Business Data Centre. Maryland. Stijn. Yogyakarta. various publications. The Economist Intelligence Unit. various publications. Delhaise. University of Maryland. Asia in Crisis: The Implosion of the Banking and Finance System. Economy of Indonesia. 1996. 1999. and M. Indonesia: Sustaining Manufactured Export Growth. Jakarta Stock Exchange. Keasey. Financial Sector Practice Department. JSX Monthly Statistics. Claessens. Center for International Business Education and Research. Unpublished thesis MMUGM. and Remuneration. Conny Tjandra Rahardja. Corporate Governance: Responsibilities. F. The Private Debt Anatomy. Wright. The Economist Intelligence Unit. 1995. World Bank. and Richard Turtil. Indonesian Capital Market Directory 1992-1998. Indonesia Country Profile. 1998. Indonesia: An Emerging Market. John Wiley and Sons. Indonesian Business Data Centre. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. Indonesia Country Report. Working Paper #58. Bank Indonesia. 14 May 1999. Lang. Jonathan. K. 1997. Embassy of Indonesia Homepage. and Larry H.. P. Embassy of Indonesia. Simeon Djankov. various publications. Indonesian Central Bureau of Statistics. Forest. P. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Institute for Economic and Financial Research.
. Large and Medium Manufacturing Statistics. 1999.Chapter 1: Indonesia
ADB Programs Department (East).
The authors wish to thank Juzhong Zhuang. As the Korean currency. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. a practice that was not checked by creditors.1
The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. 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. timely exit of poor performers from the market. the Republic of Korea. This has been the crux of the corporate governance problem in Korea. Seoul. Further. 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.
. Business managers and controlling shareholders were maximizing firm size at the expense of profits. internal control mechanisms. and corporates were sent reeling.1). the Government and business sector had good reason to reflect on the causes of the crisis. Department of Economics. Chung and Yen Kyun Wang1
2. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. or capital market discipline. 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. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. David Edwards. the Korea Stock Exchange for its help and support in conducting company surveys. markets.2 Republic of Korea
Kwang S. both of ADB. Chung-Ang University. Korea) in November of that year. The country’s winners would then emerge based only on economic efficiency. and Graham Dwyer for his editorial assistance.
accountability of controlling shareholders and boards of directors.4 1993 513 174 33. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. and improvement of bankruptcy procedures. T. Copeland. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data.1 1995 560 163 29. Many firms left some questions unanswered. II
Table 2. the corporate sector. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades.1 1996 561 163 29.
. This study also reviews the legal and
The survey was conducted mainly through the Korea Stock Exchange. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. and J Murrin (1995). where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital.9 1994 531 165 31.1 Listed Firms with Positive Economic Value Added. Government reform goals for the corporate sector include enhancement of corporate transparency.1 1997 518 104 20. This study collects and analyzes data on the Korean economy. Source: Korea Stock Exchange. and individual companies. especially chaebols.1 1998 490 164 33.54
Corporate Governance and Finance in East Asia. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. 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. which distributed and collected the questionnaire. June 1999. 1992-1998
Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. Vol. capital market discipline. The EVAs are the same as the economic profit as explained in T.
Weaknesses in the overall corporate governance system in Korea had many ramifications. Koller. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance.
In the period 19481961. reviewing government policies responsible for the development of the modern corporate sector. Yang. and other necessities domestically. clothing. and employees and their role in shaping corporate governance practices. the board of directors system. Section 2. It then presents recommendations for further reform in corporate governance and financing. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Section 2. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. Section 2. The Government tried to produce food.2.Chapter 2: Korea 55
regulatory framework for the corporate sector and reform measures taken after the crisis. corporate control by the Government. It reviews such elements as shareholders’ rights.1
Overview of the Corporate Sector Historical Development3
The development of the Korean corporate sector is closely related to the progress of the economy.4 contains analyses of corporate financing and its relationship to performance. which account for a substantial portion of the Korean economy. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. and Yim (1998).2.2 presents an overview of the corporate sector. It traces the country’s economic development. From 1948 to 1961. Section 2.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols.
The review of historical development of the Korean economy draws substantially from the book by Sohn.
2. Section 2.
.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. Major economic indicators for some of these periods are shown in Table 2. The evolution of the modern Korean economy can be divided into four periods. and naturally adopted an import substitution policy.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. This chapter is composed of six sections. creditors.2 2.
the Government was not successful in solving the problems of slow growth. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).8 (8.1 35. Economic Statistics Yearbook.8 15. d Refers to 1997.949.2 Key Macroeconomic Indicators Annual Average (percent.2 30.7 37. largely because of political instability.1 15. Vol.4 10.
Table 2.9) (7.0) 492.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.6 11.9) 1. In the Plan. 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 8.1 9.332. and implementing new budget and tax measures.8 24. IMF.2 1980-1989 8.0) (297.7 30. The Government tried
.4 24. and inconsistent economic policies. This goal required very high savings and investment rates.0 41.5 250. 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.9b 15. Source: Bank of Korea.447.855. high unemployment and inflation.2 452. b Refers to 1979.265.5 38. lack of strong drive.1 29. modernizing the industrial structure.2 757.9 — — 21. the Government called for an unprecedented average annual economic growth rate of 7.2 1.4 (1.3 8.2 6. a Refers to 1971.7 14.4 1990-1997 7.5) 8.4 29.56
Corporate Governance and Finance in East Asia.5) (1.4 29. Export Drive: 1962-1971 Between 1962 and 1971. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.9 794.7c 11.0 27. and large current account deficits.2 31. c Refers to 1989.2 314. e For maturities of one year or more.1a 21.1
— = not available.1d 9. International Financial Statistics.8 12.8 (724.753.102.2 32.
The well-educated. 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. During this period. But the liberalization trend turned out to be short lived as current account deficits continued. In 1971. Exports increased sharply from $41 million in 1961 to $2. In 1963-1964. but the average growth rate for 1965-1969 shot up to 10 percent. but tariff rates were raised to 40 percent in the 1960s.3 percent to 60. channeling funds from curb markets into the banking sector.2 billion in 1972. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported.5 percent. the growth of gross domestic product (GDP) raised domestic savings. the Government tried to provide exporting firms with a free trade environment. the import liberalization rate was 55 percent. Also. The average growth rate of the economy from 1960 to 1964 was 5. due to continuous current account deficits. imports of consumer goods and luxury items were highly restricted. a modest improvement over the 4. boosting internal investment resources. and cheap labor force was well utilized by the export-led growth strategy. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. and maximizing mobilization of domestic savings on the other. Bank deposits increased rapidly. The exchange rate system was a kind of crawling peg until 1974. resulting in high real interest rates. while the average tariff rate was 39 percent. abundant. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT).4 percent. This change raised the import liberalization rate from 9. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects.
. which laid a solid foundation for a steady growth path.Chapter 2: Korea 57
to meet its targets by borrowing large amounts of foreign capital on the one hand. up from 30 percent in the late 1950s. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system.3 percent average between 1954 and 1959. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. In 1964. During the first five-year plan period. However. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports.
Unlike the previous system. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. The Government took emergency measures. There were three reasons for the switch: first. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation. In 1972. faced the danger of bankruptcy. 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. it tried to substitute imports and export high value-added HCI products. 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
. These practices contained an implicit government guarantee that large businesses and banks could never fail. and assigned them to specific chaebols.6 billion between 1973 and 1981 into these sectors. reducing or exempting debts of farmers and fishermen. shipbuilding. Third. overburdened with debts and high interest rates. The Government encouraged a variety of business projects. The Government targeted six industries—steel. and giving low interest rate loans to banks from the central bank. By promoting HCIs. machinery (including automobiles). where preferential export credit was given to almost every exporter. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. These included rescheduling business debts. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. becoming a seed of the economic crisis in 1997. less developed countries forced Korea to adjust its industrial structure. electronics. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. Second. Vol.58
Corporate Governance and Finance in East Asia. It promoted HCIs by supplying massive capital for construction and development. the Government felt the need to strengthen the defense industry. investing a total of $9. nonferrous metal. the domestic economy was stagnant and many businesses. the emergence of competition of other low-wage. in the face of a world economic slump. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). II
Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). announcing rescue packages for businesses and banks. and chemicals—as future core industries.
as it had to control only a few large chaebols. various measures to increase competition were taken. imports were further liberalized while tariff rates were lowered. low
. with many turning into the now well-known chaebols. The severe world recession caused by the second oil shock. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. The plan of the 1970s was thought to be successful in the long run. However.Chapter 2: Korea 59
through state-controlled banks. Economic Liberalization and Globalization: 1980-1997 In 1979. Firms that followed the Government expanded greatly. The two important ones were import liberalization and deregulation of the financial sector. Meanwhile. 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. Evaluations of HCI promotion policies are mixed. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. Meanwhile. price controls were abolished. In order to improve economic efficiency. Macroeconomic policies became hostages of the industrial strategy. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. a heavy foreign debt burden. including denationalization of banks. coupled with political uncertainty due to the assassination of President Park in 1979. Such an approach gave the Government increased control over the economy. however. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979.2). New start-up firms. and the large excess capacity of HCIs. the Government adopted comprehensive measures to promote economic stabilization. especially between 1979 and 1985. such as widespread underutilization of capacities of HCIs and related plants. fiscal expenditure maintained zero growth. the Government restructured some large businesses through forced liquidation and M&As. and their utilization ratios were very high. The growth rate of the money supply was reduced drastically. In 1986-1989. including forced liquidations and mergers and acquisitions (M&As). Cheap credit and distorted prices resulted in overexpansion in the HCIs. The incentives available became more market-based. the policy wasted substantial amounts of resources in the short and medium terms. met increased difficulty. exacerbated the overcapacity problem. faced with high inflation.
The low value of the dollar led to a low won and high yen.1 percent. In 1990.” A large-scale business group is called a chaebol. 47. Industrial and trade policies were modified to be consistent with WTO. The most important element characterizing chaebols is the concentration of ownership. but it chose to liberalize gradually. 2. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. the import liberalization ratio reached 98. whose business activities are controlled by an identical person. 13. total debts. Vol.
.9 percent. and total workforce. further increasing its pace of import liberalization.2 Rise of the Large Business Groups (Chaebols)4
The Korean Fair Trade Act defines a business group as “a group of companies. II
world interest rates.60
Corporate Governance and Finance in East Asia. 46. 45. The official rate fluctuated within a band. total sales. Korea began participating in many multilateral trade negotiations during the Uruguay Round. Meanwhile. total assets. In 1993. and declaring that it would follow Article XI of GATT. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII.1 percent and average tariff rates 8. 4.2 percent.2.9 percent. with the 30 largest in the total economy in 1997 standing as follows: value-added. 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.3 percent. the importance of chaebols was increasing. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. while continuous and large current account surpluses saved Korea from the foreign debt problem. and low oil prices. In 1988. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. The Government tried to adjust economic policies and regulations to meet global standards. the Government committed itself to further liberalization of the goods and capital markets. and acceded to the World Trade Organization (WTO) in 1994. The birth of chaebols can be traced to the selling of Japanese colonial properties that were reverted to the Korean Government after World
The historical review of chaebols draws substantially from the paper of Lee and Lee (1996). which gradually widened.9 percent. Korea adopted a market average exchange rate system.
of Subsidiaries 604 616 623 669 Average No. the number of subsidiaries declined drastically due to corporate restructuring. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. In the mid-1970s.
. Chaebols are also excessively diversified. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. This policy contributed greatly to the expansion of chaebols. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources.Chapter 2: Korea 61
War II. it was more effective to deal with a small number of companies to secure tangible outcomes.3
Source: The Fair Trade Commission. and tax breaks to key industries to promote exports and industrial upgrading.when the Government put a great deal of emphasis on development of the HCIs. The Government provided subsidies.1 20. Important managerial decisions are made primarily by owners.5 20. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. In this sense. 1993-1996
Year 1993 1994 1995 1996 No. Since the Government controlled most business activities.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. financial assistance. This galvanized the fast growth of chaebols.8 22. the ownership and management of a chaebol’s subsidiaries are not separate. Since the 1960s. Table 2. From the standpoint of the Government.3 Subsidiaries of the 30 Largest Chaebols. However. Table 2. One reason for this controlling power is inter-company shareholding among subsidiaries. Chaebols have a history of substantial concentration of ownership. and they are aided and supported by one another. of Subsidiaries per Chaebol 20. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. chaebols that maintained a close relationship with the political authorities were able to grow fast. reaching 669 in 1996. after the financial crisis.
They had to meet certain requirements in terms of firm size. profitability. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. Since chaebols are engaged in many different businesses. years since establishment. Meanwhile. there are many negative assessments of organizational structures and practices of chaebols. 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. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. and were allowed extra depreciation charges for tax purposes. in addition to the usual economies of scale. For example. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972.2. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. On the other hand.
. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. This could ensure their stable growth and enhance their investment abilities. including the “economies of organizational size” inherent in multi-product and multiplant firms.62
Corporate Governance and Finance in East Asia. II
Theoretically. However. etc. Vol. Under this law.3 Role of the Capital Market and Foreign Capital
In the 1960s. In the early years after the enactment of the law. chaebols can benefit from synergies. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. they can reduce uncertainties and dilute risks through sharing of information and diversification. 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. diversification can make chaebols stable through the portfolio effect. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. which may ultimately lead to the decline of social efficiency. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. 2. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries.
however. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.020 151. was established to invest in domestic shares beginning in September 1985.Chapter 2: Korea 63
During the 1980s and 1990s. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138..1 30.9 918.570 95.6
Year 1985 1989 1990 1994 1995 1996 1997 1998
Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.4 40.0 965. several important policy measures were implemented to promote the development of the stock market. Third. a country fund.151 117.9 34. The Korea Fund.6 747. 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. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused.798 Market Capitalization as a Ratio to GDP (%) 8. Also that year.4 654. the Government announced the gradual opening of the capital market to foreign investors in January 1981.5 406. First.9 833.989 137.476 79.0 49.0 79. The aggregate
Table 2. Beginning 1990. Because of government policies and the booming economy. continued until 1989.7 934. Inc. Second. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. The policy to expand the size of the stock market.1 Market Capitalization (W billion) 6.1 16.4 Development of the Stock Market. In this regard.217 141. 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). As shown in Table 2. the stock market grew rapidly during the 1980s.4. especially those paying small or no dividends.
. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. 1985-1998
No.370 70.2 44. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.
338 4. 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 1986-1989.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.264) (3.001 4.852) (2.694) 2. The relative size of the stock market diminished to 44 percent in 1990. The growth in the number of listed firms also slowed in the 1990s.149 13.287 (340) 73.414) 5.413) 56. 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
313 (9) 696 809 147 (808) (115) (311) (832) (2.183 12.642 21. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. and other liabilities.546 (2. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.86 percent of GDP in 1997.382
Permit basis.440 1. currency and deposits.742 (3.141 4.542) (1.870) (1.953 10.944) 8. but rose again to 34.942) 42. Source: Balance of Payments. Table 2.239 19. Vol. However.910) 2.924 (1.5 Private Capital Flows to Korea. Bank of Korea. but increased sharply to 79.64
Corporate Governance and Finance in East Asia.326
1. and 1993.737 (333) (297) (607) (2) 218 2.255 2.017) 1.450 24. Other investments include loans.296) (6.085 2.453 (2. due to declining stock prices.714
1.123 3.150 5.455) 13.858 4.817 16.534)
1.553 8.2 percent by 1989.583 25 10. trade credits.868
(518) (418) 63 1. II
market value of all listed firms represented only 8 percent of GDP in 1985.433) (9.500 7. The aggregate market value of listed shares bottomed at 16.352 471 3.800 (7.658) (3.875 21.008) (3. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.59 percent in 1998 and to more than 50 percent in the early months of 1999.571 2.347 3.126 (1.
.785 (1. and stayed at the 30-40 percent level up to 1996.
Table 2.339) (9.650 (1.
and (iii) chaebols. Of this. The dismal performance of the Korean corporate sector compared to the
. However. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2.5). increasing to 76 percent in 1997.China and the US. (ii) listed firms. Return on equity (ROE) and return on assets (ROA) showed similar patterns. equity. 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 $42.4 Growth and Financial Performance
This section looks at the performance of (i) the aggregate corporate sector.China. Corporate sector net proft margins increased from 1993 to 1995. Taipei. In addition to FDI. Profit rates of Korean firms were relatively low compared to those of Taipei.6 percent in 1997. the growth rates of equity and sales dropped sharply in 1996 and 1997. This would lay the foundation for evaluating the effect of corporate governance on performance. excluding FDI.2. portfolio investments amounted to $73. and sales of the aggregate sector during this period were very high (Table 2. other net private capital inflows amounted to $130 billion during 1985-1998. 2.6). This indicates that a substantial proportion of debt was denominated in dollars. and high production costs were the main reasons for low FDI in Korea. weak incentives for attracting FDI.Chapter 2: Korea 65
Complicated government regulations. Japan’s was consistently higher. following the sharp depreciation of the won. Between 1986 and 1989.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. The ratio is generally in the same range for Japan and Korea. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Table 2. Korea had substantial current account surpluses and experienced net private capital outflow.2 percent in 1987. The same categories will be analyzed in later sections. The growth rates of total assets. Net private capital inflow.9 billion. but between 1988 and 1993. but dropped in 1996 and were negative by 1997. The contribution of the corporate sector to GDP was 73.
1 2.3 17.7 325.5 1.
Table 2.0 8.4 1. Financial Statement Analysis Yearbook.9 13.5 2.9 5.6 (4.7 15.8 22.6 9.9 8.2 9.2 1.6 4. Source: Bank of Korea.0 10.1 5.0 13.3 21. ROA = return on assets (ratio of net income to total assets).6 Growth and Financial Performance of the Nonfinancial Corporate Sector.3)
5.0 0.2 13.7 4.8 21.3 308.5 1.5 1.2 18.0 (0.4 2.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent)
Year Korea US Japan Taipei.4 4.8 1.5 4.3 6. Note: Ratio of ordinary income to sales = (ordinary income/sales).2) (0.7 4.3 335.8 8.6 424.1 8.0 6.7 4. ROE = return on equity (ratio of net income to stockholders’ equity).1 6.9 2.2 1.3 312.4
1.1 2.6 13.6 1.2 19.0 3.6 1.9)
DER = debt-to-equity ratio.8 1.3 1.7 15.China
1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
3.Table 2.4 2.7 1.9 3.3 11.5 4.5 3.9 5.6 2.0 13.7 2.5 (0.7 3.2 13. 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
23.4 2.9 5.2 1.9 16.9 16.6 318.4 10.8)
.3 21. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).6 3.4 1.5 7.9 18.4 —
6.1 — —
— = not available.7 3.3 3.9 4.8 2.9 3.5 0.0 4.9 2.1 2. Source: Bank of Korea.0 305.9 2.4
19.9 18. Net profit margin = ratio of net income to sales.3
14.0 7.8 3. Financial Statement Analysis Yearbook.
but higher than that of small firms. trade. followed by mediumsized firms and large ones. Net profit margins. while their average net profit margin was lower than that of medium firms. Performance followed similar patterns across different industries (Table 2.and small-scale firms (Table 2. A comparison of performance by firm size reveals some interesting results.10). gas.4 percent. 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. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2.6). a year ahead of the other industries. Growth rates of total assets are generally high. The growth performance of large firms for the 1988-1997 period was better than that of medium.
. However.9). the exception being the electricity. and steam supply industry. this may be an indication of the bias toward large firms in terms of access to credit. In most years. However.Chapter 2: Korea 67
other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. This preference of Korean firms has its roots in the structure of corporate governance. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997.5 percent while the aggregate sector recorded only 13. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. Again. ROEs. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. It is notable that the construction sector’s profit rate began its decline in 1995. sales of listed firms grew 18. with the wholesale and retail trade sector and the construction sector having the highest figures. The other financial ratios follow the general pattern of the aggregate corporate sector. Small listed firms were hardest hit by the financial crisis. both ROA and ROE were lower for the listed firms compared to the latter. with equity in wholesale and retail trade even contracting. The manufacturing. In 1997. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. construction. the average ROE was lowest for large firms. Profit rates of most industries are also quite low. This may be related to its having the lowest DER. All sectors experienced a sharp decline in equity and sales growth in 1997.8). and transport sectors recorded negative profit rates in 1997.
3 10.5 14.3 8.9 428.3 18.3 10.5
Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.9 0.6 14.8 16.5 338.3 15.1 28.5 1.1 27.6 0.2 15.2 16.6 12.4 17.4 2.2 12.0 19.4 4.7 1.5 5.0 23.4 10.6 2.4 10.4 15.5 23.7 16.8 2.5 3.9 13.8 35.0 18.9 (0.2 2.5 (5.0 1.9 10.7 520.1 296.0 15.1 21.8 526.9 (0.0 24.2 5.4 1.0 1.7 (3.3) (1.2 18.8 24.0 15.8 14.6 14. Renting.5 239.5 432.0 2.4 0.4 2.0 5.2 423.0 24.8 12.1 290.0) 4.0 16.2 (1.0 7.8 3.0) 1.4 5.8 7.5 1.2) 6.8 0.4 350.5 4.4 740.7 0.2 25.0 1.9 (0.7) 2.0 18.1 10.6 7.3 1.4 12.1 16.4 9.5 (0.2 0.5 13.0 1.5 6.3 2.8
Real Estate.8 16.8 1.2 6.0 245.7 10.3 285.8 12.2 20.9 10.8 34.2) 22.6 16.1 1.0 1.1 2.8 14.0 2.6 655.6) 3.4 458.0 (0.9 16.5 28.7 7.3 8.5 30.1 0.7 294.6 12.3 14.2) (0.8 2.9) 1.5 286.8) 0.7 (0.2 36.9 9.8 0.2 5.4 5.9 2.9 29.6 1.4 2.5 270.8 16.1 22.3 288.5 1.9 31.0 12.8 13.8 3.6 1.1 1.9 5.5 27.9 538.3 14.6) (6.0 22.7 514.3 2.5 569.2 241.8 302.0 2.1 1.1 20.0) 0.3 11.8 616.1 0.8 Growth and Financial Performance of Selected Industries (percent)
Growth Performance Year Assets Equity
Financial Performance NPM
Manufacturing 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 13.5 16.1 396.4) 0.6 3.6 318.8 22.5 5.4 1.5 306.0 9.9 16.5 (1.2 315.0 (4.0 1.6 0.2 5.8 23.3 8.7 17.1 1.4
.9 340.1 2.5) 0.5 6.6 17.6 11.0 5.3 31.0 (0.2) 15.8 562.5 1.6 17.2 0.0 1.0 22.1 17.1 (0.2 7.8 32.2 20.6 6.0) 0.7 30.2 6.3 25.Table 2.1) (3.4 5.6 24.6 5. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.9 2.5 19.9 1.4 348.4 14.8 345.1 (0.7 22.4 2.2 24.0 2.7 5.8 22.3 11.4 2.8 2.1) 0.0 21.6 3.9 25.4 (0.9 3.5 1.8 24.5 483.4 10.1 7.2 16.8 1.1) 3.4 3.7 317.5 473.1 0.7 228.7 21.4 10.9 14.3 15.9 19.0 22.6 375.7 9.0 3.6 15.4 474.8 10.0 37.0 16.3 1.4 0.0 254.3 8.3 15.8 461.4 291.8 17.7 4.2 0.9 16.3 15.5 1.6 14.3 13.8 10.
1 1.7 2.1 (0.0 (1.6 512.0 14.6 14.2 15.4 2.9 1.2 10. Source: Calculated using data from Bank of Korea.5 344.9 4.0 89.7
— = not available.2) 13.5 14.4 14.5 12.9 12.5 13.1 4.6 20.1 323.9 3.4 1.4 3.4 7.2 18.3 0.7 0.3 4.6 (2.7 — — — — — 14.4 633.8 529.3 4.1 21.8 12.1 (11.1 (2.3 19.5 15.4 3.1 3.3 740.9 17.2 90.4 0.8 15.3 2.6 4.8 7.7 510.0
Transport.8) (12.6 4.4 169.6 12.5 539.3 1.9 10.5 11. Gas.5 11.8 6.6 8.0 (15.0 1.6 16.3) 4.6 — — — — — 17.6 172.1 8.9 (10.8 11.5 0.2 10.6 8.4) (1.8 14.6 9.8 9.4 11.8 3.4 16.3 543.7 0.1 16.9 8.1) (0.4 0.9 18.6 12.3 23.3 9.0 21.3 125.1) 1. Financial Statement Analysis Yearbooks.1 12.7 19.6 1.2 10.3 8.0 2.8 12.7 16.3 18.8) 1.6 19.9 8.5 2.3 1.7 20.3 524.8 111.5 14.7 15.7 187.3 0.5) 22.7 11.3 34.5 8.Table 2.1 15.9 332.8 0.0) (0.2 143.8 14.1 15.4 2.2 7.4 (2.6 (2.7 11.4 367.5 16.5 (2.2 14.9 9.2 2.1 15.9 (11.4 6.5 47.5 26.9 7.0 2.4 21.4 7. b NPM denotes net profit margin.
.4 13.3) 15.8 0.5 15.1 17.3 112.6 15.6 9.0 5.3 3.5 462.9 9.1 6.6 6.6 3.9 6.4 6.4 30.0 1.3 — — — — — 10.6 19.7 14. a New equity does not include capital surplus. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.0 1.5 4.7 7.9 4.3 (2.2 11.6 9.4 3.1) 5.4 9. Storage.6 18.3 4.4 15.9 18. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.9) (8.0 13.8 3.4 0.7 12.7 11.5 30.7) 0.6 2.9 456.4 10.2 3.1 14.4 341.8 (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 — — — — — 31.9
Electricity.2 698.0 98.4 12.0 921.9 321.0) 1.6 6.062.2 14.0 14.6 21.4 (0.9 12.5 14.6 — — — — — 0.4 1.8 4.4 — — — — — 448.5 612.3 18.7 7.1 2.9 10.7) (4.6 34.4 12.2 122.2 18.6 0.5 482.1 11.6 8.7 116.0 5.2) 0.0 106.3 12.6 6.7 2.3) (1.3 8.2 1.1) (0.2 18.6 1.2 — — — — — 2.4 1.8 8.3 17.5 117.0) 1.8 6.0 7.5 307.5 14.3) 11.9 17.2) 9.1 11.
0 3. sales (45. the top 11-30 chaebols experienced a decline of
.1 6.4 1.3 2.9 2. In 1995.0 0. the 30 largest chaebols accounted for 13. Vol.5 19. of which four were listed. Chaebols have been the most important actors and engines of growth in the Korean economy.6 0.7 Net Profit Margin 0.6 2.70
Corporate Governance and Finance in East Asia. followed by the top 6-10 (Table 2.12). unless otherwise indicated)
Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. The number of Hyundai member companies rose to 57 in 1997.6 (1.3 20.5 ROA 0.8 0.4 1.9 2. and close to half of total assets (46.3 0.7 (5.1) 4.1 1.9 1.4) 1.1 1.9 26. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.2 9. 1985-1997 (percent.6 22. debts (47. In 1997.7 percent) of the corporate sector.6 and 2.6 23.9
Source: Constructed using data from Korea Investors Service.8 24.3 (0. The top five chaebols registered the highest growth rates.9 11.9 Growth and Financial Performance of Listed Companies.5 5.
Performance of Chaebols This section uses available data on the top 30 chaebols.9 0.4 22. of which 16 were publicly listed (Table 2.3 15.7) 0.5 ROE 3.2 2.7 1. Hyundai Group.0 18. had 46 member companies. Generally. The criteria for selection of largest chaebols have changed a few times.4 1. The smallest group had 16 members in 1995.5 0.9 percent). It should also be noted that when the financial crisis struck in 1997.2 9. 1998.1 percent of the economy’s total value added (excluding the financial sector).11).8 6.3 4.9 21.2 0.6 1. Kis-Fas.12). Between 1993 and 1997.9 percent).8 5.4 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2. the largest chaebol.5 19. II
Table 2.7 1.9 6.2 6. and net profits (46.3 percent).4 0. it is the chaebols’ large firms that are listed.6 3. but the number of designated groups has been fixed at 30 since 1993.
0 1. 1998.2 2.1 1.6 2.6 3.8) 6.7 (0.1 0.6 1.0) 1.7 (1.3 1.8 0.8 0.9) (6.8 1.3 (0.6 (0.8 10.8 16.7 2.2
Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.6 1.2 1.1) 5.9 5.6 9.0 6.2 3. 1988-1997 (percent)
ROE Large 9.6 0.4 2.3) 0.8 6.9 2.1 2.8 0.0 16.9 6.2 13.2) (1.2 Small 13.7 4.9 (0.3) 5.8 7. Source: Korea Investors Service.5 17.5 5.0 19.2 2.5) 1.0 (4.6 7.3 15.2 7.3 9.5 1.6 8.6 13.2 12.5 5.6 (1.8 6.
.7 (1.4 16.4 6.0 1.5 0.6 3.9 0.8 3.9 2.8 0.8) 1.5 (1.7
3.5 25. Others are medium firms.3 11.6 2.9
3.3 Medium 14.6) 0.6 0.2 (0.4 5.0 10.9 0.9 22.5) 1.4 1.7 2. Kis-Fas.2) 0.10 Growth and Financial Performance of Listed Companies by Size.1 11.6 1.3 3.4 Medium Small Large Medium Small ROA Growth Performance Large 17.4 11.9 25.3 (0.1 8.6 5.3 15.9 1.2 10.0 1.9 14.5 2.4 1.3 6.5
Net Profit Margin
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average
2.9 2.4 3.8 (5.9 0.1 2.0 15.5 3.2) (1.9 1.0 17.8 17.2 0.0 1.7 18.4 3.2 13.Table 2.0) 0.6 2.0 4.7 1.9 6.6 6.4) 1.
774 7.475 2.990 2.376 35.423 5.927 16.640 4. 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.574 3.Table 2.924 2.951 3.743 40.287 10.690 3.090 6.427 9. Source: Fair Trade Commission.303 3.853 1997 53.935 2.599 — 2.458 6.910 3.761 31.158 1.
.246 11.798 — No.398 — 2.313 14.129 2.433 3.131 3.158 7.309 14.486 6.873 2.457 14.677 3.956 3.445 4.147 5.117 4.11 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 43.929 12.364 5.597 351.455 22.756 5.651 38.177 — 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.996 1.346 3.370 6.967 7.395 31.995 2.180 2.766 3.501 13.
3 16.0 6.8 27.7 4.5 5.2) (2.0) 3.0 2.5 32.4) 1.1) (1.9 20.2 (2.7 0.1 10.6 25.4 30.8 0.3 19.2 (5.8 Assets 12.2) (0.7 15.5 2.2 (16.5 27.5) (0.1) 0.3 27.3 9.3 11.7)
Source: Bank of Korea.9 3.5 20.6 4.4) (0.2) 1.Table 2.2 1.0) 12.0 2.3 0.3 14.2 3.6 19.4) (14.9 20.7 1.5 (0.7 10.1 2.6 Financial Performance Net Profit Margin 1.0 17.3 1.4 (2.7 13.2 0.1 (1.9 1.3 1.0) ROA 1.5) (0.2 (2.0 31.1 27.0 2.7) ROE 5.4 0.6 1.2 11.9 17.9 18.12 Growth and Financial Performance of the 30 Largest Chaebols.4 38.3 0.2 0.
.8 18.5) (0.2 20.3) 0.9 3.1) 0.1 19.4 12.6 18.5 19.6 (0.3 15.0 1.0 0.7 15.1 (3.3 3.1) (0.7 10.4 26.1 (2.0 19. 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 12.1) (0.9 24.0 0.2 0.
and vulnerable balance sheets.74
Corporate Governance and Finance in East Asia. Vol. internal and external control mechanisms. it refers to the degree of concentration and shareholdings in the hands of an “identical person. There has been a wide range in DER among chaebols.
2. However.13).3. loopholes and inconsistent policies spawned strategic behavior and agency problems.1 Patterns of Corporate Ownership
The ownership of most Korean listed firms is highly concentrated. and government intervention interacted through a set of laws and regulations to bring about the existing structure. and the companies that are under the control of the largest shareholder.5 Founding families are mostly still the largest shareholders and.
While “ownership concentration” can be defined and measured differently in different contexts.3
Corporate Ownership and Control
This section looks at the key aspects of corporate governance in Korea. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. weak corporate control. from 190 to 3.765 percent (Table 2. except for 1995. coupled with weak corporate governance.95 percent. 2. chaebols had a higher average DER than the corporate sector as a whole.
.7 percent growth in total assets. Only the top five chaebols registered a positive net profit margin in 1997.” in Korea’s legal and regulatory framework. technology. Their worst year was 1997 when ROE hit -15. However. resulted in the chaebols’ excessive leverage. 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. Ownership patterns. his/her relatives. The absence of a well-developed equity market and the provision of subsidized credit. In general. By the end of 1997. a pyramidal structure of corporate ownership is prevalent. in this instance. more important. II
2 percent in their sales and a very low 4. the average DER of the 30 largest chaebols reached 519 percent. includes the largest shareholder. and led to a high concentration of ownership. 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. The Commercial Code stipulates the basic governance framework and applies to all corporations. and access to credit.
5 464.8 313. Halla 17.5 3.855.13 The Top 30 Chaebols’ Debt-to-Equity Ratio. Lotte 11.3 572. Hanjin 8.2 471.8 336. Ssangyong 7.065. Tongyang 22.7 354. Byucksan 1996 1. Dongkuk Steel 19. Dongah 14.8 312. Kukdong Construction 29.9 321.6
. Jinro 20.7 621.0 436. Hanjin 8. Hyosung 18.0 218.7 688. Kia 9.6 936. Dongkuk Steel 19.1 190. Daelim 16. Dongbu 24.1 278. Jinro Debt-to-Equity Ratio 376. Kumho 12.3 315.3 297.Table 2. Doosan 15.5 383.5 343. Daewoo 5.4 622.7 267.4 175.441. Newcore 30. Hyundai 2. Ssangyong 7. Doosan 13.4 556. Samsung 3.2 328.1 385.9 751.3 328.0 486. Samsung 3.5 2. Daewoo 5.6 516.1 477. Dongah Construction 16. Sunkyung 6.6 2. Hanil 28. Kia 9. Kolon 21. LG 4. Hansol 17.2 292. Hanbo 15.0 370.7 620. Hyundai 2. Hansol 23. Sunkyung 6. Hanwha 10. Sammi 27. Haitai 26. LG 4.4 205. Lotte 11. Hyosung 18. 1995-1997 (percent)
Chaebols 1995 1.2 924.1 3.2 423.4 192.1 674.6 409.0 506.2 346.7 416. Halla 13.2 2. Daelim 14.5 337. Kohap 25. Kumho 12.244.764. Hanwha 10.
Daewoo 4.8 338. Hansol 16.6
Sources: aFair Trade Commission. Hanjin 7.0 419.1 438.8 647. Hyosung 17.3 676.5 519.225. Dongkuk Steel 20.6 335.8 468. Tongyang 24.5) 404.9 1. Kohab 18.6 478. Doosan 15. Newcore 26. Shinho 1997 1.5 (1. Jinro 23.501. Financial Statement Analysis Yearbook. Anam 22. Anam 27.8 347.9 465.5 386.4) 513.9 578. Daesang 27. Ssangyong 8.1 359.13 (Cont’d)
Chaebols 20.0 907. bBank of Korea. Miwon 30.784. Keopyong 29.8 658.5 261.8 590.6 590.Table 2.3 347.1 433. Lotte 12. Samsung 3. LG 5.0 305.9 490.5 323. Hanwha 9.7 370. SK 6.214. Haitai 25. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Hyundai 2.
. Kohab 22.1 375.498. Newcore 28.1 472. Kolon 21.5 (893. Kolon 19. Halla 13.0 505. Keopyong 29. Dongbu 23.6 424. Tongyang 24. Shinho 26.6 416. Hanil 28.7 1.5 1.600. Dongbu 21.5 576.7 944. Daelim 14. Dongah 11. Kamgwon Industrial 30.9 216.9 472. Kumho 10.3 399. Haitai 25.3 1.8 307.4 1.8 399.
The reduction can be
. including investment trust companies. the entrenchment effect outweighs the incentive effect. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. that is. Thus.Chapter 2: Korea 77
When controlling shareholders hold a very small percentage of the shares. individuals were also the largest shareholder group. fluctuated widely during the period. However. while those owned by banks. the Government. The next important group was “other corporations. Theoretically. The pattern of distribution changed little through 1992-1997. and insurance companies increased during the period. the year the stock market was in a frenzy due to buying sprees. the extent of ownership by these individuals declined gradually after 1988. However. the incentive effect once again dominates.. Among listed nonfinancial companies.” followed by banks.7 percent by 1997. The holdings of financial institutions.” foreigners. with a given range of managerial shareholdings (for instance. including banks and other financial firms. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding.14). 10 to 30 percent). Beyond that range.6 percent by 1997. i. the percentage of holdings by individuals slipped to 60. and then steadily declined after 1993. but their shares declined to 21.e. The percentage of shares owned by “other corporations. the ownership structure can bring about an incentive effect.1 percent. resorting to extensive use of pyramiding to maintain control. From 69. and state-owned companies and securities companies declined. large ownership can also bring about the entrenchment effect. managerial entrenchment becomes more likely. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. Composition of Ownership Among listed companies.
6 13.0 59.2 9.5 1.8 17.0 7.2 17.1 18.1 18.8 2.9 17.2 8. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775
9.6 36.1 11.9 19.1 60.3 5.6
No.6 20.8 4.7 3.2 4.1 1.4 5. etc.9 36.3 17.1 3.2 5.9 5.7
4.0 28.2 1.9 4.2
B.4 14.8 1995 548 2.2 9.2 8.1 21.3 1.1 8.4 34.1 4.2 1993 511 2.3 8.5 1989 498 0.0 5.1 8. c Data from Korea Stock Exchange.0 5.2 7.5 18.6 2.5 16.3 18.0 60.5
Note: Ownership is based on number of shares.6 22.3 2.5 1992 508 2.6 12.4 6.1 21.3 18.0 4.9 2.8 17.” includes commercial banks.9 1.4 13. d Constructed from data files of the Korea Listed Companies Association.0 9.5 6.2 3.8 59.5 4.3 1994 521 1.7 7. b “Banks.6 16.5 6.7 9.9 37.7 18.4 1997 551 1. mutual savings.b
A.8 69.6 16.3 1996 570 2.0 27.3 26.6
16. investment trust companies.2 18.6 1991 505 0. Listed Nonfinancial Companiesd 1988 406 0.9 26.8 5.7 6.14 Ownership Composition of Listed Companies.9 2.0 8.Table 2.6 19.7 8.7 14.1 10. etc.2 2.1 2. 1988-1997 (percent)
Financial Institutions Securities Firms Total 28.4 5.3 39.5 60.7 1990 531 0.5 12.4 18.6 8. of Firms
Banks.6 9.6 9.8 2.2 5. a The State covers the Government and state-owned companies.5 62.4 Insurance Firms Other Corporations Foreigners Individuals 39.1 68.8 59. and finance companies.1 17.4 13.7 59.9 1.
.9 15.5 7.3 5.3 1.5 1.5 7.8 5.3 17.7 9. merchant banks.
The holdings of other corporations are mainly equity investments in affiliate companies.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. indicating their heavier reliance on inter-firm financing investments. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and
. foreign holdings were derived from purchases through country funds and direct capital investments. In most instances. whether partial or absolute. However. Compared with its holdings in all listed companies.16). and small companies. 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. did not vary significantly (Table 2.8 percent of listed shares in 1997. financial institutions had more shares in the manufacturing sector than in primary industries. Individuals held the majority of the shares in all industries except in telecommunications. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. Corporate holdings averaged 16 percent throughout 1988-1997. 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. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. and US (Table 2. and service of motor vehicles (Table 2. the Government was the sole owner. other corporations’ holdings shifted toward service industries.18).15). In general. Institutional investors. medium. This trend can be explained by government ownership. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. held 26.17). However. of some banks. UK. This is low compared with those in Japan. as distinguished from individual and foreign investors. Over the years. electricity. Before such liberalization. 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. In 1998. categorized into large. The ownership distribution in listed nonfinancial firms.
Paper.2 2.2 64.7 17.5 4. Paper.8 7.7 14.1 0.1 0.0 9.5 85.8 Individuals 83.5 3.7 29.6 5.4 7.5 17.9 8.4 8.8 8.5 6.3 2.9 42.2 54. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.8 3.5 0.8 7.1 4.2 — — 0.4 14.2 0.0 1.9 10.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.7 20.9 15.1 0.9 23.1 8.7 2.4 56.0 10.9 52.5 0.9 60. 1990 and 1997 (percent)
Financial Institutions The Statea — — 0.0 8.6 — — 2.0 — 39. and Printing Chemicals.8 7.8 73.5 0.3 62.2 9.5 — — 0.3 7.7 2.6 1.8 1.8 7. Motor Vehicles Electricity.7 59.3 9.7 22.8 6.3 0.2 9.1 7.3 10.3 38.8 3.2 17.6 3.4 0.9 16.7 2.6 11.3 2.6 24.8 5.7 20.4 Banks.7 6.7 1.9 1.3 1.15 Ownership Composition of Listed Nonfinancial Firms by Industry.2 22.4 1. Gas.2 7.5 — 1.0
1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 0.3 13.7 64.3 1.4 8. Elecl Mach.9 19.1 65.Table 2.0 7.9 0.0 0.4 — 0.0 9.8 7.3 4.5 — 0.3 0.0 9.5 7.4 2.1 88.2 — 0.2 1.5 12.4 62.0 — 0.4 8.1 19. 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
.7 63.4 5.7 22.3 57.1 0. and Printing Pulp.0 20.0 9.1 8..2 9.0 2.6 8.9 4.2 0.4 1.7 14.9 1. and App.3 6.2 0.9 66.6 18.4 56.9 59. Rubber.5 19.3 11.1 27.1 10.2 1.2 0.3 0.1 1. Etc.9 55.
9 69.4 — 1. Elecl Mach.5 1.8 4.6 20.4 0.4 58.9 20.3 1. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.8 57.5 3.8 12.6
— = not available.9 6.1 9.9 57.4 68.3 2.4 6.2 4.5 4. Motor Vehicles Electricity.2 4.4 1.5 12.9 7.9 5.4 2.9 20.9 18.2 4.4 1.8 3.8 27. mutual savings.4 4.6 7.0 3.9 5.4 45. and Printing Pulp.
.8 0.2 4.2 0. Paper.2 8.0 5.0 6. a The State covers the government and state-owned companies.6 6.7 2.6 2.7 19.5 7.5 63. Source: Constructed from data files of the Korea Listed Companies Association.6 5.7 2.4 9.9 2.5 6.5 5.9 6.1 — 0.2 5.7 4.1 3.6 2.2 13.4 2.0 1.0 43.9 1.9 1.1 2.2 1.7 5.6 59.3 8.4 4.8 0.7 23.” includes commercial banks.8 5.9 0.5 0.1 54.8 11.0 11.7 2.3 1.5 3.8 2.1 18.78 81.4 20. Note: Ownership is based on number of shares.6 60.3 60.5 4.5 3.4 43.9 2.3 65.6 75.7 2.3 15.6 0.3 0.9 1.4 2. investment trust companies.1 3. b “Banks.2 7. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics. and App.6 2.6 0. and Printing Chemicals.1 4.3 57.6 18.4 3.2 1.1 6. etc. and finance companies.6 14.7 6.1 1.6 3.3 6.5 59.6 1.2 49.0 8.0 4.7 17.0 7.6 6.8 2.8 2.3 6.8 54.9 2.2 6.0 6.8 6.0 60.4 1. merchant banks.9 7. Rubber.9 78.4 76.5 3.8 5. Paper.1 1.9 2.2 5.3 31.7 1.2 0.1 — 1.2 23.5 — 2.3 7. Gas.1 2.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.4 16.1 25.4 58.1 9.2 3.
8 4.4 61.
Table 2.1 6.6 60. mutual savings.9 4. The State covers the government and state-owned companies.5 6.1 Banks.3 6.0 Other Corporations 16.4 5. etc. etc.6 16. of Firms
Independent Firms Affiliates of 30 Largest Chaebols Total
316 117 433
Source: Constructed from data files of the Korea Listed Companies Association.5 2.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.9 2.4 2.4
No.8 3.4 21.
.16 Ownership Composition of Listed Nonfinancial Firms by Size.8 2. of Firms
Large Medium Small Total
211 208 80 499
Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.1 8.4 17.9 5. and finance companies.0 6.5 16.7 8.4 1. Securities Firms Insurance Firms 2. investment trust companies.3 Banks. Source: Constructed from data files of the Korea Listed Companies Association.4 61.” includes commercial banks.4 5.Table 2.5 Individuals 60.5 18.4 2.5 62. merchant banks.c Securities Firms Insurance Firms Other Corporations Individuals 58. c “Banks.2 1.8 4.7 Foreigners 4.8 60. 1997 (percent)
The Stateb Foreigners 4.4 4. etc.8 6. 1997 (percent)
The State 1.5 19.7 6. Others are medium firms.5 4.7 4.7 1.5 8.0 1.8 1.7
No.7 0.1 2.
only closed-end investment companies and traditional investment trust companies are allowed. This has had profound implications for corporate governance and the market for corporate control in Korea. rather than the individual.4 26. In 1997. Generally. his/her family members.8 10. and the companies under the control of the largest shareholder.8 9. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. Among nonfinancial listed firms.20). At the moment.3 47. while family members accounted for only 30 percent. corporations held 70 percent of the controlling blocks of shares.6 39. for example. the majority shareholder group in all listed companies consists of the corporate.6
Individuals 23. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.3 54. defined as those holding less than 1 percent of shares.
Institutional Investors 42.1
financial institutions’ establishment of corporate pension fund accounts. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.18 Ownership Composition of Listed Firms in Selected Countries. minority shareholders.5 45.7 16.6
Foreigners 9.8 56.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.19).1 8.3 6.Chapter 2: Korea 83
Table 2. including those of the largest shareholder. 1997 (percent)
Country Japan Korea Taipei. 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
. investors (Table 2.China United Kingdom United States
Source: Stock Exchange of Korea. Foreign holdings of Korean shares were 9.5 20.
30.9 2.1 4.0 4.1 23.7 44.0 2.9 3.9 7.6 22.0 29.0 25. Source: Stock Exchange of Korea.5 43. 1992-1997 (percent)
Majority Shareholders Corporation 15.Table 2.7
Note: The majority shareholder includes the largest shareholder.8 Individual Subtotal Other Shareholders Corporation 3.0 66.0 69.3 18. and the companies under the control of the largest shareholder.
. Minority shareholders are those holding less than 1 percent of shares.8 72.1 28.2
Minority Shareholders Subtotal 71.8 8.3 Subtotal 5.4 5.6 2.2 26.0 22.9 32.7 16.4 3.1 14.4 7.9 33.1 5.1 21.3 2.1 37.6 46.7 6.6 5.7 7.0 1.1 5.2 2. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.1 32.9 Individual 2.19 Ownership Concentration of All Listed Firms.9 6.1 15.8 73.0
1992 1993 1994 1995 1996 1997
41. his/her family members.6 26.7 18.2 2.
5 12. which held less than 1 percent of a company’s outstanding shares as of 1997.8 57.20 Ownership Concentration of Listed Nonfinancial Firms.4 28. Ownership concentration tended to be lower in large compared to medium and small listed firms.3 62.0 20.4 23. the Government has retained a large number of shares. The practice of hidden shares seems to have been less prevalent in recent years.7 18. In most industries.5 13.9 Other Shareholders 18. ownership was relatively diffused due to government regulation.8 54. and mining categories. Majority ownership is also high in the chemicals. 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. the majority owner held more than 20 percent of an average firm.9 29. minority shareholders.0 58. collectively owned less than 50 percent of an average firm. It was highest in medium-sized firms before 1993 and. rubber and plastics. In telecommunications. hiding shares offers no additional tax or other benefits.5 60.9 25.9 48.1 50.21]). Besides.2 15.8 Majority Shareholders 27.8 25.6 57.6 11.3 25.
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.Chapter 2: Korea 85
Table 2. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.22).8 12.9 12.6 58. In such cases. 1988-1997 (percent)
Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.0 22. Meanwhile.8 28.4
Source: Constructed from data files of the Korea Listed Companies Association.
. Across industry.9 27. thereafter. in the small firms. 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 2.5 23.
2 23.5 47.9 10.4 11.2 20.8 29.7 21.7 17.4 16.5 41.2 26.8 21.3 26.
.6 34.6 38.8 25.5 21. Paper.8 44. 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.2 19.4
Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.1 49.0 51.8 31.2 34.9 26.3 39.9 Minority Shareholders Majority Shareholders Other Shareholders 12.2 46.0 21. 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 36.0 54.7 27.8 41.6 50.8 51. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.0 30. and Printing Chemicals.8 55.Table 2.7 26.1 17.2 48. Gas.7 29.2 37..1 19.4 53.5 20.7 24.0 39.5 52.2 22.7 36. and Printing Pulp. and App.3 19.5 44. Paper.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.5 23.6 25.5 19. Motor Vehicles Electricity.9 44.6 53. Elecl Mach.5 16. Rubber.6 19.8 24.1 43.
5 21.4 30.2 11.1 20.5 Other Shareholders 19.5 33.7 17.3 21.9 26.4 30.6 11.8 50.9 56.8 52.8 11.5 49.7 57.8 17.5 19.8 56.9 16.8 28.7 14.5 12.5 28.6 15.2
Source: Korea Listed Companies Association.9 60.9 28.9 53.7 31.7 15.2 32.5 27.4 29.1 16.7 28.2 26.5 19.0 26.2 21.0 24.2 21.7 16.9 21.9 23.2 52.5 26.6 31.3 26.9 22.1 48.0 59.8 62.7 57.1 27.2 Majority Shareholders 26.3 27.5 51.6 62.0 55.9 12.9 17.8 52.2 18.3 19.Table 2.6 55.3 25.4 47.0 66.9 55.4 30.5 10.4 21.1 15.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.6 27.1 58.2 55.
.3 55.8 27.2 50. 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. 1988-1997 (percent)
Year Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Medium 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Large 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 No.2 12.7 22.6 59.5 12.4 51.6 65.2 21.2 56.6 24.
Hong. They analyzed firms in which controlling shareholders participate as managers. H. thus a firm destroys value. and Kim (1995) reached a similar conclusion. TQ increases as the SCS increases. from the standpoint of the controlling shareholder.88
Corporate Governance and Finance in East Asia. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. If SCS is below 10 percent. Kim (1992) and Kim. although turning points in the value of firms are different. Where direct cross-shareholding is not allowed. Shleifer. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. If SCS is above 20-25 percent. Vol. which can then pass the equity capital to a third. One of the merits of pyramiding. often at terms unfair to one of the transacting parties. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. In Korea. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. TQ has a maximum value. it means the firm creates value. The Code prohibits a subsidiary company from owning shares of its parent company. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. which is the company holding more than 40 percent of outstanding shares of its subsidiary. one company can still place equity investments in another. The study by Kim. TQ is below 1. TQ is above 1. one company from a chaebol group could obtain debt payment
. Hong. For example. This type of inter-firm investment. is effective control of a certain group of companies even with a smaller investment. H. if TQ is lower than 1. affiliated companies have been able to conduct inter-firm transactions. The relationship between TQ and SCS shows a similar pattern. J. If SCS reaches 10 percent. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. and Vishny. If SCS is below the range of 20-25 percent. the firm destroys value. 1988). This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. If TQ is higher than 1. thus a firm creates value. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. II
Ownership Concentration and Financial Performance J. Kim (1992) found the relation between TQ and SCS to be nonlinear.
neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms.5 corporations and two individuals. together having a total of 292 domestic subsidiaries. Partial results are shown in Table 2. together owning an average of 37. The fact that corporations. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place.5 percent as of 1997. for example. Thus. standalone setups. the top 30 chaebols’ shareholding by subsidiaries was 34. Among the 81 listed firms in the ADB survey. the average shareholding of the controlling owners and their families was 8. 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. Among the subsidiaries or firms receiving investments. or an average of 13 firms per company. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. the top five shareholders consisted of 2. 34 percent were foreign companies.14. together owning an average of 38. In Table 2. or about four firms each. 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 3.4 corporations. not individuals. Twenty-two of the 81 respondents were independent. although they are likely to be insignificant. 62 percent (16 out of 26) had a corporation as the largest shareholder. Until recently. Of the 81 respondents. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. If we define the internal shareholdings of a
.23.Chapter 2: Korea 89
guarantees from other members of the group at no cost.9 percent of shares.5 percent. there are instances of direct cross-shareholding in Korean firms. For the whole sample. Among chaebol affiliated firms. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. The extent of pyramiding can be seen in some of the previous tables. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. and 319 foreign subsidiaries. For the same year. 53 percent were domestic nonfinancial firms. Thus.5 percent of shares. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. or about five subsidiaries each. and about 11 percent were domestic financial institutions. In the case of the 30 largest chaebols. 59 parent companies collectively had investments in 759 firms. In many instances. 59 were parent firms with one or more subsidiaries.
.1 1.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.1 3.4 11.2 25.0 1.5 38.8
Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.3 26.5
21.4 18.5 2.6 3. 1999
Five Largest Shareholders No.0 3.1 22.7 5.8 18. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total
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
17.9 5.4 1.9 34.5 24.8 8.4 42.6 16.7 37.5 2.5 1.8
38.5 18. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.0 13.6 3.0 21.0 2.4 25.7 19.6 3.9 29.7 39.8 31. a Number of shareholders.6 34.4 2.5 4.3 12.4 21.7 0.2 37. A few companies reported less than five largest shareholders.Table 2.5 4.0 1.4 38.
7 9. As of 1997.7
1992 46. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. 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. New York: Praeger. Hattori (1989) identified three patterns based on data in the early 1980s. Jae Woo.4 13. Chicago.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns.6 33.7 31.” Paper presented at the Annual Conference of Financial Management Association.4 10. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. 34. pp. 79-95. 15 October 1998.5 34. 1987-1997
Type of Shareholding Internal Shareholdings Family Member Companies
Source: Korea Fair Trade Commission. Ungki Lim. The family and member companies’ shareholdings have been declining over time. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Based on these studies.5
Judging from the historical record.2 33. H. 1997.24 Internal Shareholdings of the 30 Largest Chaebols. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. 1989.8 40. the ownership patterns can be described as follows.4
Hattori. Lee.Chapter 2: Korea 91
chaebol as the shareholdings of the controlling family and the member companies of the group. Tamio.24 shows the average internal shareholdings in the 30 largest chaebols.4
1987 56. the controlling families owned 8.2
1994 42.2 12.2 15. Lee.1
1997 43.5 percent.
. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held.8 33. Table 2. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.5 percent and member companies.” In Korean Managerial Dynamics. Chung and H. “Japanese Zaibatsu and Korean Chaebols. 1998. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.0 8. C. it appears that the chaebol families have had a strong desire to expand their business bases. Table 2. edited by K.
Vol. Sun Hong Kim. Thus. there is no controlling shareholder. and business activities. For example. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. completely dissolved under financial distress. other firms. the family controls the group’s member companies by its own shareholdings. But the former chief executive officer (CEO). The family itself holds shares in some subsidiaries.” shows a simple pyramidal structure.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. and subsidiaries’ equity participation. Also. The Hanjin Group. it had 18 listed and 39 private companies. The third (Type C) is “indirect control via complex shareholding. The Kia Group was about the only management-controlled group but was out of existence by 1999.92
Corporate Governance and Finance in East Asia. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. The fourth type (Type D) is “management control. consisting of eight listed and 16 privately held firms as of 1997. is an example of this type. which in turn hold shares in some of the other subsidiaries. Most of its member firms were acquired by. A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. The controlling family has sizable investments in two base companies and smaller investments in many others. and his management team exercised full control over the group without much interference from major investors. which then make investments in the subsidiaries. subsidiaries have extensive investments in other subsidiaries. As of 1997. The Hanwha Group can be classified as such a company. investments made by the base companies. The second (Type B). Hyundai Motors acquired Kia Motors via an international auction. II
The first (Type A) is called “direct family ownership. The two base companies have investments in three other base companies. It consists of seven listed and 24 privately held firms. or merged into.” Here the family directly controls a base company and a nonprofit foundation. One of the
. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. The Hyundai Group exemplifies this. called the “indirect control via base company.” Under this type of ownership pattern. holdings of the nonprofit foundation. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. financial. Investments between the lower level subsidiaries are rare.
following the amendment of the law. Existing guarantees had to be resolved by March 2000. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. 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. Until the end of 1998.
. However.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. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. thus hurting the shareholders of stronger firms. The Government is also considering whether to allow consolidated taxation for pure holding companies. the Fair Trade Act). This was the reason why chaebols chose to employ pyramidal structures. 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. Also. It remains to be seen whether they will adopt the holding company structure in the future. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. These amendments prohibited holding companies and direct cross-shareholding. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. A third disallows multiple layering of holding companies. They hindered early exits (liquidation. At this early stage. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. only operating holding companies were allowed to be established. This limit was also applicable to banks and insurance companies. The prohibition of holding companies was also abolished in 1999. 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. One condition requires that the DER of the holding company should not exceed 100 percent. Initially. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. bankruptcy reorganization.
The staff of these organizations were employees of member firms. The 30 largest chaebols are now required to publish “combined” financial statements. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. Despite chaebols’ decision to dismantle the chairman’s offices. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. Chaebols maintain that the restructuring headquarters will exist only for a limited period. there have been no significant changes. Since the economic crisis. boards of directors. II
etc.) of nonviable member firms and helped afford a disproportionate advantage to chaebols in obtaining favorable bank loans because (it was generally believed) the Government would not let large chaebols go bankrupt. 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. and transferred funds generated by one firm to another. until urgent restructuring is complete. which put together the accounts of all members of a chaebol. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical.3. Vol. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. The office established strategies for the group as a whole. Their operating costs were borne by the member companies rather than by the controlling shareholder. usually in the rank of a company president. In 1998. Some chaebols have disintegrated or shrunk in size.2 Internal Management and Control
Monitoring of corporate management by shareholders. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. 2. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. planned for capital raising and allocation on a groupwide basis. These offices were legally informal and functioned as the headquarters of chaebols. and the capital market was almost nonexistent until the recent reform
Corporate Governance and Finance in East Asia. The chairman’s office had its own chief executive officer. who is universally called the “group chairman.
the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. Meanwhile. There are many reasons for this. As of 1997. but some large ones have two or more. Banks. the creditors did not declare defaults. Loan agreements and debt indentures did not include strict covenants. In most listed companies. except for banks. Even when the covenants were violated. Board of Directors General Characteristics of the Boards Under the Commercial Code. This policy managed to hamper any monitoring initiatives from the capital market. The board elects one or more representative directors from among the board members. With few exceptions. corporations should have a board of directors consisting of at least three members. especially chaebols. had their own governance problems.
. However.Chapter 2: Korea 95
efforts. Under such circumstances. Legal provisions to protect investors were limited. The Government’s policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. or at least acts as the de facto CEO. Even where the largest shareholder is not the representative director. he or she generally approves major decisions made by the management. this was complicated by the prevailing attitude that large companies. the representative director was also the chairperson of the board. Thus. the controlling shareholder is officially the representative director and the CEO. and takeover codes were not accommodative to active monitoring. the concept of fiduciary duty of managers was not well established. only the Government could play an effective role in monitoring corporations. 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. were too big to fail. in most Korean firms. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. as the major creditors. Most companies have one representative director. control is not separate from ownership.
companies have to disclose in their annual reports the frequency of board meetings. other than the representative director(s). all of whom were managers. A few large companies had more than 50 directors.
. 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. 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. the attendance rate of outside directors. Moreover. II
When the Commercial Code first introduced the corporate board system in the 1960s. 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. In order to address this concern. In the 1999 annual shareholders meetings. were supposed to be outside directors. almost all companies succeeded in adopting cumulative voting. However. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. However. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. Vol. With the boards consisting only of insiders. Recent Reform Efforts on the Board System In 1997. 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.96
Corporate Governance and Finance in East Asia. and their positions (accept or reject) on matters voted on in board meetings. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of 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. members of the board. Despite the qualification requirements. 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. 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. Further. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies.
9 percent on average. In March 1999.5 percent of the shares. a blue-ribbon committee. Directors were also chosen on the basis of their relationship with the controlling
. although some banks recently have established board committees. On average. an audit committee. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. which had extended financial support in their recent recapitalization efforts. are required to have a majority of outside directors. the chairperson of the board was also the CEO and on average held 10. Where the chairperson was not the CEO. Where the two were separate. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer).1 percent of outstanding shares of a listed company. he or she held 6. the Korean Code recommends that large listed firms should have at least three independent directors.2 percent and the CEO 14. These results are in accordance with the new listing rules introduced in 1998. In 78 percent of the responding firms. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. inside directors owned 16. having no controlling shareholders. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange.Chapter 2: Korea 97
The committee structure of the board as found in the US has not yet been adopted by listed companies. who would comprise at least 50 percent of the boards. The average board had 8. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis.4 directors. they had a parent/child relationship in 20 percent of the cases. This is because most banks. this committee adopted the Code of Best Practice in Corporate Governance. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. and a nominating committee. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. In September of the same year. the Corporate Governance Reform Committee. 88 percent had plans to hold elections in the near future. The controlling shareholder of some banks is the Government. Among the firms with no outside directors.1 percent and outside directors 1. Meanwhile. Among others.
the term of appointment of directors and board chairpersons is three years. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. in some firms. These were established only recently. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. 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). the management nominated director candidates (64 percent of the directors). Less frequently. About five directors per firm have been in office for more than one term. the management determines the remuneration.
. among the 81 sample firms. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). Vol. 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. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. However. and fixed fees plus performance-related pay. one person was sitting on nine boards and this person was the CEO of a chaebol firm. In one case. the board had a nomination and an audit committee. and shareholding (10 percent). In 13 percent. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. relationship with controlling shareholders (21 percent). Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. According to the Commercial Code. In some instances. the board had no committees. II
shareholder (30 percent). a total of 562 directors were sitting on two or more corporate boards. In 1997.98
Corporate Governance and Finance in East Asia. In most firms. In 91 percent of the sample firms. This rather long tenure must be due to their status as controlling shareholders in most firms. As discussed earlier. In a very small number of firms. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. The current chairperson has been in office for 6.2 years on average. including stock options. founders of the company acted as the chairperson (22 percent). election of directors was based on shareholdings (7 percent) and status as founder (7 percent). in 23 percent. The board or the management then determines compensation packages for individual directors. Most frequently.
In 20 percent. In the survey. In such cases. According to the survey. When CEO is not the chairperson. In less than 20 percent of the firms. CEO is also the founder in 52 percent of the firms. the payment is about five times the CEO’s annual salary. In a handful of sample firms. compensation is by fixed salary in 74 percent of the firms.
. In the 25 firms where CEO was not the chairperson of the board. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. CEO generally has the ultimate power to decide on corporate affairs. shareholding in three firms. in which there is no controlling shareholder. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. the survey tells a slightly different story than is generally believed in Korea. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. CEO was given shares by the family. Ensuring that a company serves the public interest is considered a less important responsibility of CEO.2 years. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. he or she was selected on the basis of professional expertise in 15 firms. decides on important matters on his/her own in 13 out of the 44 firms. fixed salary plus net profit-related bonus in 9 percent. CEOs have been in their positions for an average of 9. and fixed salary plus performance-related pay including stock options in 13 percent. It indicates that 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. In 4 percent of the cases. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. and in another 21 percent CEO bought shares in the market. However. In cases where CEO is not the largest shareholder and chairperson. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO. CEO simply follows the orders of the chairperson. he or she does not enjoy much power. who is not the chairperson. In 21 percent of cases. and was appointed by the Government in five firms. it was proposed by CEO and approved by the board.Chapter 2: Korea 99
Management CEO In the survey sample.
but in practice is fixed and understood as part of a fixed salary. and
. 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. 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. 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. This action was in response to calls by international investors and. Senior managers were even often called directors although they were not official members of the board. 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. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. disclosure. Korean firms have rarely used shares for executive compensation. Penalties for fraudulent financial reports were increased. The bonus is supposed to be linked to company performance. Vol. (ii) establishment of accounting standards for financial institutions. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. However. in particular. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards.100 Corporate Governance and Finance in East Asia. The commission has played an active role in introducing new rules on corporate governance. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. and accounting standards. II
Senior Executives In the past. 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. from IMF and the World Bank. it was common for all senior executives to be elected as directors at the shareholders meeting.
Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. however. In practice. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. Thus. 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. Notwithstanding a regulation limiting the votes of the largest shareholder to a maximum of 3 percent of the outstanding voting rights in selecting an internal auditor. they also have the power and duty to monitor the activities of executive directors. but 49 percent confessed that they have not followed international standards at all. 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. 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. Consolidated reporting was introduced before the outbreak of the crisis. 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 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.Chapter 2: Korea 101
(iii) establishment of accounting standards for “combined” financial statements of chaebols. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. the internal auditor is considered to be a subordinate of the
. 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. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. Under the Commercial Code.
this problem will largely disappear. 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. Vol. External auditors are selected for a term of three years. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. In order to increase independence. 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. Previously. 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. 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. In the ADB survey. II
controlling shareholder/CEO.6 years. The current external auditors have been associated with the surveyed companies for an average of 4. the board of directors had the power to appoint an external auditing firm. and creditors selects it. then the Securities and Futures Commission can appoint a new one. About 100 listed firms will be subject to this requirement. however. Accepting these arguments. Big Korean accounting firms are affiliated with US accounting firms. underdeveloped market discipline for accounting firms. If the company changes its external auditor for reasons that are not listed in the relevant regulation. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. Listed and registered corporations must publish financial statements audited by external accounting firms. 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. But this problem can be mitigated if auditors function under the umbrella of the board. as a monitor of management in the Korean (and also the Japanese) system. If the status of internal auditors is elevated to that of independent board members. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors.102 Corporate Governance and Finance in East Asia. but since 1998 a committee consisting of internal auditors. and lack of strong professional ethics in the accounting profession.
. In the past. outside directors. does not have the power to hire and fire the managers. almost all firms affirmed that the external auditor is independent from the company. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. This is because the auditor.
Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. One common share should have one vote. The securities companies and banks are the second and third. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting.3.Chapter 2: Korea 103
2.” The survey shows that the Korea Securities Depository holds 69. Under the Commercial Code. The management is the most important proxy. 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. the Depository is subject to “shadow voting.” Companies can increase the number
. However. small shareholders do not attend the annual meeting and that. in general.79 percent of the shareholders. This shows that a relatively larger number of shareholders send in their proxies.77 percent of the shares.21 percent of total shares issued. Internet. respectively.93 percent of the shareholders but 26.53 percent of the total shareholdings. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. 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. No companies have so far introduced voting by mail.3
Voting Rights and Practices Under the Commercial Code. amendments of the articles of incorporation require a “special resolution. The Depository represented 20 percent of the shares attending the meetings. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). corporations cannot issue common shares without voting rights. the Depository is instrumental in getting resolutions passed. charter amendments. Approval of mergers and major divestitures. However. A total of 326 shareholders per firm. and dismissal of directors and internal auditors require a “special resolution. About one fifth of the listed firms issued nonvoting preferred shares. These voters represented only 5. attended the last annual general meeting. or 10. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. The above results indicate that.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. or telephone. representing 62. Thus. for some firms.
and major investment projects (only five firms answered this question). Those that are most likely to be rejected relate to election of directors.0 percent. Vol. For recommendations for dismissal of directors and internal auditors. 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 0.5 percent. demand changes in business policy. an institutional investor based in the US. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. In February 1998 and again in March. It also attended the shareholders meeting of several companies to present the views of outside shareholders. As an example. II
of votes required for a resolution to amend the articles. the board of directors decides on issues of shares within the limit of the authorized capital. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms.104 Corporate Governance and Finance in East Asia. Various measures have since been taken to improve investor protection. dividend proposals. Due to the changes in rules for investor protection. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. Shareholders have preemptive rights. the Tiger Fund. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. laws and regulations were generally very loose in protecting the rights of minority shareholders. In four out of 62 respondents. Shareholder Protection Before the economic crisis. Changes in the authorized capital require an amendment of the articles of incorporation. The company also agreed to the right of the fund
. mergers and acquisition plans. Only two out of 62 respondents to this question have had cases in which proposals were rejected.01 percent. the requirement was lowered from 1 to 0. from 3 to 1. 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. Proposals put forward by management are rarely rejected at the general meetings. or block charter amendments considered harmful to minority shareholders. However. but these can be waived by an amendment of the articles of incorporation. and for access to unpublished accounting books and records. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings.
As for bond issues. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. This has strengthened the accountability of controlling shareholders as de facto CEOs. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. For further protection of investors. After the economic crisis. Banks have played some limited role in monitoring the investment activities of chaebols. In fact. In 1974. Thus. underwriting securities firms acted also as trustees.Chapter 2: Korea 105
to recommend two directors to the corporate board.
. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. and not strictly enforced. and transactions with major shareholders. simple. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. mergers and acquisitions. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. The laws and regulations of the country protect shareholders from interested transactions. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. affiliated lending or guarantees. However. 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. 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. The covenants in loan agreements and bond indentures were very loose. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits.4 Control by Creditors
Role of Creditors in Corporate Monitoring Traditionally. managers were considered to be subject to the duty of care. Before the amendment. loans to directors. creditors did not interfere with the management of a debtor. there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants.3. but it was not entirely clear whether they had the duty of loyalty as well. 2. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management.
Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. 11 banks. II
acquisitions. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. 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. However. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. Vol. In 1994 the approval requirement was abolished. there have been concerns that the Government might use the system to intervene in the management of the business groups. this proposal has only a slim chance of being accepted by the Government or legislature. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. However. 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. as discussed earlier. 10 nonbank
. Under the system. In 1996. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. including. 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. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. Besides the setting up of an “External Auditors Committee” by firms. and purchases of real estate. 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.106 Corporate Governance and Finance in East Asia. Purchase of real estate should be financed by equity capital and not by borrowed funds. creditors now have a bigger say in court proceedings for receivership and composition. In turn. on average.
renegotiation took place after the crisis. while a third think that creditors have weak influence. For a small number of firms. and other financial institutions. and purchase or supply of raw materials. Among the creditors. collateral was taken away. For more than half of such firms. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. One tenth of the firms received assistance from the Government in loan applications. More than half of the firms think that creditors have no influence on their management and decision making. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. NBFIs infrequently ask for collateral. Creditors usually exercise their influence through covenants relating to the use of loans. subsidiaries. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. in order of importance: affiliated companies. The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. The borrower’s relationship with most banks has lasted for more than five years. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. collateral is more likely to be required of loans for working capital than for fixed investments. mutual guarantee agreements. holding companies. whereas seven of the 17 nonfinancial corporations are. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral. When loans could not be repaid on time. With respect to the types of loans. Most of the financial institutions are not affiliates of the borrowing company. banks are most likely to require collateral. payments were usually rescheduled through negotiation without any penalty. The assistance came from. A few creditors exercise influence through covenants relating to major decisions by the company. penalty was involved in rescheduling. or through their shareholdings. 16 percent
. Most firms feel that requirements for collateral have been tightened since the crisis started. or creditors filed for receivership. holding shares of another company by both the borrower and the guarantor.Chapter 2: Korea 107
financial institutions (NBFIs). Only a few feel that creditors have very strong influence. controlling shareholders. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. and 17 nonfinancial corporations.
In cases where the creditors are unable to reach an agreement on a workout plan.5 The Market for Corporate Control
Government Policy Toward Hostile Takeovers Until 1994. Behind these new strengthened roles of creditors is the newly set-up FSC. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. Third.3. Separate from but emulating the CRA. In this connection. have been the driving forces for restructuring activities of the largest 64 chaebols. will get involved in the restructuring and workout processes. are summarized below. 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
. including commercial and merchant banks. Vol. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. First. This committee was set up in accordance with the provisions of the CRA. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. Second. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. and 1 percent by the Government. major creditors. II
by other affiliated companies. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. 2 percent by holding companies. especially banks. the Korean Government maintained a policy of protecting the incumbent management of listed companies. 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. The new ways through which creditors. the delegation has the right to approve wide-ranging financial activities of the firm. 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. and in continued monitoring of debtors. 2.108 Corporate Governance and Finance in East Asia. Under a contract signed between the creditors and the debtor. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. banks and other institutional lenders are playing more important roles than ever before. 4 percent by subsidiaries.
Privately placed CBs cannot be converted into shares in one year.Chapter 2: Korea 109
unless he or she obtains prior approval of the Securities and Exchange Commission. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. turning to white knights. A company cannot issue new shares to a third party without first amending the corporate charter. and announcing competitive tender offers by the controlling shareholder. a total of 13 hostile takeover attempts occurred. it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. hostile takeovers by tender offers began to appear in the capital market. 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. For takeover defense. listed firms rely mainly on shareholdings by the largest shareholder. 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. 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. Publicly issued CBs require three months before their owners can convert them to shares. more than half of these attempts failed. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. but were completely eliminated in 1998. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. corporations cannot limit the voting rights of large shareholders to a given maximum. 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). Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. The reasons for failure are diverse. However. Takeover Activity As soon as the Act was amended. Companies have also utilized share repurchases.
. Unlike Germany. Unlike the UK. Stock purchases by tender offer were also exempted. In one case. As far as institutional arrangements are concerned. Between 1994 and 1997.
2. are designated as public companies. In 1998. In 1999. except for the banks. 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. 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. For the steel company. Charter amendments have also been employed by some firms to limit the maximum number of directors. 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. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. 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. Many of the takeover targets in the past did not have a controlling shareholder (group). Currently the limit is 3 percent. In their charters. Some had two or more large shareholders who had joint control of the firm but could not cooperate. an electric power company. and a bank had government ownership. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. It is harder now to find such firms. As of February 1999. the limit will be eliminated when it is fully privatized in two years.7 percent on average as of the end of 1997 for nonfinancial listed firms).110 Corporate Governance and Finance in East Asia. Korea Telecom. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress.6 Control by the Government
State-Owned Enterprises Government ownership of listed companies is very limited. As of the end of 1997. Hostile takeovers in Korea will be rare in the future. For the others. 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.
.3. Vol. in which the Government still holds the largest ownership. was newly listed. The Government-owned listed companies. 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. Another reason is that many listed firms belong to chaebols.
It was abolished before the economic crisis but another regulation. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. which was introduced in 1996. only qualified firms could issue new shares. Even where employees hold
. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. administering through a self-regulatory committee of the securities industry. There is no active debate or discussion going on about this potentially difficult issue. especially those belonging to chaebols. as applied to four large corporations. For example. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. nominated by the minister in charge of the company in question. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. Meanwhile. But this rule. the Government. The Government’s right to send public officials to the boards was eliminated.7 Employee Participation in Corporate Governance
Employee participation in corporate governance is very limited. Labor is not represented in corporate boards. 2. There were also limits on the amount raised and the number of issues per year. In addition. which limits the total amount of bonds issued by the five largest chaebols. Beginning in 1999.Chapter 2: Korea 111
The Government used to appoint a few public officials to the boards of state-owned corporations. The nonexecutive directors are now recommended by a committee. The Government has frequently imposed restrictions on the use of capital markets by large companies.3. more state-owned corporations became subject to this new board structure. and approved by the Chairperson of the Planning and Budget Commission. 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 2.3. 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. Further. the main bank system.1).
Under the Labor Management Council Law. and 66 percent manual workers. Collective bargaining is. but 27 percent of them felt that it was strong. carried out at the enterprise level. In 1987. 2.
. of which 2 percent were senior managers. II
shares of their companies through employee stock ownership plans. The typical collective bargaining agreement has a one-year duration. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. The relevant regulation was amended recently in order to facilitate voting by individual employees. The respondents of the ADB survey had 2. The union had no influence on the management in 17 percent of the firms.654 employees per firm on average. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. employers are required to meet with representatives of labor unions at least once every three months. in principle.1 in 1997. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. operation. Two thirds of the respondents had an organized union.9 in 1980. Vol. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Under the Capital Market Development Act of 1968. and 2. In actuality. About half of these firms considered the influence of the union on the management of the company to be weak.5 in 1990. 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. Local unions in the same industry have established industrial labor federations. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. In these firms. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. which were generally much lower than estimated values. Under another law enacted in 1972 to induce private companies to go public. the management usually consults the union on major issues relating to the management. At the national level. In 70 percent of the firms with organized unions. The percentage of shares held by the employee stock ownership plans in listed companies was 1. and development of the company. they delegate their voting rights to plans’ representatives. the council meetings have been superficial.112 Corporate Governance and Finance in East Asia. there are two federations of labor unions. 32 percent technicians and professional staff. Trade unions are organized on an enterprise basis. union members account for 54 percent of the employees.
Chapter 2: Korea 113
Corporate Financing7 Overview of the Financial System
The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7
The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.
114 Corporate Governance and Finance in East Asia, Vol. II
counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.
Chapter 2: Korea 115
Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump
116 Corporate Governance and Finance in East Asia, Vol. II
after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the
Chapter 2: Korea 117
total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage
especially the domestic bond market. and organization of commercial banks. The Government adopted a cautious approach. Since 1985. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. implementing the first stage in November 1991. On the basis of flows of funds. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market.5 percent in November 1981. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. and liberalization of foreign and capital transactions. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector.1).
. The capital market. short-term finance companies. as a first step toward liberalization of capital account transactions. With the privatization of nationwide commercial banks. Also. Vol. Internal funds include retained earnings. development of the money market. finance companies. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. Moreover. Korean firms have been allowed to issue CBs in international financial markets. II
Interest Rate Deregulation Plan.118 Corporate Governance and Finance in East Asia. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. budget. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. mutual savings. the business scope of financial institutions was greatly widened from the early 1980s. the Korean Government announced its Financial Liberalization and Market Opening Plan. etc. In addition. revision of the credit control system. was liberalized drastically in 1998 after the financial crisis. the Government simplified various directives and instructions regulating personnel management. which resulted in the establishment of a number of new banks.2 Patterns of Corporate Financing
Corporate Financing Practices In this section. listed companies. It included such important issues as interest rate deregulation. Meanwhile. Some policy loans were also abolished. In June 1993. depreciation. and the 30 largest chaebols. 2.2.4.
25. financing by corporate bonds and CPs was more significant than by new equity.Chapter 2: Korea 119
and net capital transfers from the Government. comprising internally generated capital (retained earnings. It measures the degree of financing growth in total assets by additional equity. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock).25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. 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. but it remained less than 10 percent of total financing. Securities finance became a more important source from 1988 onwards. the proportion of foreign borrowings in total finance rose steadily. The share of external financing. The SFR averaged 28. This means that internal funds after dividend payment were insufficient to finance growth in total assets. except for the stock market boom of 19871988. and 1997. including all sources other than retained earnings.26 shows the four measures of corporate financing calculated from Table 2. and allowances) and new equity capital. and government transfers. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. was 71 percent during the period. capital surplus. Equity capital represents the shareholders’ commitment to the business. Meanwhile. Before 1988. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. 1994. In securities finance. depreciation. The corporate sector used
. the corporate sector’s most important source of external finance was bank borrowings. In 1988 when the stock market boomed. on average. particularly in the 1990s in response to the liberalization of the capital market. except in 1991. depreciation. Financing Patterns of the Aggregate Corporate Sector Table 2. It measures the degree of financing growth in total assets by additional debts. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent.4 percent in the precrisis period 1988-1997. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. particularly in the short term. Table 2.
3 27.7 2.6) 5.8 56.1 12.5 0.1 1.8 0.2 13.2 6. b Includes capital surplus.6 0.6 11.4 — 28.8 (0.7 1.1 17.6 (0.25 Flow of Funds of the Nonfinancial Corporate Sector.7 32.2 6.7 71.7 6. 1988-1997 (percent)
1988 43.3 10.3 — — — — 8. depreciation.1) 4.8 1.3) 11.5 2.3 1. a Includes retained earnings.3 6.3 6.1 (1.8 — 26.5 0.9 10.7 14.4 9.7 1.3 6.7 7.6 14.4 0.3 2.5 9.2 1.3 1.6 77. Bank of Korea.0 2.7 8.7 14.0 3.4 2.1) 4.7 12.7 13.7 — — — — 9.
.5 2.8 -2.6 5.1 1.6 9.0 9.8 8.0 22.2 — — — — 9.6 3.6 2. which is the excess of current value over issue value of stock.1 3.4 2.4 15.0 10.9 28.4 27.8 15.1 2.6 9.6 0.3 72. and Flow of Funds.2 14. Source: Understanding Flow of Fund Accounts.2 10.0 16. Bank of Korea.3 30.7 2.4 0.4) 13.4 71.1 8.4 1.0 0.9 6.1) 6.6 11.0 5.3 3.5 2.7 4.0 1997 26.7 8.7 2.0 70.1 10.8 17.4 27.4 27.2 — 28.7 1989 1990 1991 1992 1993 1994 1995 1996 22.1 (0.2 (0.8 1.0 3.0 (0.0 11.9 10.Table 2.3 25.1 72.0 3.5 2.4 8.1 — 27.4 2.4 (2.0 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.2 13.6 4.4 1.7 11.1 2.8 4.5 16.3 16.9 0.1 3.6 0.6 1.1 36.2 26.2 15. 1994.3) 15.3 1.9 73.1 0. and net capital transfers from the Government.7 10.1 1.9 38.7 4.1 27.3 5.8 1.2 34.1 3.1 23.6 3.2 5.7 15.1 0.0 0.7 73.7 (0.4 10.4 (0.3 3.5 13.4 2.6 8.6 9.9 72.9 2.0 9.2 2.5 16.0 — — — — 8.3 — 30.6 25.0 17.6
Sources of Funds
Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.4 21.1 — — — — 12.8 1.7) 11.5 29.4 11.0) 12.6 0.6 4.6 4.8 30.7 10.8 1.4 3.9 34.8 27.7 10.5 0.6 10.9 9.2 0.
an average of 59.6
Excludes capital surplus.6 62. the corporate sector relied heavily on external financing for its expansion.7 28.0 5.3 60.0 57. Its IEFR and NEFR dropped to 23.4
IEFR 63.3 59.4 12. NEFRs. average SFR was 37.0 11.4 37.8 62. 45. respectively.5 and 76.2 percent of incremental asset growth was financed by equity.6 26.1 17.Chapter 2: Korea 121
Table 2. There were significant time trends.4 27.7 40.1 percent in 1988 during the stock market boom.8 percent of its total asset growth through debts.3 73. Bank of Korea.5 68. Bank of Korea.3 12.9 28.6 percent and 1.2
IDFR 36. On average.4 percent. While SFRs. 1994. Source: Calculations from Understanding Flow of Fund Accounts. and the total debt ratio was much higher in 1996 and 1997 at 62.7 40.
.4 percent (Table 2. 1988-1997 (percent)
Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average
SFRa 43.5 percent.26 Financing Patterns of the Nonfinancial Corporate Sector. in the manufacturing sector. NEFR registered 20.3 11.7 9.8 10. and IEFRs were declining.7 26.9 percent by 1997 when net profit margins were negative.1 39.7 30. but plunged to 5. declining to 26. Lower income diminished the industry’s equity position toward crisis year 1997.8 28.9 46. dropping to 26.6 percent over the 10-year period. It dropped to 28 percent the following year. IDFR reached 73.5 31. In periods of high economic growth such as in 1988.27).3 percent in 1997.6 percent. Across industry. The balance.9 60. but also continuously fell.0 42.7 percent in 1997.5 percent in 1997.9 22.4 percent.1 12. respectively.2 37.1 26.5 12.
additional equity to finance 12.1 53.3 27. higher than the aggregate 40.4
NEFRa 20.7 40. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years. Manufacturing financed 54. higher than the aggregate 28. indicating a high financial risk position.0 27. was financed by additional debts.2 percent of the growth in total assets.3 59.6 percent. SFR peaked at 44 percent. Incremental financing from equity was 40. and Flow of Funds.
Categorized according to company size.3 28. then increased to 20.2 21.7 37.8 4.0 42.8 IEFR 65. large firms showed more cyclical patterns in these financing ratios than small.5 NEFRa 9.9 percent.9 6.6 54.8 percent in 1990. and low total debt and short-term borrowing ratios. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.0 42. gas.3 52.0 3. retail. It had the highest average SFR in 1988 at 31.2 percent in 1993. Financing patterns of the wholesale.4 3.2 3.0 30.4 63. the two sectors also had low equity financing ratios and high debt financing ratios. their average SFR was higher. and steam) and the transportation.8 percent in crisis year 1997. one year ahead of the other industries.4 47. from 17.7 47. On the other hand.4 54. storage.1 29.4 37. II
The construction industry showed the most cyclical pattern in annual asset growth. the proportion of short-term borrowings in total financing has been high.6 53.6 45.7 percent in 1996. Since 1992. Vol. Since large firms were more profitable. Total debt financed an average 74.5 23. In 1997. and communication sector had relatively high incremental equity ratios.6 3. explaining partly the collapses of several construction companies in 1995.7 47. and hotels sector and realty/renting/business activities sector were similar. which decreased to 8.2
.7 37.6 36.and medium-sized firms.122 Corporate Governance and Finance in East Asia.6 53. the utilities (electricity.6 37.5 1.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent)
Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.0 57.1 percent of total asset growth for the period.6 62.
Table 2.6 4. Equity financed an average 25.2 62.6 37.8 50. this dropped further to 15. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. and fell to about 10 percent in 1997.2 5.9 percent of asset growth.5 7.9 IDFR 34.5 76.4 46.4 45.
.9 20.2 20.6 14.5 12.3 10.2 23.0 68.9 1.7
Wholesale/Retail Trade.2 70.8 81.2 29.1
47.2 46.3 1996 16.0 31.6 37.3 21.2 4.2 10.2 74.8 74.4) 2.0 1990 12.1 1991 14.0 17.27 (Cont’d)
IDFR 53.3 8.8 2.0 65.9 Average 19.2 8.4 26.7 78.2 25.4 2.5 87.5 23.9
52.1 4.7 1994 53.9 2.6 9.4 28.4
IEFR 46.5 1993 22.7 53.0 1.1
Trasport.6 4.8 25.3 4.3 7.5 29.9
Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average
31.8 1991 51.3 57.8 76.6 9.6 1997 29.Table 2. Storage.0 40.7 80.0 60.9 1993 63.0 34.5 76.0
74.6 37.4 1995 53.8 4.5 70.0 1990 50.3 84.7 6.9 15.1 59.7 15.6 71.0
3.3 4.7 42.0 4. Household Goods.9 29. and Communication 1988 64.7 7.9 1989 63.0 82.4 62.8 70.6 8.1 84.9 1.7 78.0 10.2 18.7
15.1 70.2 3.6 73.9 1.7 41. Hotels 1988 33.2 Average 53.5 1.6 7.0 0.8 9.1 69.9 1992 56.5 62.7 1989 26.5 20.1 19.7 1997 8.2 1995 16.9 16.5 21.9 9.0 1992 24.6 8.5 1996 42.8 54.2 5.9 30.9 33.1 66.3 19.9 80.3 (9.8 1994 15.3 47.8 29.
4) 3. and Steam Supply 1988 118.3 29.4
(107.7 14. SFR = self-financing ratio.3 62.3
Their average IEFR was also higher and IDFR smaller.4 5.7 37. Source: Calculated using data from Bank of Korea.5 8.6 1989 118.8 1993 11.3 81.0 53.4 47.1 42. a Excludes capital surplus.124 Corporate Governance and Finance in East Asia.9 28. and Business 1988 51.5 22.and mediumscale firms.0 1992 51.0 43.7 70.1 35.9 45.0 1997 24. The trend was reversed in 1996-1997.7 18.6 1991 18.27 (Cont’d)
Year SFRa NEFRa 6.7 1996 18.0 0.0 46.7 69.6 1990 82.0 21.4 IEFR 69.6 7.1 0.2 1992 18. Renting.1 1989 34. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.and short-term borrowings of these firms shot up in that period.3 Electricity. IEFR = incremental equity financing ratio.0 56. Vol.0 1.3 3.6 1997 23. Gas.0 (0. however.6 52.9 29.6
Real Estate. II
1.1 54.2 63.0 33.9 64.4 0 0 0 0 1.4 1994 72.3 92. when large firms had much lower equity financing ratios and higher debt financing ratios than small. The large firms had a higher proportion of external financing in 1996-1997.9 IDFR 31.0 79.8 Average 22.8 36.6 1995 17. Long.8 17.6
IDFR = incremental debt financing ratio. NEFR = new equity financing ratio.1 71.9 65.1 1991 56.8 135.8 1990 19.4 0.1 70.
.4 1995 62. Financial Statement Analysis Yearbooks.4 7.4 1.5 77.3 31.3 85.1 1993 55.3 7.8) 7.9 Average 75.9 57.4 1996 45.1 34.0 67.0 0.7 1994 8.8) (35.
153.5 percent is lower than that of the corporate sector in general. about the same as that of the corporate sector as a whole. the IDFR of listed companies increased to 93.6 percent. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.30). the average SFR was 28. In 1997.5 percent and their total external financing. The proportion of their short-term financing averaged 72. the top 11-30 chaebols had the highest guarantees commitments at 207.29). The average IEFR of the top 30 chaebols of 29. They were able to borrow easily from banks by issuing corporate bonds and CP. respectively. and higher than that of listed companies (Table 2.28). In 1997. External financing reached 94. and were large borrowers. The average IEFR and IDFR were 10.6 percent of total asset growth.1 percent of their equity capital. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. Group-member firms borrowed less.4 percent.7 percent. compared with 89.7 percent. for listed companies. compared with the entire corporate sector’s 35 percent and 65.2 percent. Cross-payment guarantees have been declining since 1993 and reached 91. The chaebols’ drive to expand their empires resulted in heavy borrowings. at an average 70. the lowest ratio of 58. and the top five chaebols.8 percent of their total finance in 1997. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.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. In 1996-1997.7 percent for all listed companies. Their shortterm borrowings accounted for 86. All of the top 30 chaebols relied heavily on short-term borrowings. the top 6-10 chaebols. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. and using cross-payment guarantees among affiliated companies.8 percent. but higher than that of listed companies. The largest borrowers were the top 11-30 chaebols.3 percent of their equity capital in 1997 (Table 2.3 and 89.9 percent. The debt financing ratio of listed companies was high since they relied more on external financing.
. Financing Patterns of Chaebols For chaebols.9 percent. 91.
4 29. Source: Calculated using data of Seung No Choi.1 1.6 1.6 70.9 7.1 93.6 11.7 13.3 1.
Table 2.5 91.1 8. 1994-1997 (percent)
SFRa 41. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.4 88.
.2 23.2 36. 1994-1998 (percent)
SFRa IDFR 85.3
1994 1995 1996 1997 Average
a Excludes capital surplus.6 61.6 0.2 1.3 IDFR 57.9 NEFRa IEFR 14.4 38.29 Financing Patterns of the Top 30 Chaebols.5 2.8 22.5 8.6 IEFR 42.2 10.4 12.7 12.4 1.7 1.Table 2.2 NEFRa 1.3 5. Korea Federation of Industries.5
1994 1995 1996 1997 Average
Excludes capital surplus.9 6.28 Financing Patterns of Listed Companies.8 76.3 86. Largest Business Groups in Korea.5 2.3 28.8 89.5 8.
30 Cross-Payment Guarantees of the Top 30 Chaebols. And fifth.
Factors Influencing Corporate Financing Choices Until recently.9 — — — 1994 258.3 58. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees.1
— = not available. bond issues.0 1997 91. Few firms ranked loans from NBFIs as their first preference.3 64. Second. Financial institutions did not strictly screen their loan projects and monitor their debtors. Third. company preferences in financing investment projects before the crisis were.9 153. Fourth. the Government applied high tax rates on net profits of corporations. rights issues. so that the firms engaged in lobbying to gain access to them. Firms now prefer internal funds and new equity capital. and extended loans based on cross-payment guarantees. and underdevelopment of the stock market. First.9 — — — 1996 105.0 207. Further. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control.7 150. There were several reasons for this. bond issues.3 200. the Korean economy was plagued with high inflation. and loans from NBFIs.Chapter 2: Korea 127
Table 2. inefficient investment and excessive diversification of corporations. These are followed by loans from banks. and reserves and retained earnings. poor financial and corporate governance resulted in overlending by banks. Source: Fair Trade Commission and the Federation of Korean Industries. This change implies that firms now give more attention to financial risks. Interest payments on debts were considered a loss when calculating taxes.
. loans from banks. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices.1 — — — 1995 161. According to the ADB survey. more than half of bank loans were priority loans with low interest rates. especially in the 1970s when real interest rates of bank loans were negative. the Government provided implicit guarantees on bank lending and large businesses. 1993-1997 (as percentage of equity capital)
Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. in order of ranking. Korean firms preferred debt financing (bank and nonbank borrowings).
maintenance of the existing ownership structure. Among those that never hedged against exchange rate risks. even with a heavy debt burden. 2.5 percent at the end of 1997. 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. they survived for two to three
. Only a few firms sought foreign loans because domestic loans were not available.128 Corporate Governance and Finance in East Asia. and others (29 percent) expected the local currency to appreciate in value. Diversification. and reduction in tax burden. According to the survey. Among the responding companies that had foreign currency denominated loans.4. many firms (or 42 percent) never considered hedging.3 Financial Structure. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). and futures and other financial derivatives. in order of importance. This preference has changed little after the crisis. Vol. II
In seeking external financing. the percentage of foreign currency denominated debt in the portfolio was 14. Other factors include. 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 1996.36 percent on average for these companies. For these firms. firms give their first consideration to minimization of transaction and interest costs. Nonetheless. more than half (53 percent) hedged against exchange rate fluctuations. Korea now provides a better environment for financial risk management. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. some (36 percent) thought that a hedging facility was not available or not working properly. ensuring the liquidity of the company. in selecting financing sources. 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.
13). the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms.. the top five chaebols’ ratios were much higher. (i) In terms of total borrowings to total assets. Among the main findings were the following.Chapter 2: Korea 129
years before collapsing at the time of the 1997 financial crisis (2. as well as lax financial supervision (Nam et al. In order to determine the relationship between financing patterns and corporate performance. 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. They were also higher than those of the top five chaebols until 1992. (iv) In terms of EBITDA to total assets. But since 1992. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. 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. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses.
. Table 2. the top five chaebols and the top 6-70 chaebols had similar ratios. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. However. They were also higher than those of the top five chaebols until 1991. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). These findings indicate that independent firms have had a lower leverage and performed better financially. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period.2. but the ratios of independent firms were much lower.3. except in 1991. Nam et al. (ii) In terms of net income to total assets. except in 19931995 when semiconductor prices were extraordinarily high. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. 1999).
except in the recession years of 1996-1997. the degree of diversification was highest in the top five chaebols. Indicators such as increasing debt-to-equity ratios. Their subsidiaries. and lowest in the top 3172 chaebols. Government intervention. too.31). rising nonperforming loans (NPLs) and falling
. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. had easier access to credit than the top 31-72 chaebols. debt guarantees for free. larger research and development expenditure. however. In terms of the net profit margin (the ratio of net profits to sales revenue). had a significant role.
2. or outright transfer of resources due to poor corporate governance practices. court receivership. The differences in the degrees of diversification among the three groups are substantial. and easier access to cheap credit. second highest in the top 6-30.130 Corporate Governance and Finance in East Asia. II
Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas.5
The Corporate Sector in the Financial Crisis
This section looks at the various causes of the crisis in 1997. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. The degree of diversification of chaebols that fell into default. The diversification of the top five chaebols remained at about the same level within the period. 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. Vol. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. The diversification of chaebols under workout was much lower than that of the top 6-30. Meanwhile. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. its profit rate declined. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. During 1985-1997. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector.
1 0.6 0.9 1.7 1.5) (1.4 1.8) 2. p.3 1.1 0.6) (20.5 (0.0 1992 1994 1.3 1.1 (3.8 3.11.8 0.5) (2.3 0.0) (0.3) 0.3 1.4 (0.1) 1.4) (4.7 1.1 4.6 0.3 (0. Management Research Institute.6 1.2 (0.0 6.9 0.2 1.31 Net Profit Margins of Chaebols.1) 2.1 (4.1) (1.3) 0.7 0.6) 0. Background and Task of Structural Adjustment.6 1.2) (4.2 (0.3 1.8) (4.8) 1997 0.6 1.3) 0.1 1.0 1.7) (1.8) (3.0 1.1 1.9) 2.8 1.2 (17.6 1.5 (4. 1985-1997
Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.9 8.3) (12.5 (0.4) (2.4 1.0 (7.5 1.3) (1.0) 0.3 (0.8) 0.1 1.2) (4.7 0.5 (0.4
(1.3 1.0 0.3) 1. Beyond the Limit.7 3.9) (1.1) 0.3 (0.0 (0.7) (0.5 1.0) 0.5 4.8) (1.8) 0.9 0.7 0.1) (5.6 7.2 (0.8 0.6 0.5 2.8 1.7) (0.1 0.2) (0.8) (37.3 1.7 1.8) 0.1 (0.0) (4.1 (4.3 1.1 1.0 (2.8 3.1) (1.7) 0.2) (3.1 2.3) (0.6 (10.5) (2.6) (12.5) (7.3) 0.1 (9.9 1.3) (0.4 (2.6 0.0) (3.1) (2.5 1.2) 0.4 (1.6)
0.2 0.7 (0.4) (1.9 0.5 1.1)
— = not available.2) (4.8) 0.1) 0.9 1.1 0.5 1.1 (1.7 (1.7 — (0. 1998.6 0.1 0.2) 1.2 1.Table 2.8 (0.3 1.2) 1.8 1990 0.7 0.6 1989 1.6 1. Source: Whan Whang.6) (12.6 (0.6 5.3 3.2) (13.4 0.2) 2.2 1.7 (0.3) 0.1) (6.6 0.3 (3.9) (8.2 (0.1 0.2) (0.8) (20.7) 0.3) 1.4) (6.7 (4.9 1. Court Receivership.1) 1.8) (11.1) 2.
.9 0.8 0.4 2.6) 0.4 0.3 0.2 1.6 (0.9 (0.3 0.5 (0.1 1.3 (0.6 0.3 1.6) (0.3) 0.6
0.8 (0.0 4.2) 1.5 0.4) (0.4 (0.8) 0.2 (1.4 1.2 4.2) 2.8 0.2) (13.2 1995 3.9) 0.7 0.3) 0. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.5) (0.0
0.8 0.9) 2.3 1.3 0.5 (6.4) (1.3) 12.2 1.7 1.1 0.1 0.7 2.5) 0.6 3.8 (0.8) (1.1 1.4) (1.6) (0.4 1.4 1996 0.7 0.3 0.4 0.0) 0.0 1987 1.3 1.1 1.4 (1.4 (0.6) 0.1 0. Chung Ang University.9) 2.8) 1.4 0.2 1.0) (0.9) (9.8) (0.
the independence and objectivity of the external auditor were often questioned. 2. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. internal auditors cannot be expected to perform their function independently of management. 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. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. Meanwhile. 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 to the development of the market for corporate control. this has led to entrenched management. 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. Thus.
. Ownership concentration also had ramifications on corporate transparency. a committee composed of internal auditors. and creditors should select (recommend) the external auditor. outside directors. the boards of all listed companies were composed of insiders only. They were then almost automatically elected at the general shareholders meeting. A remote trigger in the Thai crisis was all that took to push the economy over the edge. Moreover. Until 1997. Vol. a firm’s board of directors had the power to appoint an external auditor. Now. after the crisis. But in 1998. Thus.132 Corporate Governance and Finance in East Asia. 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.5.1 Weaknesses in Corporate Governance
Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. Until 1997. Along with government policies to protect the status quo. II
corporate profitability were signs that the Korean economy had reached the edge of a slippery slope.
individuals. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. usually a member of the founding family. and some differences in Korea’s generally accepted accounting principles from international standards. a large issuance of preferred stocks with no voting rights. participated in the stock market as short-term traders rather than long-term investors. 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. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. Many changes were introduced to promote M&A in the 1990s. corporate accounting information was not reliable due to the lack of independence of external auditors. 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. These included restrictions of shareholdings of institutional investors. Meanwhile. There were no effective monitoring mechanisms for its management. as a whole. however. and restrictions on hostile takeovers.Chapter 2: Korea 133
There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. as well as institutions. regulatory and practical difficulty in implementing proxy voting. 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. Under the direction of the controlling shareholder. Traditionally. has an unsound capital structure and
. One reason is that the percentage of inside shareholdings for an average listed firm is very high. the Government maintained a policy of protecting the incumbent management of a listed company. In this situation. when a large diversified chaebol. Diversification can reduce chaebols’ risks through the portfolio effect. These internal dealings made strong firms weak and helped marginal firms survive. Many of the takeover targets in the past did not have a controlling shareholder. restrictions of voting rights of shares of institutional investors. However. profitable firms within a chaebol tended to subsidize unprofitable firms. prevalent window dressing practices. hostile takeovers in Korea will likely be rare in the future.
Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. Vol. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. while (non-chaebol) independent firms had much lower borrowing ratios. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. financing choices of listed firms in order of preference were bank loans. Financing preferences changed drastically after the crisis. The new preference ordering is as
. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. and a high degree of inefficiency in the economy. and other individual markets. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. However. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins.3 Manifestations of Weak Corporate Governance and Government Intervention
Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. 2. The Government’s supervision and regulation of financial institutions were poor. the typical chaebol firm had an extremely high DER.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. and internal funds. 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. 2. Further. Such problems may eventually cause ripples through the entire economy. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. II
strong financial links among its member firms through investments and cross-guarantees. As mentioned earlier.134 Corporate Governance and Finance in East Asia. as the latter are well established in most business areas.5. bond issues. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product.5. share issues.
In the international financial market. Bank loans. At the end of 1996. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. 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. signaling a bearish speculative move on the won. After the financial crisis erupted in Indonesia and Thailand. 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. consisted of high proportions of policy loans. Nonpolicy loans were also considered to be cheap because of interest rate regulations. which were the most important financing source until 1987. However. as evidenced by occasional. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. 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. Implicit guarantees by the Government on bank loans to large businesses. which generally required guarantees or collateral.5 billion. 63 percent of which was short-term. In November 1997. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. share issues. reducing foreign exchange reserves to a dangerous level. As of the end of 1997. large-scale bailouts of financially distressed firms. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms.
. Other factors also contributed to this preference. The preference for debt finance also led to a relatively large foreign debt. The ratio of external debts to GDP reached 48 percent at the end of 1998. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. 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. The lending practices of banks. total foreign debt amounted to $157. bank loans.Chapter 2: Korea 135
follows: internal funds. the top 30 chaebols showed a DER of 519 percent. the Government and the Bank of Korea defended the currency. won/dollar nondeliverable forward rates increased rapidly. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. obviously contributed to overlending and aggravated the situation. and bond issues.
especially chaebols.6 percent in June 1998. total assets.000 per year starting 1992. then 20. These were the definitions until 30 June 1998.32). Doubtful loans are those for which interest is not received for six months or longer. excluding the financial sector.000 from December 1997 to February 1998. The Government could hardly help them because of the number and magnitude of business failures. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11.000 in September 1998 (Table 2. Before the crisis.200 in 1997. According to the “six months” definition. reaching highs of 6 percent in 1997 and 8.
. without strictly evaluating the creditworthiness of businesses and the profitability of projects. Further. the NPL ratio8 of banks and other financial institutions began to increase. and there is collateral. were low in 1996 and 1997. The inevitable result of inefficient investment was a fall in corporate profits. starting 1 July 1998. has given rise to various types of self-dealings by the controlling shareholder. The bank supervisory
NPLs of banks comprise fixed (substandard) and doubtful loans. However. Financial Sector Vulnerability Because of financial losses in the corporate sector.7 percent in 1997. The banks and merchant banks lent to large businesses. legal and other barriers prevented the exit of financially nonviable firms. Following the “three months” definition. and shareholders’ equity of all industries. nine out of the 30 top chaebols failed. the ratios of net profits to sales. they are defined as loans for which interest payments are overdue by three months or more. Moreover.136 Corporate Governance and Finance in East Asia.000 during January-September of 1998. It jumped to 17. the NPL ratio reached 7. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. and there is no collateral. In 1997 they became negative. Meanwhile. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. and estimated losses. II
Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. and returned to about 1. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. Fixed loans are those for which interest is not received for six months or longer. the NPL ratio of commercial banks increased rapidly from 4. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices.1 percent in 1996. decelerated from March 1998. and the pursuit of growth through excessive diversification and inefficient investment. The monthly number reached more than 3. Vol.
890 4.637 6.265 6. and Taipei. 2.673 Construction 380 354 242 195 294 585 1.751 1.769 9.Chapter 2: Korea 137
Table 2.502 11.107 6.33). 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.850 3.32 Number of Firms with Dishonored Checks.589 171.250 2. Source: Bank of Korea. In 1990-1993. This was mainly due to the high ratios of NPLs.457 2. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries. This speculation was said to be one of the causes of the financial crisis in Korea.859 3.133 3.053 5. Meanwhile.657 3. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US. and declined to 4-6 percent in 1994-1996 (Table 2.China.759 6. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.244 3.135 1.255 13.992 11. The current account deficits in terms
.856 7.553 3.517 2.4 Shortcomings in Macroeconomic Policy
The macroeconomic framework also contributed to the crisis in 1997.027 Manufacturing 1.159 10.259 2.754 3.210 1.131 1.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952
Note: 1998 figures cover only January-September.
authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.472 2.114 811 706 696 866 1.979 8.985 Services 3.544 2. As a result they had largely overvalued currencies. Compared to ROAs and ROEs of domestic branches of foreign banks.5.647 8.386 5.69 20.573 3.238 4. the ratio reached 7-8 percent.855 6. and large government-directed loans. those of domestic banks were lower in the 1990s. 1986-1998
Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. and continuous and large current account deficits. low efficiency. European countries.
1 7.China. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.6 percent (1995).556 118. although per capita income in Korea was much lower. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.266 10.33 Nonperforming Loans of General Banks.910 1.0 7.8 percent (1996). The main result of the rigid labor market was a “high-cost and lowefficiency” economy.170 1.584
Fixed (A)a 5. the ratio of short-term debt to foreign reserves was very high.832 337. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.6
Fixed loans are those requiring collateral and for which interest is not received for six months or longer.138 Corporate Governance and Finance in East Asia. Land prices and real estate rents were also high compared to trading partners.1 6. Businesses served as a social safety net.639 1. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. 1990-1998 (W billion)
Year 1990 1991 1992 1993 1994 1995 1996 1997 1998
Total Loans 90. which led to large corporate losses.1 percent (1995). Source: Bank of Korea.390 12.874 22.537 10.237
Estimated Loss (C) 958 920 840 816 213 385 490 490 648
NPL (A+B+C) 7. and Indonesia -3.4 5.430 12.827 289.929 11. Thailand -8.8 5.736 8.221 8.116 1. Mass layoffs became legally possible only after the economic crisis. II
Table 2. even in times of economic slowdown. In 1997. and 30 percent in 1996.562 18.520 194.310 6.997 9.0 8.077
NPL Ratio (%) 8.475 143. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.6 percent (1995). In addition to the overvaluation of the won. Vol.192
Doubtful (B)b 952 1.China.484 11. Korea -4.600 10. Related to this.160 11. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.
.176 7. because of the rigid labor market. Meanwhile large businesses could not legally lay off workers.649 375.584 2.705 160.739 241.652 29.
of percentage of GDP were as follows: Malaysia -8. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.2 4.190 9.954 9.0 7.
which were laden with huge amounts of debt and were on the verge of bankruptcy. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms.6. To achieve this.6 2. However. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level.Chapter 2: Korea 139
2. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. 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.
. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. Corporations. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. Downsizing by curtailing employment has been prevalent.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. had been forced into bankruptcy proceedings or merged into healthier entities. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. They have been pressured to stop such practices as providing loan guarantees. 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. including banks.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. and subsidizing money-losing units. Nonviable firms and financial institutions.
This number was at 779 firms in April and grew to 1. sellers could not find buyers as almost all domestic firms struggled to raise cash for debt reduction and for working capital needs while there was a severe credit crunch following the outbreak of the crisis. the number of potential sellers decreased somewhat from 2. banks and other creditors were reluctant to absorb losses realized by debt compositions. 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. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. Internationally. The reasons are manifold. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. II
Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. the creditor
. 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. Banks did not have the incentive to force financially nonviable firms to liquidate. Locally. On the other hand. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. potential foreign buyers waited for the price of acquisition targets to come down further. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio.138 by the end of October. In many cases. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. Vol.045 in October. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. More important. 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. Noticing this disincentive.140 Corporate Governance and Finance in East Asia. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. More than 59 percent of potential buyers were foreign firms.281 in April to 2. In their first review.
FSC has been monitoring the processes from a prudential regulation standpoint. The plans were put into action immediately following finalization. Among the sell-offs. and 16 non-chaebol corporations that had been selected as possible workout candidates. interest reductions. 11 were merged into other group members.Chapter 2: Korea 141
banks selected 55 firms as targets for exit. The workout plans were completed for most firms by early 1999. by their creditors. but viable. Among the 55 firms selected. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. 24 were liquidated. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. By the end of 1998. write-offs. A portion of the Technical Assistance Loan of $33 million. Based on these plans. workouts are being applied to non-chaebol firms identified as financially weak. These chaebols submitted plans for restructuring to improve their respective capital structures. not only for the design of corporate workout programs but also their implementation. three filed for courtsupervised bankruptcy reorganization. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. was allocated to the six largest banks for them to employ outside experts as advisors. 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.
. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. Upon completion of the evaluation. Corporate Workouts Workouts in the forms of debt rescheduling. 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. Also. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. two were acquired by newly organized employee stock ownership plans. and 12 were sold off to other firms. provided by the World Bank. the results thus far have not entirely been as desired.
In the case of automobiles. As of April 1999. aircraft. This figure contrasts sharply with the total of $700 million for all of 1997. enable chaebols to streamline their overly diversified operations and focus on several core business areas. Korea adopted and implemented policies to open its capital market completely. However. On 3 September 1998. In one case. it is hoped. uncertainty over the future
. In the early days after the outbreak of the crisis. vessel engines. First. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. and petrochemicals. Big Deals Ever since the outbreak of the economic crisis. Vol.142 Corporate Governance and Finance in East Asia. Foreign investment—in the form of acquisition of controlling interests. oil refineries. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. automobiles. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. II
creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. labor union demands of the seller were not acceptable to the transacting parties. railroad cars. the foreign buyer demanded specific protections against adverse developments in the business environment. These deals could eliminate excess capacity in such industries as semiconductors. In another.5 billion on agreement basis during the 10-month period after December 1997. Big deals have been elevated to the status of the most important means of effective corporate restructuring. some of the acquisition agreements have been discarded for various reasons. purchase of divested assets. inducement of foreign direct investments was considered to be the most effective means of achieving that end. Restrictions on foreign ownership of land were also abolished. Thus. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. power plant facilities. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. most of the big deals have entered their final stages of negotiation. and equity participation—reached about $8. Big deals would.
foreign buyers were concerned with the inflexibility of the labor market. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. In effect. Fifth. and (v) to improve the accountability of controlling shareholders and the board. many of the potential buyers believed that prices asked by sellers were still too high and there would be opportunities to buy assets on fire sales in the future. but it also has important implications with respect to corporate workouts. 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. Second. Seventh. 2. Sixth. Fourth. (iv) to focus on a small number of core businesses. (ii) to remove cross-guarantees of loans among group members. The presence of
. With this in mind. Overhaul of Bankruptcy Procedures In February 1998. Not only does this represent progress in terms of an improved institutional framework for market competition. As set forth in the agreement.6. 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. Third. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. (iii) to reduce financial leverage. these goals were: (i) to enhance managerial transparency.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.Chapter 2: Korea 143
course of the Korean economy remains high. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms.
the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. October 1998. a “Management Committee. accounting. the court may annul its previous decision and force the firm into immediate liquidation. Also. (ii) legal changes have been made so that domestic accounting practices conform to international standards. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. Korea’s Economic Progress Report. Fourth. the right to revoke court receivership is allowed to the creditors. Fifth. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. II
an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. 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.
. 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.01 percent in May 1998. First. Vol. (v) all listed companies are required to appoint outside directors beginning 1998
This and the following two subsections draw on the Ministry of Finance and Economy.144 Corporate Governance and Finance in East Asia. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. In the past this stage usually extended for as long as two to three years. and economics professions should be organized to provide for expeditious proceedings in court. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. Also. Third. number of creditors.” comprised of experts in the legal. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. etc. The changes in the reorganization procedures can be summarized as follows. Second. The purpose of this rule is to shorten the reorganization planning period.
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. administrative procedures for FDI will be dramatically simplified and made transparent. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. 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. (v) by the end of May 1999. including tax exemptions and reductions. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. to FDI). an additional nine industries will be opened or further liberalized. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. Capital Market Liberalization Since 1998.148 industries remain closed. have been instituted for FDI:
. beginning on 1 April 1999. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. which was passed in August 1998. various supporting measures. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. (vii) by the end of March 1998. In addition. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. (iv) during April and May 1998. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. 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. According to the law. including financial subsidization. and (viii) as of 1 April 1998.Chapter 2: Korea 145
(as of the end of May 1998. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. 21 industries were further liberalized or newly opened to FDI (now. only 31 out of 1. either partially or fully. As for promotion. 514 listed companies had appointed 677 outside directors). These new standards are and will continue to be strictly enforced. financial institutions could no longer require cross-debt guarantees.
The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. Three-year government bonds will be used to establish a benchmark. The law allows rental cost exemptions and reductions for FDI. Vol. To minimize potential risks. are not risk-free. II
Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. such as the high-tech industry. the Korean Government is strengthening prudent regulations and market monitoring.
Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act.146 Corporate Governance and Finance in East Asia. the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. These bonds will be issued
. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. These liberalization measures. however. as well as building an early warning system. Various support measures. It aims to establish a benchmark by consolidating various government bonds. will be provided to foreign firms in the FIZ. including infrastructure and tax support. The location of the FIZ will be determined at the request of foreign investors. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). Also.
Moody’s signed a joint venture contract with Korea Investors Service. To ensure transparency and efficiency of the fund operations. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. including the Korea Development Bank. 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. to establish closed-end investment companies. Related legislation was put into effect in September 1998. It also opened the credit rating service market to foreign competition. a primary dealers system will be introduced for healthy financial institutions. As a pilot program. It is now easy for private investors. and is promoting joint ventures between foreign and domestic agencies. Twenty-five domestic financial institutions. In order to promote a greater market demand for government bonds. financial institutions
. both domestic and foreign. According to the law. Prior to the introduction of this system. These are expected to operate for the next three years. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. but may be extended as required. invested a total of W1. Mutual funds (or open-end investment companies) will be allowed starting 2001.Chapter 2: Korea 147
monthly. but it will also help improve financial institutions’ risk management. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. and the demand for longerterm bonds increases in the future. If interest rates stabilize at a low level. The Government established specific qualification criteria and selected the primary dealers in 1999. and W1 trillion divided equally between the three balanced funds.6 trillion in these funds: W0. This law will not only provide an effective institutional environment for the disposal of NPLs. In August 1998. they will be managed by foreign investment management companies. with only minor standard exceptions.6 trillion for the debt restructuring fund. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998.
One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional
. A good governance system is essential for the healthy growth of corporations and financial institutions. For instance. However. Vol. when the limit is binding. the role of the board of directors as the internal control mechanism must loom large in corporate governance. However. There must be stronger rules to control agency problems. as stipulated by the government measure. Selfdealings. 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. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. As markets become more efficient.) and the level of interfirm investments is very high. However. In principle. this can only be a temporary measure. such as the Korea Asset Management Corporation (KAMCO).6. then the regulation will inhibit efficient investment of firms. and C investing in D. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding.. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. can utilize ABS. there is another view that placing a maximum limit on interfirm investments. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. greater efforts to improve corporate governance are preferable to regulation of interfirm investment. this regulation may not be effective in curtailing pyramidal structures.g. II
and qualified public corporations. 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. 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 corporate governance structure cannot be expected to function efficiently if this issue is not addressed. etc. cross-subsidization. 2. is inevitable.148 Corporate Governance and Finance in East Asia. More important. foreign business corporations with good credit standing are now also permitted to issue ABS. B investing in C. A investing in B. unless the limit is tight and binding. which is the case for many chaebols. On the other hand.
pp. various measures have been implemented to promote investors’ rights. using audit.
. Proposed: A Governance Monitor. 1997). 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. it will have to include making self-dealings by directors and officers. and other committees. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. governance. 1997. 23-26. Latham. If and when the law is introduced. Further. September/ October 1997. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. The Corporate Board.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. One way of motivating institutions to do this is to
M.Chapter 2: Korea 149
investors or their trade associations. Listing rules may recommend that all or large listed companies adopt an audit committee. Since the economic crisis. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. and also negligence of external (independent) auditors actionable. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. and requiring that all directors hold shares of their companies. 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. Institutional investors will play an increasingly important role in corporate governance. 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. Class action suits are an efficient means for corporate monitoring. 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.
such as the Korea Investment Trust Association. Another measure. an audit committee.
. 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. Rights of minority shareholders should also be strengthened for these institutions. strengthen its supervisory activities. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. 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. etc. 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. and thus cannot be expected to be actively involved in monitoring portfolio firms. Many of the larger investment trust companies. In the coming years. objecting to certain defensive measures proposed by the management. could prepare such guidelines. The Government can also lower the limits on investments in affiliated companies. The Government recently proposed the revision of bankruptcy-related laws. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. the Government will have to come up with appropriate policy measures to solve these problems. possibly. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. Also. insurance companies. and compliance officers. reviewing independence and expertise of candidates for outside directors. more drastic in nature. and impose stronger penalties on violations of the rules on portfolio investments. The institutions’ respective trade associations. securities companies. II
provide comprehensive guidelines for their actions in matters related to corporate governance. strengthening incentive compensation schemes for executives. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma.150 Corporate Governance and Finance in East Asia. Vol. Another concerns whether the court-appointed receiver should be given the power to convene board and shareholder meetings and also to replace directors and officers with court approval. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. 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. by all nonfinancial companies (or “industrial capital”).
Chapter 2: Korea 151
There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. through them. and financial institutions. To facilitate the development of the Korean stock market. Chaebols are overly indebted. The Government should put more efforts into developing the capital market. The Government should substantially reduce the proportion of policy loans from bank loans. In turn. and consistently show low profit rates. and thus full-scale education programs should be developed. to concentrate instead on a small number of core businesses. the banks have great leverage over the management of debtor firms. Banks should adopt strong incentive compensation schemes for management. and introducing disincentive schemes for excessive borrowings. (ii) provision of reliable accounting information. Many corporations are burdened with excessive debt and. The public and corporations should be taught or fully informed of the best practices in corporate governance. For this. private firms. 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. 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. This means that the Government can control the banks and. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. The current obligatory system of disclosure that emphasizes “hard”
. In order to minimize government intervention in bank and corporate management. excessively diversified into nonrelated business areas. such as application of higher interest rates by banks to chaebols with higher DERs. the important issues to be addressed are: (i) improvement of the corporate disclosure system. bank managers should be made accountable to shareholders but not to the Government. the elimination of implicit guarantees for financial support to chaebols. reduction of protection of domestic markets and entry barriers. and (iii) a good corporate governance system to protect investors. and stop unfair internal transactions. Bank boards also need to be made more independent from management. Such measures include providing an effective corporate governance system. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). large firms. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. which could provide alternative sources of long-term corporate finance.
wage rates. At the same time. politicians. Without successfully addressing this problem. Prevalent corruption. and labor productivity should be considered. The function of securities companies as dealers of bonds should be improved. no economic reforms will be effective. and bureaucrats. on a real time basis. the information system of the bond market should be better organized to transmit. and measures to reduce corruption. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts.152 Corporate Governance and Finance in East Asia. especially among business people. penalties on violations of disclosure rules are not effective enough to have a significant impact. Future research could include causes of corruption.
information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. data on quotations and trading volumes. In determining optimal exchange rates. Vol. These should be lengthened to make them a source of stable long-term funds. is considered to be one of the major causes of the economic crisis. Policies are needed to help develop more reliable services by bond rating agencies. The development of the OTC bond market requires a well-developed dealer system. reasons for different degrees of corruption in various countries. Currently. The network should cover not only the exchange market but also OTC transactions of investors and dealers. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. The establishment of a Corruption Prevention Institute will be helpful in this regard. 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. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates.
Evolutionary Chaebol. 1999. and K. N. September 1998. M. KERI. T. 1997. S. Chon.
. Cho. edited by K. W. September 1997. and H. Korea Development Bank. in Korean Managerial Dynamics. KERI. International Financial Statistics. Hong Moon Sa.. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. pp. 1989. S. Chung and H. I. Bank of Korea. September/October 1997. Jae Woo. Lee. 1992. Lee (eds. Cho. various issues. 7995. New York: Praeger. 1993. C. Y. pp. Ju Hyun. Bibong Publishing Co.. H. 1989. 1996. Corporate Restructuring. 1995. Korea Economic Research Institute.Chapter 2: Korea 153
Bank of Korea. H. 1997. Hattori. S. 1998. Financial Studies. pp. 1995. H. Determinants of Diversification of Korean Business Groups. various issues. H. Lee. Kim. S. Hong. Proposed: A Governance Monitor. and 1998 issues. 1994. C. W. Bank of Korea. 1996. various issues. Center for Free Enterprise. KERI. Tomio. Korea Economic Research Institute. An Empirical Evidence on Value of a Firm and Ownership Structure. Kwon. Bank of Korea. Kim. I. Financial Statement Analysis Yearbook. The Corporate Board. Market Concentration and Diversification of Business Groups. Korea’s Large Conglomerates. S. Chon. Korea’s Financial System. Chung. Kang. Understanding Flow of Fund Accounts. S. H. International Monetary Fund. 1996. W. September 1998. Latham. 1997. Is the Fair Trade Policy Fair? Korea Economic Research Institute. K. New York: Praeger. 1998. 23-26. D. Lee. and J. W. Jua. Maeil Daily Economic Newspapers. various issues. Financial Studies. 79-95. C. Korea’s Chaebol. Kim. Choi. 1997..). D. K. Survey of Facility Investment Plan. Japanese Zaibatsu and Korean Chaebols. Korean Managerial Dynamics. Economic Statistics Yearbook.
W. January 1995. Ungki. Annual Conference of Financial Management Association. Korea Finance Institute. I. Kim. November 1996. H. Korea Institute for Industrial Economics and Trade. Lee. J. 1998. Beyond the Limit. and H.. U. 1999. J. 1998. S. Y. Whang. J.154 Corporate Governance and Finance in East Asia. Seoul. Sohn. K. Kim. 23. 1996. Korea Development Institute and World Bank. Nam. Korea’s Economic Progress Report. September 1998. KIEP Working Paper 98-05. Lee. 1996. and J. Conference on Corporate Governance in Asia: A Comparative Perspective. Korea Institute for International Economics and Trade. S. C. Wang. Ungki. Ministry of Finance and Economy. Corporate Governance in Korea. 1998. S. Lim. A New Trade and Industrial Policy in the Globalization of Korea. 2nd Sangnam Forum. H. K. S. Korea Institute for International Economic Policy. Vol. Kang. Korea’s Trade and Industrial Policies: 1948-1998. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Business Groups in Korea: Characteristics and Government Policy. Lim. Y. K. Yonsei University. and J. C. March 1999. Background and Task of Structural Adjustment. KIET Occasional Paper No. Management Research Institute. Yim. Capital Liberalization. 1998. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.
.. I. Chicago. 1999. Whan. II
Lee. Chung Ang University. October 1998. Joh. Real Exchange Rate and Policy Measures.. October 1998. 1995. Y. Yang.
and government subsidies were tackled during that period. The author wishes to thank Juzhong Zhuang. Inc. about a decade before the recent Asian crisis. the Philippine Stock Exchange for its help and support in conducting company surveys. staff. Roble. the Philippines. Denise B. state-sanctioned monopolies. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. for their research assistance.. This has come about following a political and economic upheaval from 1983 to 1987. the PSR Consulting. Issues such as State ownership of businesses. When the Asian crisis erupted in 1997. both of ADB. David Edwards. 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). the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. PSR Consulting. in particular Francisco C.
. 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. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity.1
In recent years. From 1993 to 1996. after the completion of debt negotiations with the IMF and Paris Club. the Philippine economy and corporate sector were in a relatively sound financial position. The lifting of the debt moratorium in 1991. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. overall. and Lea Sumulong and Graham Dwyer for their editorial assistance. The Asian financial crisis revealed that. Serrana. Inc.3 The Philippines
Cesar G. Pineda. and Liza V. Saldaña1
3. Companies of other Asian countries were already using these markets to finance investment and growth. and David Webb of the London School of Economics for their guidance and supervision in conducting the study.
and responses to the financial crisis. their growth could not be sustained. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies.
3. To implement these policies. It analyzes the impact of corporate governance on company financial performance and financing. regulatory framework. Companies finance long-term investments with short-term debt. therefore. usually with the acquiescence of bank creditors. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. composed mostly of families previously in trading businesses. control by internal and external governance agents. But protectionist policies made labor relatively more expensive and.2. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. companies were necessarily large and capital-intensive. the Government overvalued the local currency and imposed high import tariffs. These early industrialists naturally opposed any initiative to reduce tariffs. emerged to influence industrial policies.2 3. Companies were profitable because of protection from foreign competition. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. While new manufacturing industries were successfully established.156 Corporate Governance and Finance in East Asia. Vol. on family-based and controlled conglomerates. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. which leads to their easing of due diligence and monitoring standards when lending to group members.1
Overview of the Corporate Sector Historical Development
During the 1950s and 1960s. patterns of ownership. The Board of Investments (BOI) was created to draw up an investment priorities
. The policy was crafted by the martial law regime at that time. An industrial elite. Banks have significant presence as members of affiliated business groups. and on the financial crisis. Corporate financing relies excessively on bank loans. This study reviews the Philippine corporate sector in terms of its historical development. patterns of financing. II
the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. The 1980s were marked by a peaceful transition of political power. and oriented toward exports. the Government continuously revised the enabling law of BOI so that incentives were reduced in number. Reforms in policies. the “pioneer” industries identified in the IPP. In many industries. quantitative restrictions.Chapter 3: Philippines 157
plan (IPP) to encourage private sector investments by offering tax and other incentives.e. Nevertheless. The Government signaled through the IPP its intent to shape the future industrial landscape. the top three companies accounted for a disproportionately large share of total sales and assets. the State took over the generation and distribution of electricity. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. i. assumed ownership of the largest petroleum refining company. dominance by large companies. The high industrial concentration led to practices of price leadership and output restrictions and the rise of industry lobby groups—common features of an oligopolistic
. the legislative body passed the Foreign Investment Act (FIA). made less associated with capital investments. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. Starting in 1981. In the early 1990s. advance notice of areas where the country disallowed or restricted foreign investment. including the reduction of tariffs.” No strategic industry could take off without the Government’s participation in its management and operations. and orientation toward domestic markets. In 1991. and initiated the development of alternative energy sources in response to the oil crises. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government.. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. Foreign ownership was allowed only in industries with high technological and market barriers. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration. and import licensing requirements. Following government initiatives in the control of the infrastructure and utilities sectors. organizing industries into sectors and picking “winners. Exports were not competitive because of the high costs of imported materials.
1).8 10.7 5.7) (10.9 7.0 (6. In this section. only to be unsettled by the crisis of 1997.7 (13. Its growth rate began to catch up with others in 1996.7 8.2 8. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.0 8.2 7. This rate of growth was sustained by a comparable 18.2.3 9.8 5.2 9.5 9.3 8. 1990-1999 (percent)
Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.2 During 1988-1997.158 Corporate Governance and Finance in East Asia.3 7. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context.8 8.5 percent per year (Table 3.2
Source: ADB.2 7. Key Indicators of Developing Asian and Pacific Countries 2000.
3.0 7.8 8. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3. only nonfinancial companies were used.2 Korea. II
market.000 Corporations covers financial and nonfinancial companies.5 8.000 corporations.5) 3. Table 3. which was taken as a representation of the Philippine corporate sector.5) 5.4 Philippines 3.5 (7.6 7.7) 10.1 4.3 2.9 5.4 4.000 Philippine companies grew 17.2
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 1.2 (0.2) 4.9 (1.1 5.1 GDP Growth of Southeast Asian Countries.2) 0.6) 0.0 (0.1 5.2 Thailand 11. of 9. Vol. net sales of the top 1.8 4.8 5.9 6.1 8.2). however.8 percent growth in fixed
The SEC-BusinessWorld Annual Survey of the Top 1. With economic reforms introduced in the 1980s and 1990s.
.7 Malaysia 9. Rep.0 8.3 9.5 8.
7 28.1 468.6 144.9 480.5 4.4 898 1.4 188.4 63.5
Leverage = total liabilities/stockholders’ equity.8 618.5 1.8 26.225.3 862.1 66 12.1 54 11.Table 3.6 109 12.7 1.000 Corporations in the Philippines.6 1.6 900 1.5 192. turnover = net sales/total assets.3 107 13.6 35.2 2.5 119 12.6 426.4 260.647.5 14.2 Compound Growth (%) 17.2 378.8 741.1 73 5.893.
.697.5 51 4.978.2 Growth and Financial Performance of the Top 1.209.9 149 6.3 382.781.0 1.1 714.5 887 0.5 193.2 2.3 68 7.2 27.177.6 18.7 218.2 900.7 73 6. of Companies Sales per Company (P billion)
899 0.1 5.9 2.512.3 60 10.2 136.1 6.7 20.2 1.0 900 1. 1988-1997
1989 519.561.4 8.4 602.1 615.1 72. net profit margin = net income/net sales.9 3.5 1.1 33.3 121 12.6 290.1 1.8 411.1 881.8 6.9 96.2 707.3 306.9 896 2.123.2
Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings
464.4 1.5 64.7 1.160. return on assets (ROA) = net income/total assets.3 898 1.8 22.6 102 16.6 149 12.2 Average 146 12.8 5.1 51.000 Companies.3 46.9 629.4 776.6 1990 1991 1992 1993 1994 1995 1996 1997 1.4 555.1 95.6 75 6.5 1.9 898 1.7 443.2 4.9 617.332.0 148.1 1.5 446.6 954.2 338.0 1.1
Other Indicators No.4
Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin
222 14.341.9 952. Source: SEC-BusinessWorld Annual Survey of Top 1.7 238.8 902 1.5 570.191.5 72 7.317.9 78 6.131.1 4.4 861.8 4.3 941.1 181 11.394.6 896 0.9 1.8 77 7.4 411. return on equity (ROE) = net income/ stockholders’ equity.4 3.1 197 14.7 903 0.6 5.5 508.
178 1. Sources: ADB.7 percent.5
Value-added is assumed to be 30 percent of net sales. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.427 13. and the SEC-BusinessWorld Annual Survey of Top 1. This is high compared with developed countries but compares favorably with other Asian countries.474 1. Key Indicators of Developing Asian and Pacific Countries 1999.979 17. Total assets grew at an average annual rate of 22.697 1. leverage increased from 109 percent in 1996 to 149 percent in 1997. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.3 The Corporate Sector and Gross Domestic Product. II
assets.906 2. Return on equity (ROE) and return on assets (ROA) averaged 12. various years.9 23.3 percent.
. Asset growth was funded by debt that grew at an average of 20.8 percent per year. respectively.5
Ratio of Estimated Value Addeda to GDP (%) 17.9 percent for the period. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.1 19. but the extent of the increase was not as dramatic as in other Asian countries. Net profit margins for the top 1. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. Vol.394 1.160 Corporate Governance and Finance in East Asia. These rates of return are high compared with other Asian countries.172 2.8 19. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.2 percent. Further.4 20.077 1.352 1.693 1.3).1
Net Sales (P billion) 465 519 630 741 862 954 1.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%)
GDP (P billion) 799 925 1. Assuming
Table 3.000 companies averaged 7.000 Corporations in the Philippines. and by equity that grew at a higher average annual rate of 26.248 1.8 17. for the 10-year period. 1988-1997
Top 1.5 17.9 21.6 percent and 5.4 24.5 16.
A study of company performance by ownership type.0 28. The foreign-owned companies were the
Table 3.0 4.8 3.0 5.3 146 6. of Companies 73 Sales per Company (P billion) 2.4 28.8 ForeignOwned 21.9 17.4 190 5. size.3 22.0 142 22.4).2 9.1 22 10.1 Financial Ratios (%) Leverage 89 ROE 15.3 27.0 Net Income 19. corporate control structure.9 22.4 Stockholders’ Equity 32. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. The premise is that these variables have a direct bearing on corporate performance and growth. 1988-1997
Indicators Publicly Listed Privately Owned Rate. (ii) foreign-owned.8 percent of the corporate sector’s total sales between 1988 and 1997.5 GovernmentOwned 4.9 26.0 Turnover 53 Net Profit Margin 15.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.000 Corporations in the Philippines.8 No.0 5.Chapter 3: Philippines 161
a constant ratio of value added to sales.8 22.8
Growth Indicators (Compound Annual Growth Net Sales 20.3 42.
.4 Total Liabilities 26.0 31. Averaging 42.3 9.7 2. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.3 22.5 Other Indicators Share of Sales (%) 17.2 103 5.8 14.8 606 0.3 11. these figures suggest a significant and increasing contribution of the corporate sector to GDP.9 158 13.5 27. (iii) Government-owned.4 Fixed Assets 19. privately owned companies constituted the largest group (Table 3.6 Total Assets 29. various years. %) 17.7 22.5
Source: SEC-BusinessWorld Annual Survey of the Top 1. and (iv) privately owned.9 196 1.5 Retained Earnings 30.1 ROA 8.8 2.5 23 4.1 12.
Publicly listed companies had a minor though steadily increasing share in total sales. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). were among the top 1.162 Corporate Governance and Finance in East Asia. these companies were comparatively large. These were mostly large public utilities. Governmentowned companies in the top 1.3 percent. registered the largest per company sales at about P9 billion in 1997. selling an average of P4.1 billion per company in 1997. although small in number. The compound annual sales growth rate was 21. exceeding the 17. the asset base is large. With an average leverage ratio of 142 percent. foreign-owned companies borrowed more than 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.5 percent average growth rate of the entire corporate sector.75 billion per company for foreign-owned companies. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. and the second lowest asset turnover. 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.9 percent. while there were few of them.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. the highest net profit margin of 15.2 percent and ROA of 9.000 list. However. Privately-owned and Government-owned companies grew at slower rates. a level high by Western standards but at par with those of other Asian countries.000 companies in 1997. Bases Conversion Development Authority. but lower than those of foreignowned and publicly listed companies. Their ROA and ROE were both more than twice as high as those of government-owned companies. followed by publicly listed ones. meaning that the remaining 62 percent were relatively small in sales and assets. But by being most efficient in employing assets. they generated the highest return on investments. compared with P2. or 38 percent. The privately-owned companies had a high average leverage ratio of 158 percent. the second best ROE and ROA. with an average ROE of 22. Vol.5 percent.
. 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. II
second largest at about 27. and low return on investment is the norm. Publicly listed companies had the lowest leverage at 89 percent.
%) Net Sales 20. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997. and small companies.0 22. Table 3.1
Source: SEC-BusinessWorld Annual Survey of Top 1. Sales and resources of the
Growth Indicators (Compound Annual Growth Rate.3 No.8 6. of Company 159 Sales per Company (P billion) 2.2 Fixed Assets 25.Chapter 3: Philippines 163
Performance by Control Structure By control structure. But the conglomerates were larger measured in sales per company. compared with 32.3 percent for the conglomerates.5 Growth and Financial Performance of the Corporate Sector by Control Structure.4 24. depending on assets and sales.6 715 0.1 Retained Earnings 32.000 Corporations in the Philippines.1 124 5.2 23. a company can be a member of a conglomerate or independent.3 Financial Ratios (%) Leverage 98 ROE 15. the corporate sector is divided into large.6 26.0 Turnover 67 Net Profit Margin 12. and achieved higher returns on invested assets than independent companies (Table 3. medium.
Performance by Firm Size By firm size.7 Total Assets 32.0 55. various years.8 ROA 8. grew faster.2 Net Income 21.5).3 Total Liabilities 30.0 25.7 Stockholders’ Equity 34.7 2. had a lower leverage ratio.0 166 15. 1988-1997
Indicators Group Member Independent 18.3 Other Indicators Share in Sales (%) 32.
000 Corporations in the Philippines.000 list. Vol. although they comprised only 8. of Companies 79 Sales per Company (P billion) 7. for this study.2 25.5 128 10.0 7.1 No.0 156 16.0 32. indicating that they deployed resources more efficiently than large and small companies. while small companies.
.2 29.000 list.5 25. referring to the remaining companies in the list. defined in this study as the next 200 largest companies in the top 1.6 49. averaging 16 percent.2 Stockholders’ Equity 18.4 Total Liabilities 18.1 ROA 5.1 25. However.9 Financial Ratios (%) Leverage 158 ROE 13.6 31.6 Small 19.9 Retained Earnings 13.6). Medium-sized companies also performed better in terms of ROE. Sales per company in this group averaged P13. are defined as the largest 100 companies in the top 1.6 36.4 28. averaged a far less P3 billion in per company sales.8 percent of the total number of companies in the list (Table 3.6 47.9 32.5
Growth Indicators (Compound Annual Growth Rate.6 Growth and Financial Performance of the Corporate Sector by Firm Size. Large companies accounted for 56.1 percent of the total sales of the corporate sector. sales of mediumsized companies grew faster than large companies. which.7 44.5 73 6.5 12.1 81 9. II
Philippine corporate sector are highly concentrated among the large companies.
Table 3.164 Corporate Governance and Finance in East Asia.3
Source: SEC-BusinessWorld Annual Survey of Top 1.5 Total Assets 18. various years. averaged only P920 million in per company sales during the same year. 1988-1997
Large Medium 19.3 Turnover 65 Net Profit Margin 8. Medium-sized companies.7 Net Income 1.2 Other Indicators Share in Sales (%) 56.9 26. %) Net Sales 15.1 4.3 Fixed Assets 15.4 billion in 1997.0 730 0.9 89 1.
Growth of sales.6 percent. The growth and financial performance of selected industries. showed the lowest ROE.8 the previous year. and the construction sectors than for the manufacturing. reflecting to some extent a “bubble” phenomena in the former two sectors.2 billion in 1997 for this sector. from 14. specifically those industries least and most affected by the financial crisis.4 percent in 1997 from 11. utilities. of net income. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales.7 percent in 1997 for medium-sized companies.e. profits. but lower than that of construction.5 percent for medium-sized companies and 8. at 128 percent for the period.1 billion in 1996 to P4. compared with 9.8 percent in 1997. and assets was much higher for the real estate and property. Mediumsized companies’ leverage level was slightly lower.7 percent a year earlier. but suffered its largest decline in net profits in 1997. and utilities and services sectors. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. and equity up to 1996. at 156 percent. i. especially during the period 1994-1996. The real estate and property sector also suffered significantly in sales. Large. But small companies’ leverage was significantly lower. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets.2 percent for large ones.8 percent. are shown in Table 3.Chapter 3: Philippines 165
Small companies. Performance by Industry This study also looked at corporate performance by industry. assets. as indicated by the negative annual growth.1 percent. and construction. unlike their counterparts in other Asian countries. For small companies. at 158 percent on average during 1988-1997. Poor returns appear to have been caused by the low profit margin at 6. The Asian financial crisis affected large companies most severely. at -12. net income. and utilities and services sectors. manufacturing. although the largest in number. Leverage was the highest for large companies. Net income declined from P54. net income.7. averaging 10. real estate. ROE dropped to 7.8 billion in
. with their ROE dropping to 3. and profitability in 1997 when the crisis started. ROE dropped from 10..and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997.7 percent in 1996 to 8.7 billion and P35. The sector showed consistent growth in sales. Sales revenue and net income declined from P76.
Construction 27.2 12. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector. various years.0 31 0.7 83 2.5 Other Indicators Share in Sales (%) 82.0 Turnover 112 24 Net Profit Margin 5.7 ROA 5.9 2.9 2.
1996 to P56. the sector’s ROE dropped from 15.7 Growth and Financial Performance of the Corporate Sector by Industry.1 24 42.1 2.2 28 0.3 5. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.7 percent to 10. II
Table 3. Vol.0 21. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.9 5.4
Source: SEC-BusinessWorld Annual Survey of Top 1.8) 17.3 20.0 23.1 10. and was also much more limited compared with the property sectors in other Asian countries.2 8.7 Net Income (12.0 25.7 52.
.3 Fixed Assets 20.6 69 16. it does not appear to have been excessively exposed to foreign currency-denominated loans.8 Stockholders’ Equity 21.4 19. %) Net Sales 16.6
Growth Indicators (Compound Annual Growth Rate.4 3.7 28.9 17.2 37.166 Corporate Governance and Finance in East Asia.7 19.4 Total Assets 19.4 percent.3 55.6 Financial Ratios (%) Leverage 142 181 ROE 13.000 Corporations in the Philippines.7 192 9.3 Retained Earnings 17.2 45.7 10.9 23.6 No.5 12.8 41.7 billion in 1997. As a result.8 48.4 16. 1988-1997
Utilities Real Estate and and Services Property 39. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.6 Total Liabilities 18.000 companies’ total sales on average during 19881997. respectively. of Company 454 17 Sales per Company (P billion) 1.9 billion and P24.
nationalities. which regulates banks and nonbank financial institutions except insurance companies. unlike in neighboring countries hit by the Asian crisis.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. which is also the organic law governing the operations of SEC. It specifies the minimum information to be indicated in the articles of incorporation. Overall. For publicly listed companies. (v) number of directors (not less than five nor more than 15). privileges. and (viii) names. operation. and recognized rules on corporate practices. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. contains some provisions affecting corporations’ dealings with banks. and dissolution of corporations. administrative regulations. nationalities. Under the Code. which was based on American corporate law.
.2. 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. the Code requires a corporation
A company’s articles of incorporation should include: (i) corporate name. One month after registration. (ii) purpose of the corporation. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. 3. The General Banking Law. It provides the basic constitutional structure for the organization. and amount of authorized capital stock. (iv) term of existence.Chapter 3: Philippines 167
The utilities sector had the second highest leverage during 19881997 at 181 percent on average. (iii) principal office. (vi) names. Two other pertinent laws are Presidential Decree (PD) 902-A. the Corporation Code of 1980 is a compilation of important juridical rulings. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. 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.3 Legal and Regulatory Framework
The Corporation Code of 1980 is the main law governing the corporate sector. the leverage of all four industries was low. The currency devaluation bloated the foreign currency-denominated loans of these companies. and residences of incorporators and directors. (vii) number. par value. reaching up to 313 percent in 1997. and restrictions. and residences of original subscribers. and the Insolvency Law. and amount subscribed and paid by each.
(vi) penalties for violation of the bylaws. Vol. and forms of proxies and manner of voting them. and manner of calling and conducting regular or special meetings of the directors and shareholders. and reasonable. (ii) required quorum in shareholders’ meetings. In 1976. (iii) qualifications. (iv) time for holding annual election of directors and manner of giving the election notice. or officers. However. between the shareholders and the corporation. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. place. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. uniform.
to adopt a code of bylaws or rules for its internal governance. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. and employees. 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 (vii) manner of issuing certificates in the case of stock corporations. directors. duties. supervision (regulatory). 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. 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. (ii) controversies arising out of intra-corporate relations. the corporation’s articles of incorporation. among shareholders. To be valid. (iii) controversies in the election or appointments of directors and officers of corporations. and should not impair vested rights. officers. must be general. (v) manner of election or appointment and term of office of all officers other than directors. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. and control (adjudicative) of all corporations. In addition.
Some of the items that a corporation may provide in its bylaws are the following: (i) time. and compensation of directors. Its mandate is to supervise corporations in order to encourage investments and protect investors. manner of voting.168 Corporate Governance and Finance in East Asia.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. and between the corporation and the State concerning its franchise or right to exist. and public policy.
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.
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 almost 75 percent of the total. large and family-based shareholders pool the family’s ownership over many
. the top five controlling shareholders were classified into eight groups. a single shareholder held two-thirds majority control. or 80 percent (only nominally publicly listed) of outstanding shares. the top 20 shareholders collectively owned a majority of a company’s shares. or 51 percent of the total. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. In four companies. which are mostly privately owned and controlled by family-based shareholder blocs. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders.10. Through these. including pure holding companies. In 111 companies.1 percent of publicly listed companies in the Philippines in 1997. a single shareholder held operating control of a company. holding only an average of 2. nonfinancial corporations held majority control. The largest group is nonfinancial corporations. Individuals did not constitute a significant shareholder group among the top five shareholders.2 percent of outstanding shares of publicly listed companies. or 14 percent of the total. Who are the top one. the top five shareholders held more than two-thirds majority control of a company. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. Vol. five. and share prices are sensitive to movements of foreign funds. 66 percent (signifying strategic control). In 116 companies. There are advantages to establishing pure holding companies. and 20 shareholders? In Table 3. or 78 percent of the total. the top five shareholders owned more than 50 percent of the voting shares. Table 3. or about 30 percent of the total. five. The shares of publicly listed companies are thinly traded and illiquid. controlling an average of 52.174 Corporate Governance and Finance in East Asia. In four of 11 nonfinancial sectors. or 20 shareholders owned more than 50 percent (signifying operating control). In 21 companies. In 76 companies. With such high levels of ownership concentration. 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. Parent companies usually spin off operating units into new companies that they continue to control as affiliates.9 shows that in 44 companies. II
analysis of the number of companies in which the top one. or 3 percent of the total. a single owner owned more than 80 percent of outstanding shares.
and Tobacco Manufacturing. a Data for top 20 shareholders were not available for five holding 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
Communication Construction Food. and two companies in the property sector.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. Source: PSE databank.Table 3. and Trading Holding Power Transportation Property Total
— = not available. 10 manufacturing companies.
. Beverage. Distribution.
0 0.9 36.6 18.3 1.8 21.0 10.3
2.Table 3.0 0.0 0. Distribution.4 0.2 0.1 0.9 0.1 8.6 2.6 0.6 0.6 0.2 0.2 0.2 3.8 0. Source: PSE Databank.7 0.7 0.0 1.8 66.3 0.6 0.4 2.5 4.0 45.3 5.0 0.0 0.0 0.7 0.2 5.8 11.2 1.6 0.4 29.6 0.3 0.0 0. Beverage.9 52.3 0.5 13.8 0.5 12.3 37.6 5.7 0.2 10.7 3. Recreation.0 5.5 4.2 59.6 9.2 0.3 0.9 0.5 0.9 6.5 53.7 0.0 0.3 12.0 4.0 0.0 1.7 1.0 0.5 2.3 26.7 67.6 12.1 5.1 9.4 5.0 0.0 1.7 3.3 5.0 2.1
1.0 0.0 5.3 1.4 19.0 1.4 8.1 7.6 33.0 1.6 1.6 0.0 0.2 0.0 5.0 1.2 3.0 7.3 0.0 1.0 5. and Trading Hotel.0 0.0 0.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.2 3.0 2.5 0.1
Weighted by market capitalization.7 0.8 0.1 0.1 6.6 2.2 3.5 26.4 1.0 1. and Other Services Property Mining Oil Average Shareholdinga 33. 1997 (percent)
Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company
Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.
. and Tobacco Holding Companies Manufacturing.
securities brokers (1. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS).
. respectively. As a group. They can also better manage their income taxes because income from affiliated companies passes through a holding company. Investment trust funds were the most important institutional investors. and San Miguel Corporation (SMC) in food and beverages. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries.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. and insurance companies (0. while still allowing the public to own minority shares. 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.7 percent of market capitalization of the nonfinancial publicly listed companies. commercial banks (1.7 percent of shareholdings). Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce.2 percent in 1997.1 percent). The investment funds’ presence in these sectors ranged from 8. Such advantages have contributed to the popularity of holding companies among publicly listed companies.5 to 12. Petron and MERALCO in power and energy. accounting for P258.Chapter 3: Philippines 177
companies and share in the risks and profits of the group. there was no real market for investment information. Holding companies as a sector had the largest market capitalization in PSE in 1997.3 percent). The 7. with an average of only 7. Holding companies were themselves 66 percent owned by other nonfinancial corporations. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies.6 percent of market capitalization in 1997.1 percent). These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. 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. financial institutions did not have a significant ownership in nonfinancial corporations.6 billion or 26. Because of limited ownership by institutional investors. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.
The study used publicly available shareholder information and published reports. using data on the Philippines’ top 1. To understand the ownership and governance characteristics of family-owned business groups. Large shareholders and their families own these banks directly or through their controlled companies. 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.4 percent of the top 1. suggesting that most publicly listed companies are parts of business groups.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. 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. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. and increased the capital requirements for all types of banks. so far limiting their involvement to selected products.8 percent of total companies in number.000 corporations’ sales. Some 20 financial institutions were affiliated with these groups. Corporate financing depends on intermediation by banks. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector.11). the study put together a list of prominent business groups. Commercial banks hold the largest share. suggesting that business groups are common in all major markets.000 Corporations in the Philippines. remain in force to control excessive lending of banks to insiders. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. All major industries were represented. and tracked the financial performance of each company from 1992 to 1997. For this reason. 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. Still. Prudential regulations. However. including SBL and DOSRI rules. Family-based groups have larger companies since their total sales were about 33.
. many companies in family-owned groups are not publicly listed. but they comprised only 23.000 companies. including 16 commercial banks. about three fourths. This is significant considering that there were only 31 local commercial banks in the country in 1997. of the financial resources in the country. Vol. The Central Bank deregulated interest rates and foreign exchange. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies).178 Corporate Governance and Finance in East Asia. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. A common feature of corporate ownership of a business group is the centrality of a commercial bank.
In 1997. which was majority-owned by the Henry Sy group.1 percent). Foreign-owned companies mainly serve the export markets. for the Lopez group. the nonfinancial sector was real estate (60. Lopez. construction. the principal owner of SMC. and Henry Sy—as examples. as discussed in previous sections.000 companies. broadcasting (49. and more than 20 percent for the Lopez group and Henry Sy group. with the exception of Banco de Oro. it was manufacturing (36. Commercial banks are often affiliated to a particular business group. In terms of number of companies. the top 10 family-based business groups had only 119 companies in the top 1.12). Also.6 percent of the total sales of the top 1. Gokongwei. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. The main constraint may be the availability of family members that could be drawn for top management positions. In the meantime. Cojuangco. with 27 affiliated companies in the top 1. Significantly. real estate. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. and banking. a substantial proportion of group profits came from its financial subsidiaries.000. These corporate entities accounted for 53. Together. including business groups and independent companies. in most
. It is also noteworthy that. the two were closely related through their affiliations to business groups. Family-based business groups are most dominant in sectors such as manufacturing. the biggest private company in the Philippines.8 percent). an average group in the Philippines has fewer member companies.2 percent). the largest family-based business group was the Ayala Corporation Group. In terms of sales. ranged according to their sales (Table 3. 25 out of the 50 top corporate entities were familybased groups. For the Ayala group. and for the Henry Sy group. Lopez. for the Gokongwei Group.000 corporations in 1997. or an average of about 12 per group. the largest was the Eduardo Cojuangco 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. retail merchandising (69. To show this. for each of these groups. namely.4 percent of the group’s 1997 profits). the study used the four largest business groups—Ayala. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities.Chapter 3: Philippines 179
Compared with other Asian countries. and Ayala. the three largest entities were family-based groups.
5 26. 16. Consunji 4 3
Food and dairy products Construction and mining
10.3 3.0 13.5 2.0 26. 5. Flagship Company. 17. 14. construction. 13.3 11.5 47. and dairy products Investments. and mining Management.8 84. real estate. 11.
Beverages. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. 2. and food Food.0 5. beverages. 15. 6. and personal care prods Shipping. 4. and packaging Power distribution and mass communications Real estate.3 15.11 Total and Per Company Sales. 10.6 2.Table 3.5 17. 7. 9.3 2.9 2. food. 1997
Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6
Major Sector Orientation
Estimated No.6 3. power.2 16.4 6.
Real estate.4 10. and tourism Credit card
Eduardo Cojuangco Lopez Family Group Ayala Corp.1 4. of Affiliated Companies Total Sales (P billion) 123.5 6. food.6 3. 3.5 49. agriculture. Sector Orientation.7 98.0 17. telecom. and Affiliated Bank of Selected Business Groups.2
1.9 3. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution
.5 13.4 48. coconut oil.6 7. 8.1 4. 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.5 46.0
Average Sales Per Company (P billion) 6. beverages.
4 238 1.2 6. distribution.4 3. 37. 20. 36.7 0.000 Corporations (1997).6
Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication. 24. 22. 21.9 0.1 805.1
2.9 1.9 1.4 1.9 1.7 0.8 1.9 7.9 0. 34.1 1.0 0.0 1.1 0. SEC-BusinessWorld Annual Survey of Top 1.5 8.6 2.3 2. P. 35.0 2. 31.9 6.4 5. 27.3 2.7 3. 30. 32. mining. 26. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore.1 1. 23.5 2.7 0.
. 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
Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.2 1. 38. 25.0 5. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.7 4.2 4. 33.6 3.8 6.19. 29.8 1.4 3.8 1.6 0.7 1. 28. and various company annual reports. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total
Sources: PSE Databank.3 7. 39.6 5. Ramos Gaisano Family Group Felipe Yap Felipe F.
8. 12. Flagship Company. 9. 5. 11. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 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. and Affiliated Bank of Selected Business Groups. 10.Table 3. 15. 20. 7. 19. 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. 17. Alaska Milk Corporation DM Consunji. 4. Sector Orientation. 1997
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. 3.
1. 21. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement
.11 (continuation) Total and Per Company Sales. 16. 18. 2. Inc. 13. 6. 14.
Eduardo Cojuangco Lopez Family Group Ayala Corp. Uytengsu/General Milling Group David M.
48 billion. 34.48 billion. Sources: PSE Databank. F.. PT&T Corp. 30. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. SEC-BusinessWorld Annual Survey of Top 1. 36. 39. P.000 Corporations (1997). 24. Inc. Keppel-Monte Bank
Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 25.
22. 32. 28. 33. Ramos Gaisano Family Group Felipe Yap Felipe F. 23. 29. 35. 37. Cruz & Co. 31. unless otherwise indicated. 38.65 billion to P4. Refers to commercial banks.
Size class is measured in terms of sales: Large = greater than P4.
. and various company annual reports. Kepphil Shipyard Inc. Fil-Estate Development Inc. 26.East-West Bank International Exchange Bank
Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. 27.65 billion. small = less than P1. medium = P1. 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.
5 44.8 22. Inc.).2 Business Group Business Group Business Group Government.6 18. 6. and telecommunications Department store and banking Airlines.5 77.2 49. 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. coconut oil. Inc. car manufacturing. and real estate Banking. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. and food Food. 5.5 47. 10. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.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
1.1 17. 18. banking.0 38.2 16. beverages. First Pacific/Metro Pacific Group
Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.
Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 2.4 19. 16. telecommunication. 1997
Sales (P billion) Control Structure Major Industrial Orientation 123. and personal care products Shipping. 8. 24. 20. 12. 3. agriculture.8 53. 14. Fujitsu Computer Products Corp. and packaging Power distribution.8 84.5 15.0 37. 11. 19.
Beverages. 23. 4.0 24.4 48. 15. and mining Gold and other precious metal refining
.Table 3. food.7 98. 13. food.5 17. beverages. 22. and dairy products Investments. and bank Real estate. Philippine National Bank Mercury Drug Corp.12 Control Structure of the Top 50 Corporate Entities.5 46. 9.1 60. Texas Instruments (Phils. 17. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.). mass communications. 7. power.3 15. construction.5 26. food.6 26. of the Phils.
36.3 13.9 7.7 10.8
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.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. Philips Semiconductors Phils.0 12.6 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.
14.290 53. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. PSE Databank. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.5 8. Corp. 44. 28. 50. W.9 14. 42. National Steel Corporation National Food Authority Phil.0 13.
.9 6. 40. 47.5 8.7 10.7 13.25. 33.
EAC Distributors Inc. Uytengsu/General Milling Group David M.4 10. 35.0 11. 49.6 9.2 7.000 Companies Sales (%)
Cigarettes Bank Soap and detergents Management. 48.A. 43. 45.000 Corporations (1997). 26. 31.6 12. 41. 39. Philip Morris Philippines. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. 32. real estate. and various company annual reports. Consunji Uniden Philippines Laguna.4 8. 29. Inc. 27.6 1. 34.3 8. Jollibee Foods Citibank N. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 9.5 10. 46. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate
Sources: SEC-BusinessWorld Annual Survey of Top 1. corn (unmilled). Amusement and Gaming Corporation Mitsubishi Motors Phils.0 5. 37.1 9. Inc.8 6. 30..8 9.
determination of compensation to board members. these were dispersed shareholdings.
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. appointment and compensation of senior executives. investments of corporate funds in other companies or purposes. Actual control of the banks was still held by the groups. 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. Of course. voluntary dissolution. sale or disposition of a substantial portion of corporate assets.3. corporate mergers or consolidations.186 Corporate Governance and Finance in East Asia. II
publicly listed commercial banks affiliated to these groups.
. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies.8 The Board of Directors As the representative of shareholders in a company. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. and financial disclosure.2 Corporate Management and Shareholder Control
The main mechanisms by which shareholders control corporate management are the board of directors. 3. accounting and auditing. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. However. issuance of corporate bonds. Vol. although public investors held a majority of shares. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. and declaration of cash dividends. jointly and individually. They are likewise liable if they pursue financial interests that conflict with their duty as directors. removal of directors. issuance of stocks. approval of management contracts. the board of directors plays a crucial role in corporate governance. amendments in the bylaws. business groups had only minority ownership. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. such as amendments of the articles of incorporation. The Corporation Code holds members of the board of directors liable. shareholder voting in general meetings and legal protection of their rights. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies).
More than half of respondents indicated that board directors were elected during the shareholder general meetings. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. 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. or the Government without approval by shareholder general meetings.Chapter 3: Philippines 187
actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework.5 for board members. or a per diem for meetings (18 percent). But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. Making day-to-day management decisions was not regarded as an important board responsibility. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. In a few cases. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. appointing senior management.
. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. In practice. According to the ADB survey. But professional expertise is also an important criterion (28. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. protecting shareholder interests. ensuring that a company follows legal and regulatory requirements. or representatives of creditors. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. board directors were the founder of a company. or percentages of shareholdings (28.6 for board chairpersons and 7.9 percent). and determining remuneration for board directors and senior management. in a descending order.7 percent). a fixed fee plus performance-related bonuses (30 percent). the average number of years of holding office was 6. with a maximum of 36 percent. The longest was 27 years for board chairpersons and 14 years for board directors.7 percent). appointed by the Government.
A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). Unlike in Western corporate models. This suggests that large shareholders control CEOs by means other than shareholdings. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. These committees were established only recently. The audit committee selects external auditors. the chairperson of the board was also the chief executive officer (CEO). Vol. the parent company or company bylaws (21 percent). The nomination committee searches and reviews candidates for key management positions. relationship with controlling shareholders (35 percent). When the CEO was not the chairperson. II
Compensation for the chairperson was determined either by the board (54 percent of respondents).188 Corporate Governance and Finance in East Asia. About half of the active committees were audit committees and the other half nomination committees. But the independence of these outside directors is often doubtful. by tenure and compensation. or management (15 percent).
. or amount of shareholding (15 percent). Ninetythree percent of the respondents had one or more outside directors. and reviews the findings of external audits. only 35 percent of responding companies have set up board committees. Companies may set up special board committees to strengthen due diligence procedures. It is also not clear whether the outside directors were elected before or after the financial crisis. namely. 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. the CEO
The three most common board subcommittees are the compensation. large shareholder-dominated companies often view such committees as unnecessary formalities.9 In practice. In the ADB survey. and nomination committees. The ADB survey shows that in 41 percent of the responding companies. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. In some companies. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. audit. CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. however. negotiates the audit fees and scope of audits.
Fifth. or (iv) enters into a merger or consolidation with another corporate entity. Among others.Chapter 3: Philippines 189
was not related to the chairperson by blood or marriage in all of the cases except one. (ii) contracts with companies linked through interlocking directorship. equal to three years’ pay. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. 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. But about 27 percent viewed it to be ensuring steady growth of the company. to help ensure the representation of minority interests in the board. of directors representing minority shareholders. including electronic means. if the CEO’s contract was preterminated. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. shareholders may exercise appraisal rights. An overwhelming 70 percent of respondents said a CEO who was not the chairperson of the board could make key decisions only after consulting the chairperson or the entire board. the Corporation Code allows cumulative voting for directors.2 years. and (iii) involvement of directors in businesses that compete with the company. without cause. shareholders enjoy a number of rights and protection.e. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. Fourth. The average service length of CEOs was 5. Third. i. Companies are not allowed to issue shares with different voting rights.
.. 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. 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. and prohibits the removal. The longest service rendered was 27 years. Shareholder Rights and Protection Under the Corporation Code. They can vote through proxy. first. Second. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. (iii) invests in another company for a purpose different from that of the corporation.
in the Philippines. In cases of derivative suits against directors for wrongdoings or actions against insider trading. During annual general meetings where minority shareholders could exercise their rights. In the past. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. SEC proceedings were costly and time-consuming. no one has been successfully prosecuted for insider trading. Sixth. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. in cases of corporate takeovers. hostile takeovers are not common because in most companies ownership is concentrated
. where SEC made substantial progress in investigation. In practice. The company was dissolved before indictment. 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. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. a shareholder could file a derivative suit against a director to redress a wrongdoing. Consequently.190 Corporate Governance and Finance in East Asia. the Revised Securities Act has strict provisions designed to deter insider trading. because of poor compliance and enforcement as well as some loopholes in corporate laws. Last. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. However. In the case of preemptive rights. Few minority shareholders actually exercised their appraisal rights. because of the dominance of large controlling shareholders. there were often no real discussions of board proposals or actions. There was only one case. Those who did were usually offered below-market values for their shares. II
shareholders are allowed to inspect a company’s stock and transfer books. Being appointees of controlling shareholders. that of Interport Resources Corporation. Vol. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. 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. Regardless of the amount of shares held. Although transactions involving potential conflict of interest need to be reviewed and approved by the board.
Nominees held about 45 percent of the outstanding shares.3 56.13 summarizes rights that the shareholders of the responding companies enjoyed. followed by management and banks. and their activism in the corporate sector. representing 3.6
Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.0 63. Table 3.8 30.8 56. the successful hostile takeover by First Pacific Group of PLDT. The responding companies had on average 43. Table 3. An average of about 4. About 333 shareholders per company voted by proxy. Nevertheless.522 shareholders each. The ADB survey provides further evidence on shareholder rights. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. 1999.8 92.4
No 0.0 51. The brokers or securities companies were the most important proxy voters.900 shareholders per company did not vote during the last annual general meeting.2 43. appointed either by the board or shareholders during the annual general meetings.7 43.0 36.0 48. About 93 percent of the respondents contracted
Yes 100.2 69. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.6 30.2 7.Chapter 3: Philippines 191
in a few controlling shareholders and families.4 percent of shareholders but 58 percent of outstanding shares. protection.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.4 70. a company that is widely held but has a large shareholder. representing about 24 percent of outstanding shares.
SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency.. An auditor can choose among three alternative sets of GAAP. and an analysis of financial statements. intra-company receivables and payables. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. although closely related. Nevertheless.e. On average. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. vary in their evaluation of some major accounts such as securities and other liquid assets. financial reporting standards allow room for interpretation by independent auditors.192 Corporate Governance and Finance in East Asia. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. imposing penalties on violators. the local standard (i. there are many cases of poor financial reporting by large companies. Nevertheless. Because of such long relationships. In practice. the US GAAP). a hostile takeover case). The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. 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. intangible assets. II
their annual audit to an international auditing firm. independent audits do not guarantee the absence of questionable accounting practices. revaluation of fixed assets. or the accounting standard of a specific developed country (for example. the international accounting standard. Most major international auditing firms operate in the Philippines. with the longest being 50 years. From publicly listed companies. foreign currency-denominated liabilities. namely. the responding companies have been associated with their present auditors for 13 years.. long-term leases. These different versions of GAAP. the information statement transmitted to every shareholder should contain the audited financial statements. In two celebrated cases. investments in subsidiaries. Meanwhile.
. and consolidation policy. Vol. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. The Code grants a shareholder the right to inspect business records and minutes of board meetings. a management discussion of the business. the agency also requires reports on important details about their operations and management. as practiced in the Philippines).
they formed the largest group of corporate entities in the Philippine stock market in 1997. sometimes did not penalize independent auditors for poorly prepared audited financial statements. which are closely held by large shareholders and family members. However. Even for widely held public companies. Pure holding companies can be privately owned. and publicly listed. they also make it easier for controlling shareholders to expropriate interests of minority shareholders.. Controlling shareholders usually select member companies that require large
.g.6 billion. which are controlled by large shareholders with public investors in a minority position. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. When control rights exceed cash flow rights. marketing. which are usually controlled by holding companies. and financing. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). from a minority-controlled to a majority-owned subsidiary. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management. They allow risk pooling and can achieve economies of scale in management. controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. Family-based controlling shareholders use them as vehicles for controlling business groups. Corporate Control by Controlling Shareholders As in many other Asian countries. Publicly available financial information was often of low quality. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA). e. the authorities. accounting for 27 percent of the total stock market capitalization that year. 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. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. because of the highly concentrated ownership of Philippine corporations.and medium-sized businesses did not have quality financial statements.Chapter 3: Philippines 193
Many small. arguably.
with 59 percent of shares. Ayala Corporation’s majority. They are operating companies but at the same time have majority or minority share ownership in other operating companies. and customers. It has a majority control at 71. Controlling shareholders gain additional leverage in management control over minority-owed companies. an active minority share at 44.
. Ayala Land fully owns Makati Development Corporation and holds a minority stake. Inc. namely. Honda Cars (Philippines). In an active minority-owned operating company. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. II
equity investment for public listing. Minority-owned companies may also need access to resources of the group. Some holding companies are not pure holding companies.6 percent of Globe Telecom. controlling shareholders of the parent company do not participate in management. as an example (Figure 3.2 percent. Public investors collectively hold a minority of 41 percent. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate.and minority-controlled operating companies are also holding companies. 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. Vol. minority control at 42. financing. Ayala Corporation. Ayala Corporation is a publicly listed pure holding company. controlling shareholders of the parent company may eventually increase their shares to a majority position. Depending on the performance of the company. They may have a representative in the board.1). Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. at 47. and a passive minority investment at 15 percent in Honda Cars (Philippines). a family-owned pure holding company. of Cebu Holdings (a publicly listed government-owned company).1 percent of Ayala Land. active minority or passive minority holdings. the parent company plays an active role in management. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. In a passive minority-owned operating company.4 percent of Bank of the Philippine Islands. The first three companies are publicly listed while the fourth. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. It is majority-owned by Mermac. is privately owned. especially its management.194 Corporate Governance and Finance in East Asia. In cases of minority ownership..
1 Corporate Control Structure: The Case of Ayala Corporation
Family Members 100% Mermac. (15%)
MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. Inc.Figure 3. (47. (58..06%)
>15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.
>50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%)
<50% MinorityControlled Pure Operating Company
Note: Data as of 31 December 1998.96%) Privately-Held Pure Holding Company
(41. Inc.04%) <50% Ayala Corporation
Publicly Listed Pure Holding Company
>50% MajorityControlled Operating and Holding Company Ayala Land (71.6%)
<15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc.44%)
>50% MajorityControlled Pure Operating Company Makati Development Corporation (100%)
<50% MinorityControlled Pure Operating Company Cebu Holdings.
14%] / [1. Lang.76%)] [39. 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. See also Stijn Claessens. Generally.7 times Ibid. see the World Bank research papers by Stijn Claessens. Expropriation of Minority Shareholders: Evidence from East Asia. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.5% x 14. The control of companies through indirect corporate shareholdings.2).11 The Lopez family’s control rights over MERALCO was 5. a privately owned company. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector.98% x 42.64%) + (37.5%] [39. Who Owns and Controls East Asian Corporations? 11 Ibid. Lang: 1999a. defined as control by large shareholders of an operating company through minority ownership by several companies. [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. The situation offers large shareholders tremendous incentive to move resources
For details.44%] = [42. Joseph P. companies in the Lopez Group are large and minority-controlled. P.5%] / [(88.3% x 1. and 1999c. H. MERALCO. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. and a minority-controlled holding company. 1998. Being in the public utilities sector. and Larry H.8%] 5. Fan.7 times
.12 These examples show that even when large shareholder groups are minority shareholders.3% x 5.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group.64% +37. II
Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. P. and Larry H.196 Corporate Governance and Finance in East Asia.44%] / [58.14%] / [6. The Separation of Ownership and Control in East Asian Corporations.44%] / [25%] = 1. Diversification and Efficiency of Investment by East Asian Corporations. is illustrated in the Lopez Group (Figure 3. Simeon Djankov. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. however. Benpres Holdings.10 The Ayala family’s control rights over BPI was 1. Rockwell Land. First Philippine Holdings Corporation. Simeon Djankov. Vol. 1999b.
Privately-Held Pure Holding Company 88.2 Corporate Control Structure: The Case of Lopez Group
First Philippine Industrial Corporation
Note: Data as of 31 December 1998.
.76% Operating Company MinorityControlled 24.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
MinorityControlled 14.5% Operating Company MajorityControlled Operating Company
Rockwell Land Corporation
Suspension of Payments of Debts Under PD 902-A.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. 3. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. Vol.198 Corporate Governance and Finance in East Asia. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral.3. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. Control by Creditors According to the ADB survey. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. The average company. whether for working capital or capital expenditure. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. the data suggest. and (ii) how the legal framework protects creditor interests and rights. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. However. II
from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan
. 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.
it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. For example. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver.. The corporation continued to be under rehabilitation receivership as of June 1999.Chapter 3: Philippines 199
agreement. In practice. SEC and the court required that the creditors of BF Homes. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. profitable companies from going public.4. wait for 14 years from the time the company petitioned for suspension of payments in 1984. could take an indefinite period. Publicly listed companies do not represent a cross section of the Philippine corporate
. SEC could intervene to avoid asset dissipation.
3. The borrower will propose a rehabilitation plan to SEC. Under such circumstances. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. Under this mode. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. Consequently. There are two modes of suspension of payments under PD 902A. Inc. including the rehabilitation of the corporation. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. a real estate-based business group. the litigation process. There are no legal or practical limits to the time period of suspension of payments. The first mode is for simple suspension of payments. bank credit is the main source of corporate financing. under which. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. 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. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. a company’s assets are of sufficient value to cover all of its debts.1
Corporate Financing The Financial Market and Instruments
The Philippine financial market has remained underdeveloped compared with other countries in the region.4 3.
Interest rates.000 companies. compared with Malaysia ($186 billion). Even in the real estate sector. inflation. 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.g. is far ahead of the flock. however. the country experienced double-digit inflation. the minimum required to qualify as a public corporation. From the 1970s up to the early 1990s. was one of the smallest in the region at $47. especially short-term debt. However. but not to the same extent as it did in other Asian economies.4 billion (or $59 million using the average exchange rate). preferred stocks. Rising stock prices during the Ramos administration reflected to some extent the business optimism. They invested in only a few large companies whose shares were relatively liquid. The crisis affected the Philippine corporate sector.5 billion). Vol. Foreign portfolio investments also remained small. Most publicly listed companies issue only up to 20 percent of total shares to the public. The Philippine stock market is not a liquid market. 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. compared with other economies. Equity instruments include common stocks. The corporate sector raised a substantial amount of
.200 Corporate Governance and Finance in East Asia. II
sector. Malaysia. most listed companies are controlled by their five largest shareholders. and Indonesia ($61. Of the 221 companies listed in the Philippine Stock Exchange in 1997. Philippine companies were less leveraged.7 billion. Korea) ($143 billion). only 84 had sales large enough to be placed in the top 1. and less engaged in risky investments. Equity financing through IPOs was active. Table 3.14 shows that the average volume of daily trading in 1997 stood at P2. Korea and Thailand). companies expanded only at a moderate pace. the Republic of Korea (henceforth. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. As a result. the collapse of the stock market during the Asian financial crisis suggested that the earlier stock price surge in part reflected the “bubbles” common to other stock markets in the region. Foreign funds were wary of the Philippine stock market because of its limited liquidity. In part. The stock market was depressed up to the early 1990s. this is because. while interest rates were at high levels and volatile. and convertible securities. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. The market capitalization of the Philippine stock market in August 1997. about the size of Thailand’s. less exposed to foreign debt.
8 799.2 925.545.8 102.6 1.9 608.7 2. 1983-1997
Daily Trading Volume (P million) — — — — 129.0 0.8 0.0 161.5 16.0 1.2 59.4 Ratio of Market Capitalization to GDP 0.386.8 1.2 0.2 3.373.0 0. P billion)
Gross Domestic Product (current prices.3 0.4 9.9 12. Source: PSE databank.1 524.3 0.2 0.2 1.0 0.088.3 314.6 261.8 1.9 1.421.515.248.077.171.5
Year 369.9 2.2 57.4 1.7 0.3
Market Capitalization (year end.5 1.7 41.445.3 158.1 88.9 682.351.4 728.9 114.2 297.251.
.Table 3.1 5.5 26.5 72.6 1.7 207.1 0.8 1.3
— = not available.1 0.2 1. P billion)
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
19.686.7 1.121.3 59.14 Philippine Stock Market Performance.5 571.2 ($ million) — — — — 6.2 61.906.692.3 2.3 4.7 391. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.5 12.474.1 0.1 0.5 1.9 2.0 2.
Only the commercial banks. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. lack of competition among financial institutions. which in most cases is an affiliate of the issuing company. From 1988 to 1997.202 Corporate Governance and Finance in East Asia. moreover. by virtue of their large stakes in the financial system. leases. which buy commercial papers either for their own account or for their clients. which were the principal source of corporate financing in the Philippines.. because business groups often own large commercial banks. new equity. Under SEC regulations. and inventory financing. include bank credits. Because existing shareholders wanted to retain their proportionate control over their companies. The underwriter. However. which ultimately influences the pricing of commercial paper issues. are in a position to provide such discipline. Only a few large companies floated commercial papers because of the limited market. a strong regulatory system for bank supervision is imperative. The picture of the financial system that emerges is thus one of limited capital markets. Vol. 3.6 billion. sells these commercial papers through brokers. and high transaction costs. Negotiated credits. Capital markets cannot provide the market discipline that corporate investors need. corporate bond issuing was even more limited. The measures used in the analysis are:
. discounting of receivables. asset-backed credits. tight regulations. about 127 companies went public with a total value of offerings of about P134. Corporate bonds are another type of debt securities. The largest buyers have been commercial banks.4. II
equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. the rights issue was a popular way of raising equity capital. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. by volatile interest rates and the absence of a secondary market. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. and debt as sources of corporate financing by using flow of funds analysis. Debt instruments include negotiated credits and debt securities. Debt securities include commercial papers and corporate bonds. The corporate bond market was stunted. of which 85 percent was raised from 1993 to the first half of 1997. However. and the dominance of large commercial banks.2 Patterns of Corporate Financing
The study looked at retained earnings.
000 Corporations in the Philippines. 1988-1997.1 0.9 0.2 0.6 0.2 0.4 0.4 0.8 0.2 0.
. On the other hand. 1989-1997
Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1. It measures a company’s reliance on borrowings in financing asset growth. By definition. it is one minus IDFR.4 1. the SFRT was low at Table 3. the average SFRF was high at 109 percent.5 0.7 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.
All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.4 0.5 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.9 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.1 0.5 0. It measures a company’s capacity to finance asset growth by equity capital.4 0.Chapter 3: Philippines 203
Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets.1 0.9 0.3 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.5
Source: SEC-BusinessWorld Annual Survey of Top 1.5 0.6 0.4 0.15 Financing Patterns of the Corporate Sector. It measures a company’s capacity to finance growth in fixed assets by internally generated funds. It measures a company’s capacity to finance asset growth by internally generated funds.3 0. As shown in Table 3.5 0.1 0.6 0.3 0.1 0.000 Corporations in the Philippines from 1988 to 1997.4 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.4 0.0 0. during this period.5 0.3 0.2 0.5 0.5 2.8 0.3 0.0 0.9 0.3 0.3 0.5 0.2 0.8 0.5 0.15.1 Average 1.
Foreign-Owned 1. 1988-1997.16 Corporate Financing Patterns by Ownership Type. 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. Corporate Financing by Ownership Type As shown in Table 3. As a result. This was mainly caused by the declining contribution from retained earnings. except for foreignowned companies that had a negative new equity financing ratio.3 0.6 0.5
Privately-Owned 0.8 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. II
only 19 percent. the level of corporate leverage increased. 1991. internal funds were not a significant source of financing growth in total assets. In periods of an economic crunch such as in 1989. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. reflecting the capital flight caused by political instability in the early 1990s.3 0. privately.3 0. Retained earnings were the least important.204 Corporate Governance and Finance in East Asia. for all three types of companies—publicly listed. implying that internal funds were far from sufficient to finance growth in total assets.
.2 (0. Total assets grew by 23 percent that year.9 0.7 0.5 0. when it financed 45 percent of it. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. On Table 3. with debt providing 93 percent of the financing requirements. retained earnings declined and few new equity investments flowed into the corporate sector.2 0.and foreign-owned.3 0.0) 0. In all the years. 1989-1997
Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa
Publicly Listed 1. Vol. There were significant year-to-year variations.1
Excludes negative balances. Companies financed fixed assets from internal sources in hard times. debts were the most important source of financing. and 1997. In 1997. the SFRF was higher. except in 1991.000 Corporations in the Philippines. Source: SEC-BusinessWorld Annual Survey of Top 1.16.
7 7. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.0 12.5 0.8 46.3 11. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.0 8.8 3.4 41.0 13.3 10.
.3 12.6 43.0 6.8 0.4 2.7 23. especially bank loans.9 16.5 27.0 53.4 43.3 51.9 100.Chapter 3: Philippines 205
average. It presents a composition analysis of assets and financing sources for the period 1992-1996.0 1994 19.0 1993 14.6 0.6 37.0 1995 1996
13.4 3. 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 14.3 48.8 0.1 50.4 100.4 2.7 13.8 38.5 41.7 100.1 13.000 Corporations in the Philippines.0 38.0 10.9 4.6 26.9 16.5 16.5 12.7 13.1 9.8 51.and foreign-owned companies.4 100. significantly Table 3.2 3.9 0.2 100.9 12.5 9.8 26.2 3.4 12.0
Source: SEC-BusinessWorld Annual Survey of Top 1.0 10. 1988-1997.9 3.4 100.17.9 16.3 12.3 12.3 4. Foreign-owned companies relied more heavily on debt financing. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.9 38.1 15.4 10.0 9.7 4.7 2.8 39.0 9.9 24.2 51.1 7.8 17.8 4.7 2.2 12.1 10. publicly listed companies relied more on new equity financing than privately.0 100.8 3.2 100. The sector built up its short-term debts.8 16.6 48.0 9.3 13.0 9.6 48.1 49. contributing 90 percent of growth in total assets.17 Composition of Assets and Financing of the Publicly Listed Sector.2 42.4 100.8 100.3 10.
for independent companies. the easier access to external credit. Vol. group companies usually financed their investment in member companies by equity rather than debt. retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups. On average. the average SFRF of business groups was higher compared with that of independent companies. Group companies were generally more profitable than independent companies. group companies were less reliant on debt financing than
Defined as total current assets divided by total current liabilities. as opposed to 94 and 30 percent. respectively.3 0. Further.3 0. The normal standard liquid position is a current ratio of 2 or higher.13 was at 1.3 0. and economies of scale in fund raising. II
in 1996 and became more vulnerable to the financial crisis in 1997.9 0.45 in 1996. The traditional measure of liquidity.18.18 Financing Patterns by Control Structure. As shown in Table 3. Table 3. 1989-1997
Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa
Group Member 1. indicating that many publicly listed companies were likely to be in a tight liquidity position.5
Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. the current ratio.5 0. For these two reasons. their inherent ability to pool risks.
.5 0.206 Corporate Governance and Finance in East Asia. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.1 0. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded.6
Independent Company 0. compared with an average of 54 percent for independent companies.2 0.
Group companies financed an average of 45 percent of growth in total assets by debt.000 Corporations in the Philippines. 1988-1997.
8 0. 1993 with 96 percent.9 0.3 0. Excluding
The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.000 Corporations in the Philippines.Chapter 3: Philippines 207
independent companies. averaging 61 percent of growth in total assets. medium-sized companies used more debts.50 (Table 3.55 was substantially higher than the small companies’ 0.06.4
Small 0. and 1997 with 131 percent.6 0. On average.19 Financing Patterns by Firm Size. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. 1988-1997. The corresponding ratio was 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1. Source: SEC-BusinessWorld Annual Survey of Top 1.19). The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.5 0.20).2 0.76 for small companies and 0.2 0.08 and SFRT of 0. These years were 1991 with 110 percent. Large firms consistently increased their reliance on debts from 1994 to 1997. equity financed 42 percent of incremental asset growth.1 0.2 0. Table 3. compared with 55 percent for large companies and 47 percent for small ones. With assets growing at a fast pace during this period. There was also increased reliance on debt financing.3 0.5
Medium 3. Large companies’ IDFR of 0. 1989-1997
Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa
Excludes negative balances. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.88 for large companies (Table 3.3 0.47. with an average of 3.6 0.
Source: SEC-BusinessWorld Annual Survey of Top 1. The effects of the crisis of 1997 were adverse. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year.27. the total debt ratio was much higher in 1996 at 0.3 0.4 0.
The real estate industry financed its growth by substantial equity funds.5 0. The sector had the highest leverage among all industries that year. Up to 1997.79 and in 1997 at 0. Vol.3 0. the manufacturing industry financed 57 percent of its total asset growth by debt. During the crisis year. Since the real estate boom coincided with that of the stock market.47 two years later. when debts declined.208 Corporate Governance and Finance in East Asia.7 0. II
1991.3 0. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.58 and SFRT of 0.000 Corporations in the Philippines. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.4 0. Table 3. Excluding 1997 when fixed assets declined.6 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. achieving an average SFRF of 3. SFRF for the sector averaged 0. increasing to 0. debt financed about 78 percent of asset growth in real estate.32.2) 0. with an SFRF as low as 0.5 0.
.04. ranging from 41 to 118 percent.4 0.1 0.6
a Excludes negative balances.5 (0.4 Construction 0. 1988-1997.6 0.5 Utilities and Real Estate Services and Property 0. Equity financed an average of 62 percent of total asset growth.91.3 0. In the eight years preceding the crisis. The situation improved beginning 1994.20 Financing Patterns by Industry. The utilities sector showed weaknesses in internal fund generation in 1989-1994. Incremental equity financing amounted to an average of 44 percent of total asset growth. While this level is considered prudent. The construction sector was a heavy user of debt financing.6 0. the industry generated internal funds. the incremental equity ratios of the industry were high. 1989-1997
Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. while SFRT averaged only 0. many of the leading real estate companies successfully went public during that time.4 3.29.
4.00125 2. ROA.009 5. and Financial Leverage
Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. Financial Leverage. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant.860
Leverage = the ratio of total assets to total equity. the degree of ownership concentration.287 0.14 Large shareholders may borrow excessively to undertake risky projects. ROE.21. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. The Modern Industrial Revolution.3
See for example Michael Jensen (1993). more profitable. Using the PSE database. Profitability. Journal of Finance 48: 831-880. while if it fails.Chapter 3: Philippines 209
3. ROE.008 5. Source: Author’s estimates based on the PSE databank. measured by the percentage of shareholdings of the largest five shareholders.00056 1. and leverage. was regressed against measures of profitability and of financial leverage. alternatively. ownership concentration = the total shareholdings of the top five shareholders. ROE = return on equity.421 0. at the same time. knowing that if an investment turns out to be successful they could capture most of the gain.00036 2. 1992-1996. Exit. and the Failure of Internal Control Systems.230 Leverage 0. ROA = return on assets. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.004 3.
. creditors bear the consequences.
Table 3.130 ROA 0.21 Ownership Concentration.769 0. and financial leverage are all positively and significantly related to the degree of ownership concentration. As shown in Table 3. and Performance
Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. as the dependent variable.
and agriculture at 21 percent. notably remittances of overseas workers.5. which averaged 4. Vol. The export sector had a very narrow breadth. their growth gathering momentum only beginning in 1992. the country was less dependent on foreign private capital. Net trades in goods and services averaged a deficit of 4. In sum. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion.” that is. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment).210 Corporate Governance and Finance in East Asia. II
3. raw materials. Although much lower than those of other Asian countries. with a narrow exporting industry base. The largest contributors to GDP were services at 43 percent. the economy still showed vestiges of its import-dependent and substituting character. but its share had been declining by 4 percent per year since 1995.1
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. with commodities accounting for the balance. The country experienced balance of payments surpluses but these were due to transfers. Because of limited local capital. the country’s GDP growth pace indicated that it did not have a “bubble economy. Historically. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis.5 3.5 percent per year from 1992 to 1997. and intermediate goods. an overexpansion of capacities. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. Manufactures accounted for about 85 percent of exports. In 1997. more than half (52 percent) of exports were semiconductors. Compared to other East Asian crisis-affected countries. industry at 34 percent. Exports were growing at about 20 percent per year in the three years preceding the crisis.8 percent of GDP from 1995 to 1997. foreign investments in the country have been low. 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. Net investment inflows were $3. Garments was the second largest export sector at about 9 percent. After a
.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. Commercial and industrial activities in the country were largely oriented to domestic markets.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates.
which. Eventually.1 percent. From 1988 to 1996. an average Treasury bill rate of 13. Profitable operations since 1992 had allowed it to build equity. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. unlike their counterparts in the region. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. During this time.Chapter 3: Philippines 211
long period of debt moratorium and restructuring that started in 1983 and ended in 1991.3 percent. resulting in stability in the short-term debt to reserves ratio. average ROE was 13. a government fiscal surplus from 1994 to 1997. a positive balance of payments from 1992 to 1996. Total debts were only 52 percent of assets or 108 percent of equity.5 percent. adjustments were focused on the quantity and quality of the banking system’s corporate loans. assets grew at a compound annual rate of about 31 percent.8 percent.
. 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. however. 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. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis.6 billion as of March 1997. and a relatively healthy banking system. In the Philippines. The lessons from debt restructuring became the basis for the Government’s economic policies. From 1993 to 1997. the Government restructured its debts into longer tenors with a maximum of 25 years. an average inflation rate of 7. the Government sought stability and achieved this in 19921997. in turn. while sales grew by only 20 percent per year. the country and the corporate sector had no access to foreign currency debts from the international financial market. fueled also by successful IPOs during the stock market boom of 1993-1996. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. 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. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. After hovering in the range of 100 to 127 percent. Closer analysis.
net FDI remained stable at more than $1 billion.303 23. or 114 percent of net foreign direct investment (FDI).749 26. Most of this leverage happened during the boom years in the region.4 1997 762 1.22. Table 3.718 30. Vol. the country’s economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive “contagion” effect of optimism by investors and creditors about the region. It rose to $2.5 billion in 1995. 1996 = 26.101 billion or 196 percent of net FDI in 1996. growing by about 34 percent per year from 1994 to 1997. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. Debts financed a large part of this expansion. but to a lesser degree.22).300 1. Data for 1998 cover only January-August. Sources: Bangko Sentral ng Pilipinas and SEC.073 (406) 121. II
The corporate sector indeed overexpanded after 1993 like its counterparts in the region. In sum. 1995-1998
Item Net Foreign Investments ($ 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.
. But portfolio investment amounting to $406 million flew out of the Philippines.71.517 1.101 92.212 Corporate Governance and Finance in East Asia.0 1998 739 555 328 69. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. the other immediate impact of the crisis was that on foreign investment flows. It financed 26 percent of corporate capital growth.609 1.0 1996 3. Net foreign portfolio investment amounted to $1.06. mitigated the effects of the pullout and liquidation of investments in the aftermath.22 Foreign Investment Flows. 1998 = 41. In 1997. These patterns in investment and financing are similar to those of other countries in the region.47. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.2 Impact of the Crisis on the Corporate Sector
Aside from the foreign exchange adjustment. precisely.” 3. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.074 2. 1997 = 29.650 32.5.7
Note: Peso-dollar exchange rates used are: 1995 = 25.485 145.
Loan calls. Because commercial banks were strongly capitalized. they were willing to restructure and renegotiate existing loans by corporate borrowers. the sectors with the highest outstanding loans had reduced their credit exposures. depended on the liquidity and capital position of commercial banks. which held about 75 percent of the assets of the financial system in 1997. new borrowings financed asset growth. The interest rates on Treasury bills.Chapter 3: Philippines 213
Corporate financial performances and conditions deteriorated during 1997. lending rates also came down. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. Average bank lending rates climbed to their peak of 25. Companies deferred investments in new fixed assets. the corporate sector became vulnerable to loan calls and high interest rates.2 percent was barely above inflation rate. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. By March 1988. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans.2 percent in November 1997. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. By October 1998. in turn. ranged from 11 to 13 percent from 1993 to July 1997. With the increase in borrowings and reduced liquidity.3 percent of assets. The resources of the financial system that year totaled P3. then rose to a high of 22. the commercial banking sector’s capital remained strong at 17. Net profit margins were at a 10-year low at 4.513 billion. albeit at current market interest rates. with commercial banks holding P2. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. Because of weak internal fund generation.369 billion. meanwhile. When the Treasury bill rates eased in March 1998. Lending rates were well above the 20 percent level from July 1997 to March 1998. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position.2 to 28. ROE at 6.9 percent. Although corporate borrowers were not highly leveraged. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. and leverage increased to 149 percent compared with 109 percent in 1996. The real problem of the corporate sector during the crisis was the rise in interest rates. sparking a rise in interest rates on corporate loans.7 percent in January 1998. and the wholesale and
. in varying degrees for each sector. Loans outstanding of commercial banks declined by the first quarter of 1998.
5.214 Corporate Governance and Finance in East Asia. Vol. 3. However.5-6 percent. Still. The move retained the liquidity position of banks but lowered their cost of reserves. real estate loans averaged 11. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. These peaked at 14. as with its counterparts in other Asian countries. 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. In March 1997.3 Responses to the Crisis
Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. set limits on overbought/oversold foreign exchange positions of banks. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. and its experience of low. and subsequently went down to 13. II
retail trade sector. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. the ratio increased to a high of 11. single-digit NPL ratios began only since 1989. including (i) a regulatory limit of 20 percent on banks’ loans to the
. through the Bankers’ Association of the Philippines. and set up a hedging facility for borrowers with foreign currency-denominated loans.6 percent in June 1998. by 12 percent. As for nonperforming loans (NPLs). But the Philippine banking system had gone through worse crises in the past. and the financial system.3 percent in December 1997.9 percent of bank loan portfolios.5 percent by September 1998. These figures show that adjustment problems were industry-specific and that the real estate industry. was a problem sector. This allowed the Central Bank to convince the banks. thereby reducing overall intermediation costs. the fiscal position. The Central Bank adopted other measures to strengthen the financial system.
Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. First Pacific Corporation. (PAL). and the legal framework for reorganization and liquidation conditioned its response to the crisis. Financially strong companies were able to survive the crisis by effecting such internal restructuring. the Government kept inflation below 10 percent. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. In response to calls for lower bank intermediation costs.Chapter 3: Philippines 215
real estate sector. changing technologies. The acquiring company. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. Large companies with heavy loan exposures such as Philippine Airlines Inc. took more action. the Asian crisis opened a unique opportunity for foreign investors. was known to have a policy
. the country’s flag carrier. PAL. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. The policy directions and actions taken by the Government appear to have ushered in recovery. 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. (v) improving disclosure requirements on the financial position of banks. consolidating business units. Average Treasury bill rates have cooled since mid-1998.6 percent growth in 1999. The economy avoided a recession in 1998 and achieved 3. With its weakened financial position. the largest telecommunications setup in the Philippines. With prudent monetary management. In the case of PLDT. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. bank loan rates have also come down. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. Responses of the Corporate Sector The corporate sector’s financial position. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. and giving up noncore businesses. subcontracting and outsourcing. its accessibility to foreign capital. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership.
controlling shareholders can capture these profits by excluding public investors from ownership. Conclusions. however. and Recommendations Summary and Conclusions
The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. One mode was the outright purchase of shares in the open market. Consequently. When companies are highly profitable. When Cojuangco took over. The question. Although considered the prime industrial company in the Philippines.6. Vol.216 Corporate Governance and Finance in East Asia. Ownership is highly concentrated and a few dominant players control major industries.
3. Corporate governance is conditioned by the high ownership concentration of these large companies. 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. II
of investing to control companies that are dominant players in their industries. the stock price of PLDT was buoyant during the takeover period. using some or all of these means. the Cojuangcos. First Pacific. 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. Its stock price and returns to shareholders had stagnated. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. A second method was to purchase the shares of other large minority shareholders. SMC is another widely-held company managed by a minority shareholder.1
Summary. In a legal process that ended in his takeover of management. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. By itself. the Soriano family. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. is whether there are sufficient safeguards to prevent controlling shareholders from
. at a premium over the market price to reflect the value of management control. concentrated ownership of companies is not equivalent to weakness in corporate governance.6 3. eventually took over PLDT and announced a restructuring plan for the entire group of companies.
Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. were the least profitable. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders. minority shareholders need to be protected by external control mechanisms. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. an ineffective insolvency system. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. influenced by industry characteristics. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. ownership of banks by business groups. Performance was. medium companies showed higher profitability than large and small ones. The result is that corporate governance depends only on internal controls. foreign companies were the most profitable but highly leveraged. 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. Financial institutions are not significant shareholders. while the largest 20 shareholders control more than 75 percent of shares. By size. By ownership structure. Analysis of corporate financing by ownership
. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. to some extent. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. The five largest shareholders have majority control of an average publicly listed company. By control structure. an underdeveloped capital market. and the lack of market for corporate control. the most numerous in the corporate sector. The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings.Chapter 3: Philippines 217
expropriating the wealth of minority shareholders through aggressive and risky investment. With large shareholders in control. oligopolistic market structures. Leverage was within Asian norms but above developed country standards. Privately-owned companies. Ownership of publicly listed companies is highly concentrated. passive independent auditing. Returns to capital exceeded inflation rates.
superior profitability. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). 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. The difference between management control and ownership rights is usually substantial. After controlling for industry effects. selective public listing of companies in the group. Large companies owned or controlled by business groups tend to dominate their industries. Ownership concentration was positively related to both returns and leverage.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. Even in cases where the group owned only a minority share of a commercial bank. and leverage were all positively related to the degree of ownership concentration. 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. and sustained growth. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. with the foreign-owned companies found to rely more on borrowed funds. as typified by the Ayala Group. and the extent of supervision of outside institutions such as independent auditors and SEC. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. family-based shareholders gain control by such means as the setting up of holding companies. the bank usually accounted for a large share of each group’s net profits. ROE. ROA. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. A business group is an effective business organizational model for achieving leadership in industries. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. and centralized management and financing. Business groups with pyramiding structures heighten the issue of corporate governance. A commercial bank is an important part of most business groups. II
type gave similar results.
. The pyramid model is useful for centrally managing smaller companies. The extent of governance problems depends on internal control policies of the controlling shareholders. Large. Vol.
SEC’s quasijudicial functions. For example. There are systemic risks involved in highly concentrated ownership. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. mostly by highly leveraged companies and speculative investors in real estate.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. As the crisis wore on in 1998. 3. strong capital position built on IPOs in a buoyant stock market. and sound overall creditworthiness. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. there were sharp rises in the number of bankruptcies and petitions for debt relief. with recently restructured public debt.6. The Central Bank imposed strict limits on real estate lending. low inflation. are to be removed and transferred to courts. SEC officials. 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. decisions by large sharehold-
. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. a strong international reserves position. and a market-oriented policy environment. Specific actions recommended are described below. This law is flawed in concept because it supplants a market-based credit agreement with a political process. including suspension of payments. decide on the financial future of a troubled debtor. Still. resulting in the banks’ accelerated restructuring of troubled debts in this sector. 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.Chapter 3: Philippines 219
The financial crisis came when the Philippine economy was in a relatively strong financial position. the government budget in surplus. That is. 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. rather than the banks that lent millions of pesos. Under the new Securities Regulation Code enacted in 2000.
they serve to curb the powers of controlling shareholders. It has suffi-
. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. The following recommendations involve amendments to the Corporation Code that will improve transparency of ownership and address the current high level of ownership concentration in Philippine business: (i) require disclosures of underlying ownership of shares held by nominees and holding companies. Another measure would be to impose a statutory limit on the number of directorships that one can accept. Clear legal accountability is a precondition for successful shareholder activism. The adjustment should be made over a fixed period of time. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent.220 Corporate Governance and Finance in East Asia. To help ensure this. This may limit current practices of appointing prominent individuals and family members as directors. 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. to 25 percent. To strengthen the board. and self-dealing. Vol. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. inadequate disclosures. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. insider information. 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. depending on the size of the company. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards. (ii) require disclosure of material changes in ownership. II
ers often cause wide volatility in stock prices and invite reaction from creditors.
(iv) require banks to follow international financial accounting. in particular. reporting. Impose severe penalties for any attempt by banks to circumvent this regulation..g.Chapter 3: Philippines 221
cient case history that can be used as a basis for tightening its disclosure requirements. Finally. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. raising the current two-thirds majority to a three-fourths majority. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. Because ownership is generally concentrated in five shareholders. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. the board can easily muster the needed majority to approve the deal. (ii) set strict limits on lending by banks to affiliated companies. limit. and of banks in nonfinancial companies in order to avoid connected lending. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. in areas of supervisory functions of the central bank. For example. and related interests. and disclosure standards. They need legal empowerment such as higher majority voting requirements. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. prudential measures and regulations. the board will be compelled to initiate a thorough discussion of the merits of the proposed related-party deals that will require the participation of minority shareholders. e. directors. fit and
. or prohibit cross-guarantees by companies belonging to affiliated groups. and (v) closely monitor. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. officers.
proper rule. and external auditors. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. Two measures should be adopted to promote shareholder activism. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. 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. 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. Vol. institutional investors lead public investors in providing market signals to companies. foreign ownership of banks. management. In developed capital markets. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. Presently. institutional investors can be a driving force in providing market discipline to management. 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 impose market discipline by voting on strategic corporate decisions. If institutional investors are present. Its priority is to protect prospective fund investors from unscrupulous fund managers. By supporting the establishment and operation of institutional investors. 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. The current law should expand class action suits to include management and
.222 Corporate Governance and Finance in East Asia. and lending to DOSRI. This way. transparency. an active financial analyst community can begin to form.
and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. and dividend decisions. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets.Chapter 3: Philippines 223
. leadership. There are existing institutions such as Dun and Bradsreet. Legal provisions for class action suits should cover self-dealing by directors. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. 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 Credit Information Bureau that can be the starting point of this effort. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. the Government could develop the market for future issues of corporate bonds. SEC should allow minority shareholders to be represented by activist groups. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. compensation contracts. and the external auditors. 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. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. their directors and management. Securities market development efforts should coincide with strict regulation of the commercial banking sector. And by issuing Government Treasury securities in longer tenors. information disclosures. guarantees. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. These groups have an incentive to gather technical expertise.
Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. The Government should also continue to improve infrastructure. Current disclosure requirements of SEC are not rigorous enough for public investors. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. PSE and SEC need to build a liquid and efficient market. Penalties for poor conduct of auditing by independent
. Vol. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. Audited financial statements contain basic information about a company’s financial position and performance. II
and exit barriers. and publicly listed companies trade barely the minimum number of shares required for public listing. Lack of liquidity deters institutional investors. and provide quality basic services should also be heightened. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. Many large companies remain privately owned. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. Efforts to reduce graft and corruption. and various other forms of protection. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. improve enforcement of the rule of law.224 Corporate Governance and Finance in East Asia. 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. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies.and medium-scale companies can become more competitive relative to large companies. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. 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.
reorganization.Chapter 3: Philippines 225
auditors and the mechanism for imposing them are weak. SEC and PICPA need to formulate more specific disclosure standards. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. review the system of penalties on professionals involved in a company’s violation of disclosure rules. and implement those standards and penalties rigorously. and Liquidation. the new law needs to be effectively implemented and enforced. The law on suspension of payments replaces a market-oriented solution with a political process. including the resolution of intracorporate disputes. Instead.
. SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. Reorganization. and transferred these to courts. violators were made to pay only nominal penalties. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. For that matter. and liquidation of troubled companies should be made a priority of the Government. Improving the Legal Framework for Suspension of Payments. Reforming the legal framework for suspension of payments. 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. it creates a moral hazard problem. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. suspension of payments and private damage actions.
Vol. and Larry H. 1998a. Fan. and Atulya Sarin. Lang. Claessens. and Larry H. Working Paper 2088. and Fausto Panunzi. 1989. Jr. Simeon Djankov. 1994. and Kenneth Lehn. May. 1997. Claessens. Denis. Alba. Thailand: From Financial Crisis to Economic Renewal. 1988. Pedro. Demsetz. Journal of Finance 2 (1). H. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. Bangko Sentral ng Pilipinas. Michael. and Clifford Holderness. and Larry H. Emilio. 1998. Claessens.
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Abonyi. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. The Structure of Corporate Ownership: Causes and Consequences. 1999. World Bank. Journal of Political Economy 93 (6). Philippine Macroeconomic Prospects: The Next Ten Years. Dennis. XXIX. Key Indicators of Developing Asian and Pacific Countries 1998. Lang.226 Corporate Governance and Finance in East Asia. World Bank. Working Paper. Discussion Paper. October. Journal of Financial Economics 25: 371-395. P. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. H. Expropriation of Minority Shareholders in East Asia.. Dennis Gromb. and Larry H. Lang. Joseph P.
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It was inefficient in financial intermediation. The corporate sector also contributed significantly to the crisis. As a result. had been plagued with prudential problems for a long time. with the currencies of Indonesia. The fixed exchange rate policy. but also the stalling of East Asia’s “economic miracle. The majority of these debts were not properly hedged. both of ADB.” After mounting an aggressive defense of the currency. Malaysia. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. the Stock Exchange of Thailand for its help and support in conducting company surveys. poorly regulated and sheltered from competition. Asian University of Science and Technology. the Thai Government conceded and adopted a floating exchange rate regime. The banking system. Korea). short-term private debt obligations grew to about 60 percent of total private sector debts. Thailand. Thai corporations were collectively overexposed to exchange rate risks. Faculty of Business. magnified the impact of these problems on the economy when the crisis hit. David Edwards. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. Chonburi. 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.1
In May to July 1997. the Thai baht came under pressure from speculative attacks.
. and Philippines all depreciating significantly. For the period 1994-1996. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. In the prelude to the 1997 crisis. Republic of Korea (henceforth. The author wishes to thank Juzhong Zhuang. with Thai corporations overutilizing short-term foreign currency-denominated loans.4 Thailand
4. heralding not only a financial crisis in the country.
Associate Professor. the banking system merely validated the financial risks. and Lea Sumulong and Graham Dwyer for their editorial assistance. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies.
2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans.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. This study examines these and other factors that might have weakened corporate sector governance in Thailand. with government policy providing support but avoiding direct interference. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. Section 4. Section 4. II
There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Section 4. and a family-based corporate ownership structure. To protect domestic industries. its growth and financial performance. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). Section 4.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.230 Corporate Governance and Finance in East Asia.
4. Vol.2. Import tariffs on machinery and heavy equipment were removed. The National Economic and Social Development Board was created to plan the country’s economic and social development. as well as its legal and regulatory framework. The country initiated national economic development planning in 1961 when the economy was growing rapidly.2 4.
. lack of transparency and adequate disclosure.1
Overview of the Corporate Sector Historical Development
The corporate sector has long been considered the engine of Thailand’s economic growth. while new industries were encouraged to reduce the need for imports. The study then considers policy recommendations with emphasis on corporate governance improvement. the Government increased tariffs on products that could be produced locally. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. The First and Second Plans (1961-1971) Under the first two plans.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand.
5 percent in 1973 and 24. became a major problem as domestic investment declined.4 billion from overseas and increased taxes on numerous items. The focus shifted to export promotion. capital inflows.
. The Third. Unemployment. averaging 1. Inflation levels were low. However. Consequently. chemicals. Budget deficits also increased throughout the Fourth Plan.3 percent in 1974. Fourth. and reduced current account deficits. especially foreign aid from the United States. with the devaluation of the baht in 1984 a major step in this direction. canned foods.4 percent of GDP. resulted in increases in the current account deficit. processed steel. Inflation reached 15. lower than anticipated due to a worldwide economic recession.15 billion per year or 4. however. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. remaining high until 1981. The decline in imports was steady. an improved trade balance. and increases in world food and oil prices. it proceeded with its development plan for the industrial sector. As a result. helped offset these deficits. The Government had to shift emphasis to restoration of economic stability. To close the fiscal gap. the industrial sector grew at a faster rate than the agricultural sector.6 percent per year. External factors. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. Average growth for the period was 4 percent per year. At the same time.Chapter 4: Thailand 231
During this period. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. gross national product grew by about 7 percent per year. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. The average budget deficit reached an all-time high of $2. Budget deficits remained a major problem during the Fifth Plan. the Government borrowed $6. however. Industrial sector growth was also rapid and many industries (tires. The results were increased exports. including a weakening of the dollar. with the agricultural sector the major contributor. leaving the Government no choice but to resort to overseas borrowings. the value of the baht remained stable. Thus. and automobile assembly) emerged. textiles. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. the current account registered a surplus in 1986. the government’s debt burden escalated. including luxury goods.
Vol. The country also attracted a large amount of foreign direct investments (FDIs).5 to 13. United States. the property sector began to collapse in 1996. averaging 10. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. respectively. combined with its liberal financial policies.4 percent targets.2 percent target. while exports expanded considerably. From 1989. Private sector investment grew at an average annual rate of 7 percent.6 percent. The manufacturing sector became a dominant force in the economy. from only $31 billion in 1992. The country’s high ratings in the international capital market. Growth of exports and imports averaged 14.5 percent. Growth rates during 1987-1991 ranged from 9. an oversupply of housing emerged. The exchange rate was steady at around B25 to the dollar. China—went to export-oriented manufacturing industries. property development. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies.7 and 11. II
The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. reaching an annual inflow of $2 billion in 1991. rather than to productive activities. compared with the 14. better than the 5. Most of the FDIs—originating mainly from Japan. and Hong Kong. Average annual growth in real GDP was 8 percent. Europe. Thailand became a debtor’s market.
. increasing its share in total export value from 42 to 76 percent.232 Corporate Governance and Finance in East Asia.8 percent. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments.2 percent per year. compared with the 8. with private foreign debt reaching $92 billion by the end of 1996. compounded by a slump in property sales.8 percent. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. lower than the target of 8. invited a deluge of capital seeking profitable investments. Singapore. the bulk of domestic investments went to speculative ventures such as real estate.6 percent target of the Seventh Plan. By 1995. On top of its predominantly “borrowed” nature. Inflation was 4. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. and the stock market.2 and 13.
However. its policy had always been to protect domestic banks. a policy that held throughout the first six economic development plans.” which later became the master plan for the development of the Thai capital market. a former Chief Economist from the US Securities and Exchange Commission. 4.3 percent in 1996. And because the Government considered the banking system vital to the development of the economy. Sidney M.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. the Government passed the Public Limited Company Act. prepared a comprehensive report entitled “A Capital Market in Thailand. Foreign banks were barred from competing directly with domestic banks. the capital markets didn’t play a significant role until 1975.Chapter 4: Thailand 233
Toward the end of the Plan period.8 percent in 1995 to 1. SET officially became “the Stock Exchange of Thailand” in 1991. Exports went into a tailspin. many companies considered the Act too restrictive and a hindrance to growth.2 Development of Capital Markets
Although the corporate sector has long been the government’s main tool for economic development. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. The deficits caused the Government to rely on even more external borrowing. the Bank of Thailand and
. the signs of an economy about to falter were there. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. which raised the debt service ratio. on account of an overvalued baht that weakened export competitiveness. Before the capital market emerged. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. the Government amended the “Announcement of the Executive Council No. In May 1974. In 1978. with growth shrinking from 23. placing all publicly listed companies under regulation. In 1969. 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. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. Robbins. the corporate sector’s main source of funding was the banks. Under the 1962 Commercial Banking Act. which was amended in 1979 and 1985.2. In his report. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. In 1972.
while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision.” The Government also granted financial institutions overly generous bailouts. Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. the World Bank had recommended such a move. to cater specifically to its
. Externally. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. While the Bank of Thailand had the regulatory power to influence business practices. The regulatory measures were inadequately designed and poorly enforced. and new financial instruments. Earlier. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. At the end of the Sixth Plan. the Government was under international pressure to deregulate the financial sector. The introduction of these two laws came just after the Government’s signing of Article VIII of an Agreement with the International Monetary Fund (IMF) in May 1990 to deregulate and liberalize financial markets. Thailand’s capital market entered a new era with improved legislation and regulation. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. increased financial market activities. the financial and banking laws were generally ineffective. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector.234 Corporate Governance and Finance in East Asia. it usually relied on “moral suasion. Thai banks gained access to a variety of funding sources from around the world. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. In the 1990s. II
the Ministry of Finance had full authority to supervise all commercial banks. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. Laws were enacted to stimulate growth of the corporate sector. With the liberalization of financial markets. Vol. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. However.
Type of Business Agriculture.3 Growth and Financial Performance
Since the 1978 enactment of the Public Limited Company Act. and Communication Financing. The result was a corresponding growth and development in Thailand’s capital markets. and Business Service Community. 1978-2000
Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. and Restaurants and Hotel Transport.1). 4.1 30.5 791.6 350.3 trillion have been registered with the authority (Table 4. with B1.Chapter 4: Thailand 235
fast-growing neighbors.0 Paid-up Capital (B billion) 1. Insurance. Social and Personal Service Total
Note: The data for 2000 is as of October 2000.3 83. in that order.1 trillion and paid-up capital of B1. and Water Construction Wholesale and Retail Trade.1 Public Companies Registered. however.6 23.291. Worldwide.394. In terms of capital. Real Estate. Financial deregulation and liberalization were key to realizing that vision. Forestry.9 261. Hunting.9 16. the financial sector is the largest.6 2. Source: Department of Commercial Registration.101.5 111.0 21. finance.6 1.9 1.
. Thailand.0 19. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. The majority of the companies are in manufacturing. Ministry of Commerce.5 50. and wholesale/ retail trade and restaurant/hotel sectors. the country became recognized as an economic development model for other emerging economies. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.0 110.1 78. Gas. 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.2 11.4 trillion in registered capital and B791 billion in paid-up capital. and Fishing Mining and Quarrying Manufacturing Electricity. about 661 companies with total registered capital of B2. Storage.2.
allowed Thai financial institutions and corporations to obtain funds overseas.4 96.5 1. The development of the corporate sector closely followed the development of capital markets.2 40. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.3).236 Corporate Governance and Finance in East Asia. 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 1.0 20.5
1. The signing of Article VIII with the IMF.4 277.
The 1997 crisis battered the primary market for securities.1 — — — 6. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994. respectively.8 — 26. After the passage of the SEA of 1992. While a rebound was apparent beginning in 1998. reducing the value of offerings to a little more than a quarter of the previous year’s level.2 Public Offerings of Securities.2 12. The number of listed companies and securities steadily increased until 1996 (Table 4.7 billion and B27.8 151.3 1996 1997 65.5 billion and B1 billion the previous year.3 31.1 286.6
8. Vol.7 27.3 22.9 37. reaching a precrisis peak in 1996 (Table 4.6 39.4 51. meanwhile. II
B261 billion.3 6. The stock market also became an invaluable source of funds for corporations.8 billion.5 39. reached
. moreover. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. These peaked at B89.2 25.0
0.5 — — 56. the value of public offerings rose steadily.7 5.7 136. Domestic and offshore debt issues reached B54.9 31. from only B20.2 5.7 7.2).8 201.9 1998 1999
15.1 2.4 34. the year before the crisis struck. the capital market became instrumental in the rapid growth and development of the corporate sector.1 599.6 7. Market capitalization.3 194.7 billion in 1996. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.8 1995 64.7 9.6 174.0 1994 82. Securities and Exchange Commission of Thailand. Source: Key Capital Market Statistics. Table 4.1 54.6
— = not available.
4 percent to 5.535 1. But instead of shifting to a low gear. ROA dipped from 10. however.360 1.
its high point in 1995 at B3. had been on the rise throughout the 1980s. however. not all public companies are listed on the SET. The upward trends for ROE and ROA continued through 1989. The key financial ratios of all companies listed on SET bear this out (Table 4.683 1. then stalled in 1990. The trend reversed in 1995. return on equity (ROE). the average times interest earned (TIE) was down to 5. their share rising from 17 percent in 1993 to 43 percent in 1997. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the
. Source: Securities and Exchange Commission of Thailand. Foreigners accounted for an increasing proportion of SET’s turnover value. By the early 1990s. Meanwhile.1 by 1996.303 930 855 1. and gross profit margin. The financial leverage of all companies declined until 1994. when long-term debt grew as Thai corporations began to borrow heavily to finance growth.8 percent.560 1.201 2.5 at its peak in 1987. Side by side with this surge of financing for corporate growth.114 1. in the end.4). gross profit margin rose until 1991 before falling in 1992. pulled down by active public offering activities. ROE similarly fell from 21. Corporate profitability. While the decline in gross profit margin was not as sharp.301 3.Chapter 4: Thailand 237
Table 4. the averages for all three profitability ratios took a downswing all the way until 1996.6 trillion.133 1.268 2. as measured by return on assets (ROA). Throughout the 1990s. corporate profitability had been declining.3 percent in 1989 to 3.325 3. From 10.4 percent in 1996.610 1. resulting in their inability to fulfill debt obligations.281 832 373 356 482
Due to listing requirements and other reasons.565 2. 1993-1999
Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index
1993 1994 1995 1996 1997 1998 1999
3. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments.3 Statistical Highlights of the Stock Exchange of Thailand. was the ominous deterioration in the key financial ratios of publicly listed companies.193 2. the companies could not generate enough net returns from their assets and equity.
1 52.5).2 35.4 Key Financial Ratios of Publicly Listed Companies. was also distinct in the region.5 63.9 66.7 5.2 10.4 5.7 34.1 16.7 12.1 9.7 27. resulting in higher collateral values for borrowers.0 29. these companies opted for debt. which fell from 16 percent in 1991 to just under 6 percent in 1996.2 6. was felt across industries.4 119. II
Table 4.4 4. Despite the availability of the equity market. Vol.7 15.4 47.6 12.7 12.1 44.9 8.8 8.1 114.6 41. Among the crisis-hit countries.8 14.3 91.4 7. which was particularly significant in the two years preceding the crisis.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.4 12. and footwear had the lowest at 11 percent.4 18.0 139. The downtrend in corporate profitability.7 54.7 21.5 15. 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 (%) (%) (%) 3.6 138.6 168.2 49.9 51.2 10.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.2 27. Hotels and travel showed the highest ROE of 15 percent while textiles.4 26.2 10.4 3.4 9.4 24.4 7.7 12.9 140. Severely affected by global competition throughout the decade.8 5.7 35.8 151.0 125.6 27.4 44.3 10. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations. US.6 7.4 34.9 144.7 27.0 7.3 4. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.8 51.8 25. clothing.3 12. Korea and Thailand had the highest debt-to-equity ratios.5 50.5 9. A major reason for this was the rapid rise in asset prices.6 36.8 11.9 27.5 52.7 59.1 60.4 12.3 8.7 12.9 7.4 28.4 51.5 30.0 145.2 161.1 16.0 63.8 54.8 88.2 215.7 5.9 39.0 3.2 64. Overall.0 117. 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 7.7 20. Thailand’s ROE. clothing.1 120. the textiles.7 80.9 14.7 4.5 38.9 77.238 Corporate Governance and Finance in East Asia.6 125. and footwear industries also experienced losses.5 51.8 5.1 242.7 5.4 139.
practice of heavy borrowing.2 27. They were generally more efficient in managing their assets and
5 94. measured by total asset turnover.5 Average Key Financial Ratios by Company Size.4 Legal and Regulatory Framework
Before 1992.6 12.6 61.3 49. which would be disruptive to company management.3 88. For instance.2 18.0 20.3 135.3 15.3 43. the law disallowed cumulative voting.8 10.1 29. 4. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.2.3 52.5 6. although the performance of listed companies in the late 1980s was strong.5 87.3 23.8 6.7 14.2 10. During the 1990s. 1985-1996
Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6.6 31.8 6.3 176.4 116.8 142.4 52. the overall activities of listed companies. could lead to a high turnover in the board.0 48. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.8 26.1 6. They also tended to use more financial leverage than small companies as their total DERs show. weaknesses became evident.0 83.1 5.6 7.
.4 8.5 7. However.7 6. US.9 20. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.2 12. also deteriorated. total asset turnover declined after 1989.6 10.7
Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 6. Although stable in the 1980s.9 13.6 30.6 5.
capital despite the higher gross margins of small companies.7 10.3 49.Chapter 4: Thailand 239
Table 4. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.1 13.3 164.3 25.8 62. it was thought. Cumulative voting.2 121. In sum.1 Small Medium Large 5. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.2 134.6 30.1 25.8 47. by the 1990s.
the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. As the succeeding sections point out. that creditors had generally little influence on the management of corporations. and external monitoring and control of corporations were also weak. II
Another issue was the proportion of shareholding by top shareholders. Vol. coupled with weak corporate governance. As it turned out. Cumulative voting was made optional. and the punishment for management misconduct was also lightened considerably. concentrated ownership. The Public Company Act of 1992. Fortysix companies responded. but not all questions were answered. The protection of minority shareholders was inadequate under the Public Company Act of 1992. as a group.5.
4. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector.
. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually.3
Corporate Ownership and Control
Ownership and control of corporations in Thailand are highly concentrated. The law prohibited the largest shareholders. adopted to promote the development of publicly listed companies. for instance.240 Corporate Governance and Finance in East Asia. the exit of these provisions appears to have contributed to the 1997 financial crisis.
ADB survey questionnaires were sent to all Thai listed companies in early 1999. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. However. played an important role in bringing about the financial crisis. This will be discussed in Section 4. The provision discouraged original family owners from registering their companies. An Asian Development Bank (ADB) survey conducted for this study shows. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. relaxed the contentious provisions of the 1978 Public Limited Company Act.
Table 4.3 5. on average.2 4. respectively.7 11.1
Patterns of Corporate Ownership
A World Bank study covering nine Asian countries finds that firms in Japan and Taipei. Across industries. 56. this was not the case.0 53.1 percent of control rights.6
Average for 1990-1998 period.9
26. one would expect the public.4 percent of outstanding shares.5 9.1 12.3.3 percent and 18. 1990-1998
Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five
28. Most large Thai corporations listed on SET started out as family businesses.4
26.1 7.0 7. Unfortunately.4 6.7 7.China have the least concentrated ownership.
. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.4 5.3 7.9 55. But with their increased reliance on new varieties of equity and debt instruments.3 percent. the top five shareholders of each of publicly listed Thai companies held. China firms have the highest single shareholder ownership concentration at 35.8
32. In contrast.2 4.8 5.9 52.6).6 4.9 6.6
28. with the largest shareholder on average controlling 10.1 3.5 28. with the top three shareholders accounting for almost 50 percent (Table 4.4
26.4 10.9 52.4 6.2 56.7 percent. Indonesian.9 3. and 28.0 3.9 11. Ownership Concentration Between 1990 and 1998. In the past.9 52. Thai. 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 3. and Hong Kong. these companies obtained funding solely from banks or from their own retained earnings.1 5.3
28. 33.9 3.4
26.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.2 4.4 4.2 11. Stock Exchange of Thailand. there were only slight variations in the pattern.0 56.0 5.7 12. and minority shareholders to stake their claim in the control and regulation of these companies.3 7.6 68.1 5.9 54.8 11.7 6.9 percent of shares of a company.1 5. Source: Comprehensive Listed Company Information Database.0 7.Chapter 4: Thailand 241
4.3 11.3 16. creditors. Ownership was most concentrated in the packaging.9 4.1 11.6 57.1 4.
242 Corporate Governance and Finance in East Asia.001 0.058* ROE (0. Leverage.005** 0.7 percent of outstanding shares on average (Table 4.533)*** Debt-to-Assets (0.8). as measured by debt-to-equity and debt-to-asset ratios. *** at the 1 percent level.031 3. 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. ** at the 5 percent level. Table 4. year. owning 26. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. * Denotes significance at the 10 percent level.116) Debt-to-Equity (1.029 3. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. including those that are publicly listed
.003 0. with a top-five ownership concentration of at least 60 percent.169*** 0.800
(0. Company size is significantly related to ROE and leverage. 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. II
agribusiness.7 Statistical Relationships between Corporate Profitability. and Company Size
Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. Ownership Concentration.
Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. results show a significant positive relationship between ownership concentration and financial leverage. Through these holding companies. and building and furnishing industries.7). Vol. founding families maintain effective control of entire groups. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.001*** 0.080 6. and ownership types.037
0. US.115 9. On the other hand.647
Note: The regression included dummy variables for industry.001) 0.022*** 0.034*** 0.090
0. Based on a regression analysis.
8 28.5 Individuals 13.4 1.2 1.8 23.1 0. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.5 NBFIsa 6. Established in 1980 with a registered capital of B300 million. the affiliate firms rarely hold shares of their parent companies.6 25.3 0.5 Government Other 0. averaging about 18.
in SET. the company.3 1.Chapter 4: Thailand 243
Table 4.0 19.3 20. a company listed in the real estate sector of SET.9 19.
.7 5.3 27.5 0.3
— = not available.5 1.6 5.4 1.6 percent of outstanding shares.7 0. a NBFIs denotes nonbank financial institutions.0 18. The ADB survey indicated that listed companies held shares in an average of 11 companies.6 28.9 0.6 1.2 1.5 5. operates five of the most successful shopping malls in Thailand.9 6. Source: Comprehensive Listed Company Information Database.1 1.8 0.0 3.4 20.3 27. one of the founding members.2 18.3 27.8 1. In 1994.3 1.9 15.7 — 1.9 7. individual members of the Chirathivat family aggregately hold 25. including finance and investment companies.2 5. This practice is illustrated by Central Pattana.5 26. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.5 0.5 2. with 29. These individuals usually hold important management positions in concerned companies.5 1. 1990-1998
Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.4 1.3 percent of outstanding shares.6 1. Stock Exchange of Thailand.3 1.7 1. the company increased its registered capital and became a public company listed in SET.9 18.4 22.0 17.1 1.2 7. In addition. Although holding companies set up affiliate firms. unlike in Japan where crossshareholding is common.5 percent. owned by the Chirathivat family. Individual family members also hold a significant amount of outstanding shares. a joint venture among three families. The largest shareholder is Central Holdings Company. The top 10 shareholders include a holding company owned by the Tejapaibul family.1 4.5 0.7 Bank 2. Typically.6 1.
On average. duties. with the envisioned privatization master plan. II
another of the company’s founding members. these shareholders are able to control the company. Only a handful of companies have the Government among their large shareholders. they exercise limited influence in operations because of the restricted size of their shareholdings. and a state bank.9 percent of outstanding shares. Across industries. Although the list of top shareholders of publicly listed companies includes financial institutions. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company.5 percent of total outstanding shares. qualification. the predominance of individual family members and holding companies in the top shareholder list remains valid. roles.. However.5 percent of total outstanding shares of listed companies.2 Corporate Management and Control3
Board of Directors The Public Company Act of 1992 stipulates the appointment process.
. In effect.3.244 Corporate Governance and Finance in East Asia. For example. Except in the hotel and travel service sector. Nonbank financial institutions hold an aggregate 5. the top 10 shareholders consist predominantly of members of founding families and their holding companies. they account for 80 percent of total outstanding shares. In such cases. only one tenth of listed companies have commercial banks on their top-five shareholder list. Together. Thai Airways International Plc. on average. the Government owns the majority of the shares. Another example is Bangchak Petroleum Plc. where the top three shareholders are the Ministry of Finance. Moreover. and responsibilities of directors of public companies. 1. The Government holds.
Discussions in this section are based on results of company surveys by SET and ADB. the Government’s role in public companies is expected to decline. has the Ministry of Finance as its only large shareholder with 92. By owning 62 percent of voting shares. both conducted in 1999. the Petroleum Authority of Thailand.1 percent of total outstanding shares of listed companies. Vol. 4. commercial banks account for only 1. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. There was a trend of rising government shareholdings throughout the period 1990 to 1998.
Meanwhile. Unless stipulated in public companies’ articles of association. and to comply with the laws and articles of association. Although 28 percent of the chairpersons came from the ranks of independent outside directors. 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. Three companies indicated that the CEO and the chair were close relatives. Generally. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. directors are required to act with care and honesty for the company’s best interest. the majority (71 percent) had board chairs who were also members of top management teams. but not in 22 others.
. directors could be compelled to compensate the company for damages arising from their misconduct. while 15 percent of respondents went beyond the requirement. directors may be imprisoned or fined. while 30 percent of respondent companies held board meetings monthly. Some companies (36 percent) had five to six main board members holding seats in their executive boards.Chapter 4: Thailand 245
Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. If found in violation of these provisions. selection was based on relationships with controlling shareholders. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. In their business conduct. 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. meanwhile. directors shall be elected at the annual general shareholders’ meetings (AGSMs). In addition. Many companies have a formal policy on corporate governance and business ethics. an executive board consists of senior management and some main board members. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. In five other companies. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. The ADB survey indicated.
the auditor is not
. 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. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule.246 Corporate Governance and Finance in East Asia. Also. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. Companies already with audit committees did not have independent outside directors as audit committee members. Chair. not an independent assignment. with 41 firms admitting the use of services of international auditing firms. the remuneration packages had to be approved during AGSMs. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. 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. All respondents confirmed the use of external auditors. Half of the companies in the SET survey had a separate remuneration committee. However. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. Where different. In 25 companies. In one company. Three companies allowed their management to determine the chair’s compensation package. while 19 companies observed only some of them. 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. II
Compensation of Directors. the work of this committee was often considered part of the executive board’s responsibilities. Vol. Audit Committees and Accounting Standards Since January 1999. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. These committees were mainly responsible for determining compensation for senior and regular staff. however.
(ii) The prudential role of outside directors is limited by the noncompulsory character of their participation in key decision-making bodies such as the audit. The Act also holds directors liable for any damage to shareholders. stipulates the proper conduct of shareholder meetings. there is the danger that top management may be capable of unduly influencing the board’s decisions.Chapter 4: Thailand 247
independent from the company. While safeguards are in place. (i) No standards are enforced in the content and timing of notices for shareholder meetings. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. there are also significant gaps in the system of shareholder protection. or other financial instruments. as well as the registration and holding of shares. and executive committees. According to the ADB survey. The Act. However. SEC. Relationships between firms and external auditors are generally long-term. remuneration. although recently. (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. shareholders can claim compensation in cases of negligence or dishonesty by management. For instance. Forty-four companies indicated that they had proxy voting in place. averaging about 14 years. likewise. At least 28 responding companies had the following
. most responding companies have rules and regulations intended to protect shareholders. debentures. SET. As a result. SET’s rules and regulations closely follow this Act. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. shareholders have access to reliable information at no cost. In the majority of these companies (38 out of 46 respondents). Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. with 13 companies allowing proxy voting through mail. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. and the Bank of Thailand— are not clearly defined. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms.
Almost 82 percent of shareholders. on average. such protection has been insufficient. and mandatory disclosure of related interests and significant shareholders’ transactions. While stimulating the growth of the sector. 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. and insider trading.
. the only group of shareholders that can exercise rights is the top five shareholders. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. 66 percent of total outstanding shares. In theory. In practice. Although the attendees held. Vol.3. minority shareholders are assured adequate legal protection. But the exercise of these rights requires even higher shareholding levels. it would be difficult for minority shareholders to gather the shares needed to take action. II
mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. did not vote in previous AGSMs. Only a small number of shareholders attended the latest AGSMs. In effect. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. and call an extraordinary session. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. Banks would be obvious candidates to implement these mechanisms. 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. On paper.248 Corporate Governance and Finance in East Asia. however. 4. given their importance in providing finance and their stake in companies.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 with the ownership concentration of Thai companies. takeover of the company. representing only about 28 percent of shareholdings. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. they comprised only 8 percent of total shareholders.
while 18 said none of their creditors required collateral. 11 experienced rejection after the crisis started. In the end. Apparently. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. Normally. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. 17 indicated that only some of their creditors had such a requirement. 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. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. Under a weak bankruptcy system.Chapter 4: Thailand 249
Historically. borrowers seldom lose control to creditors even when they default and become insolvent. creditors’ collateral requirements were tightened after the crisis. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. Debtors had many handles to stall the bankruptcy process. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. when insiders want to expand their company’s operations without losing control. while loans for fixed investment were also more likely to be supported by collateral. For 20 of the 46 responding companies. Leverage allows the assets and operations of the company to grow without diluting corporate control. the majority believed that creditors had little influence on company management and decision making. Only three companies thought otherwise. however.
. Actual bankruptcy proceedings took more than five years on average. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. However. creditors do not always require project feasibility studies or business plans in granting loans. Most companies reported that banks were more likely to require collateral. they resort to borrowing. other than losing control. to solve debt repayment problems. as the ADB survey confirmed. which could cause a delay by at least a year. There were many options. a company’s reputation and its long-term relationship with creditors sufficed in many instances. including procedural disputes. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. such as that seen in Thailand before the crisis.
which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares.250 Corporate Governance and Finance in East Asia. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. and failed to provide managers with strong incentives to perform efficiently. The second category is the tender offer. According to the SEA of 1992. with a significantly lower total tender offer value of B8. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. The first category is the acquisition of shares in the open market. Vol. 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. In 1996. there are two categories of merger and acquisition activities with associated regulatory measures. SEC was later made responsible for regulating corporate takeovers. In this case. before the extent to which the bankruptcy framework has been strengthened becomes clear. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. there were 41 cases of tender offers. There are detailed requirements regarding such notification. Although merger and acquisi-
.3 billion (Table 4. there were only six tender offers.9). of shareholders: (i) all shareholders must receive tender offers. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced.3 billion. It will take years. its main role is to ensure transparency and fairness. whether directly or indirectly. Since the introduction of the Public Limited Company Act of 1978. SEC has no authority to either approve or reject tender offers. II
The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. however. In 1994 and 1995. The market for corporate control has not been active in Thailand. Such efforts would serve to strengthen external discipline on controlling owners. with a total tender offer value of B42. only a limited number of successful mergers of public companies have taken place. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. if the purchase of shares implies a change in the directors or business activities. Recently. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders.
. but the average shareholding is smaller than 1 percent of total outstanding shares.2 7. Because of the current crisis.8 81.9 Merger and Acquisition Activities. not with a view to becoming involved in actual management. 1993-1999
Year 1993 1994 1995 1996 1997 1998 1999
Tender Offer Valuea (B billion) 5.2 6.3 11.2 6. they have mostly been concerned with short-term gains.5 6. it remains small. employees are even less willing to accept common shares as a form of compensation or benefit. Employee Participation in Corporate Governance There has been little. Even when companies offer ESOPs.0 55.8 8 27 14 6 9 13 23
Tender offer value refers to the minimum offer value. if any. trading by mutual funds in SET represented less than 10 percent of total trading.7
Purchase Value Number of % of Tender Offer Value Companies 84.3 6.9 3. Few companies offer employee stock option plans (ESOPs).Chapter 4: Thailand 251
B billion 4. but employees have never been represented in the board of directors since their shareholdings are minimal. Eleven of the 46 responding companies in the ADB survey offer ESOPs. employees regard the plans as monetary incentives.1 75.3 60.1 19. Source: Securities and Exchange Commission of Thailand.7 11.6 17. Twenty-nine firms indicated that employees held shares of their companies. But instead of opting for an active role in the market for corporate control. most of these were forced mergers or related to rescue packages.4 23.1 58.
tion activities increased after 1997.1 84. employee participation in corporate governance in Thailand. Pension funds are perhaps even weaker in Thailand.2 8. Provident funds for government workers and workers in public enterprises have been established only recently. While the Thai mutual fund industry compares well to those in other developing countries in the region. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. Since 1994.
300. In 1996. although its role increased in the wake of the crisis. 1992-1999 (B billion)
Outstanding Loans from All Financial Institutions 2.0 339.1 5.4 519.9 2.0 424.5 Outstanding Loans from Commercial Banks 2.171. and Bank of Thailand.10 Size and Composition of the Thai Financial Sector.1
Corporate Financing Overview of the Financial Sector
A breakdown of the Thai financial sector for the period 1992-1999 (Table 4. total assets of commercial banks amounted to B5.0 SET Market Capitalization 1.161.5 6.252 Corporate Governance and Finance in East Asia.268.4 1.8 3.10) shows that Thailand is a highly bank-dependent economy.8 941.775.979.133.390. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.1 7. Competition from foreign banks was limited as they were not allowed to engage in full branch operations. Bangkok Bank Ltd.4 3.663.193.0 3.1 3.325.3 5.4 4.5 4. Vol..564. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. accounted for 28 percent of the banking sector’s total assets. Table 4.5 4. II
4. the next four largest banks accounted for 63 percent.430.485.4.1 6. The share of domestic banks in the banking system’s total assets was 80 percent.477.912.230.
The Banking System Until recently.4 4.037.1 3. Thai Bond Dealing Centre.2 262.5 5.1 Domestic Debt Securities Outstanding 215.6 1.372.6 2. The bond market played only a marginal role in corporate financing.5 trillion. the banking sector was highly concentrated.
.3 1.0 8.360. The country’s largest bank.4
Year 1992 1993 1994 1995 1996 1997 1998 1999
Source: Stock Exchange of Thailand.559.3 546.119.2 2.825.669.6 6. 15 of which were domestic banks.906. there were 29 commercial banks.
Despite the worldwide market crash in 1987. owning 70 percent of the country’s second largest bank.3 trillion. The number of listed companies also quadrupled between 1981 and 1993.2 trillion.Chapter 4: Thailand 253
The Government was also a major figure in the banking system. reaching 355. and 20 new foreign banks. and almost all capital account transactions were deregulated. self-regulatory organization under the
. finance.8 in 1998. SET is organized into 32 major industries. the Bangkok Stock Dealing Center (BSDC). In 1993. 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. BSDC is a nonprofit. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. the market rose steadily and reached a record high in the fourth quarter of 1993. SET immediately recovered due to the strength of the Thai economy. Easy access to commercial bank loans by family business groups. Some 347 companies were listed in the same year with a total market capitalization of B3. In 1995. In contrast. was set up by 74 members with an initial capital of B500 million. Because borrowers carried the exchange rate risk. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. In the following years. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. BIBF banks also enjoyed tax incentives on their operations and profits. an over-the-counter market. the stock market entered its first boom period in 1986. The Government removed controls on capital and dividend repatriation in 1991. 12 existing foreign banks. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. also made it unattractive to raise capital from the equity market. Turnover value reached B2. SET was not very active. Licenses were granted to 15 Thai banks. and property have accounted for the bulk of trading volumes. After that. The Equity Market During the first few years of its operations. Through the years. due to their close ties. The lack of supply of quality shares was a big problem for SET at that time. the SET index declined. Benefiting from rapid economic and industrial growth. banking.
there were two kinds of companies in SET—“listed” and “authorized” companies. After initial public offerings. Only one security was listed in BSDC in 1995 and two more in 1996.5 percent and collectively owning at least 30 percent of paidup capital. Before 1993. The allocation procedure is nondiscretionary. but dropped the following year to B122 million. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. The primary market is supervised by SEC. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. however. It separated the primary and secondary markets to promote more flexible and effective supervision of both. and (ii) a minimum of 300 shareholders. and pro forma balance sheet and income statements. 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. The company should then appoint a financial adviser. SET established new requirements for initial public offerings. approved by SET. with each facing different listing requirements. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. In 1996. Turnover value was B1. SET. the two classifications were merged. the BSDC was dissolved in 1999. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. among other functions approved by SEC. securities deposit center. lottery drawing must be used to ensure fairness.254 Corporate Governance and Finance in East Asia. Consequently.
. each holding no more than 0. 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. Listed companies were those that had (i) paid-up capital of at least B20 million.8 billion in 1996. and securities registrar. If approved by SEC and the SET Board of Governors. turnover value was negligible and the BSDC Index remained flat throughout 19961998. so now only listed companies are traded in SET. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. to assist in the public offering process. securities can be traded in the secondary markets. The listing application should be submitted concurrently to SEC and SET. Vol. According to the SEA of 1992. stock trading can commence within five days. Company applicants must have an established history of operating under substantially the same management. II
jurisdiction of SEC. In 1998. also acts as a clearinghouse. In July 1990. which consist of SET and BSDC. financial projections.
it represented only 9 percent of GDP. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. The budget surpluses of the 1990s eliminated the need for new bond issuance. compared to 110 percent in the US and 74 percent in Japan in the same year. To gain some perspective of the size of the bond market in Thailand. 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.9 billion. In 1996. and the Government did not issue new bonds during 1990-1997. while secured debt instruments accounted for just above 10 percent. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. Investors had limited knowledge of debt instruments. it accounted for a small share of the entire financial sector. 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. however. 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. The bond market in Thailand started in 1933. the Bank of Thailand assumed responsibility for regulating the bond market. was also instrumental to the growth of the corporate debt market. Upon its founding in 1942.Chapter 4: Thailand 255
The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. the first bond rating agency in Thailand. Beginning 1961. The Thai Rating Information Services. A turning point of the corporate debt market was the enactment of the SEA of 1992. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. The recent financial crisis. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions.
. The proportion of domestic convertible debt instruments increased until 1995. However. in 1994. which encouraged limited companies and public companies to issue debt instruments. the size of the corporate debt market rose to B132.11). Four years after the passage of the SEA. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization.
this had climbed to B200.3 29.6 — 0. Vol.1 141.0 60.8 55.3 8.4 — 26.0 17.4 57.5 — — 32.
. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.0 7.2 43.3 13. By 1995.3 — 14.2 57.0 26.0 0.2 2. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.8
Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.9 30. a surge attributed to capital inflows encouraged by high returns on Thai bonds.7 5.6 19.7 90.5 5.2 45.8 47.5 43.256 Corporate Governance and Finance in East Asia.9 40.1 107.1 55.
then declined substantially in 1996 and 1997.1 12.7 28.2 89. Total offshore debt offerings peaked in the run-up to the financial crisis.5 138.3 140.9 5. the year the crisis unraveled and the baht was floated.8 31. The following year.3 22.3 50.0 281.9 20.7 132.2 — — 50. total offshore debt offerings had plunged by 68 percent to a mere B28.9 37.7 538. by the end of 1997.0 86.1 10.9 37.9 0.11 Offerings of Debt Securities.5 billion.1 6.0 333.1 289. turnover value had reached B51.0 — 5.1 59.7 5.3 46.6 — — 0.5 — — — 3.0 5.4 — 9. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.7 — — — — — 4.4 49.8 191.8 167.9 329.4 billion.2 39.5 — 39. II
Table 4.0 27.3 6.0 — 26.1 315.7 0. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.1 21.1 121.1 8. 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
— — — — — — 400.8 2.7 95.4 — — — 1.7 7.5 55. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.0 — 5.7 821.3 — — 3.5 10.5 37.5 — 0.1 — — — 29.6 billion.5 — — — — 1.3 3.3 46.0 33.2 28.7 — — 40.7 0.4 110.1 — — 6. However.1 61.1 41.4 7.7 — — — — — — — 77.
these accounted for 33 percent of total liabilities. while for the property development industry.2 billion as a result of the default of debentures due to the Asian crisis.4. significant variations can be noted. In 1997. Across industries. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. these comprised 31 percent. In any case. short-term loans accounted for more than 40 percent of total liabilities. At lower than 5 percent of total liabilities.2 Patterns of Corporate Financing
An examination of financing patterns among Thai companies listed in SET shows that on the asset side. Turnover fell further to B72. judging by their relatively low levels of retained earnings. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. steadily easing up between 1990 and 1996. The proportion of accounts receivable also declined steadily. with equity levels remaining high despite an increase in debt. In addition. In the same year. Equity financing remains an important part of listed companies’ long-term financing. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. 4. cash balances. turnover value plummeted to B106. they also had a relatively small proportion of equity and
. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. Companies in construction and property development seemed unable to generate internal funds. There was also little change in the trend in retained earnings within the seven-year period. For the construction industry. and marketable securities holdings. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier.1 billion in 1998. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. Retained earnings accounted for about 30 percent of total equity financing. From 1990 to 1996.12). Construction and property development industries tended to have high proportions of long-term loans and debentures. a trend most apparent in the leap between 1991 and 1992. The average for all industries was only 22 percent. Longterm loans accounted for about 20 percent of total liabilities.Chapter 4: Thailand 257
compared with investment in equities. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996.
4 49.7 50.6 21.7 36.3 6.8 25.6 100.8 3.0 100.6 18.2 42.9 3.3 18.6 38.7 1.3 14.3 34.9 17.2 15.2 2.9 14.3 17.9 6.12 Common-Size Statements for Companies Listed in SET.258 Corporate Governance and Finance in East Asia.4 21.3 1.0 100.9 17.9 38.2 1.8 37.0 100.0 100.2 1.6 14.3 14.9 14.6 0.8 21.6 36.6 51. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.0 13.5 0.6 11.2 12.9 2.6 12.2 34.5 43.9 14.9 6.5 1.2 2.7 16.6 0.0 100.7 9.0 48.6 15.5 37.6 8. 1990-1996 (percent)
Item All Years 1990 1991 1992 1993 1994 1995 1996 2.3 34. II
Table 4.2 16.1 50.9 49.2 22.7 52.8 46.9 43.6 10.3 2.8 8.9 16. Printing and publishing companies had lower financial leverage than companies in other industries.7 0.9 14.7 17.3 1.2 17.
were highly leveraged.1 17.8 14.0 100.0 100.2 3.0 12. US.1 49.8 34.8 35.3 12.2 1. Vol.0 2.0 14.8 10.1 18.1 2.2 43.9 18.0 51.0 100.9 20.3 38. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.4 14.3 18.1 7.4 8.0 100.8 7.3 21.2 2.6 13.6 22.9 15.0 1.0 15.6 0.1 36.8 9.3 50. The level of total liabilities for the group characterized by high ownership concentration
.2 17.2 17.5 1.7 7.2 2.0 100.8 1.4 6.9 10.8 9.6 6.0
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.7 15.4 2.6 100.2 43.2 17.3 48.6 50.4 43. medium.13).8 6.2 45. compared with the 44 percent general average.6 2.2 16.1 5.6 0.7 18.0 100.4 49.0 7.9 12.7 16.8 19.8 20.0 100.5 14.0 100.0 100.4 17. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.1 13.3 49.5 9.0 10.3 25.5 1.9 0.9 14.4 48.9 40.4 7.5 11.7 14.8 17.8 37.0 10.2 35.5 9.0 6.4 17.9 50.
2 0.0 41.5 21.4 13.
was 53 percent of total assets compared with 49.0 7.3 16.9 16.0 100.6 2.5 100.Chapter 4: Thailand 259
Table 4.4 18.7 12.0
Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 1.9 2.4 37.1 36.3 35.3 8.0 100.2 14.8 13. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.5 percent for low ownership concentration companies.4 35.9 0.4 7.9 7.
.7 percent for medium ownership concentration companies and 49. 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. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.2 45.13 Common-Size Statements of Public Companies by Ownership Concentration.0 6.9 50.8 37. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.0 19.4 50.5 18.1 53.5 11.4 3.7 17.0 14.4 49.6 22.0 16.1 49. For the high ownership concentration group.6 15.0 6.1 18.6 47.9 100.2 22.0 Low 1.8 12.3 1.3 1.2 8.9 36.9 21. US.8 13.6 14.7 19.2 11.1 44.6 9.3 100.5 13.6 0.6 100.0 Medium 2.
4 5.8 percent in 1990 to 52.6 41. however.7 34.7 in 1994 to 5.4 139. thus rendering them more vulnerable. bond issues overtook loans from commercial banks as the second preference.
The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.7 percent in 1996.1 23.7 28. and rights issues.7 12.3 61.8 65. While further detailed investigations are necessary. Vol. the choice of financing is determined by the company’s liquidity considerations.4 7.0 25. and maintenance of the existing ownership structure. More important.9 140.9 7.4 44.1 52.1 31. II
Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.260 Corporate Governance and Finance in East Asia. Public companies relied more on short-term debt financing in the period before the financial crisis. The ratio of total debt to total assets increased from 50. these firms more easily increased their leverage. Table 4.1 in 1996.0 50.2 68.9 51. Such deterioration of financial positions during the period was a common feature of listed companies.9 14.7 5.6 125.7 66.2 35.7 34.7 11.4 12.9 63.3
Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.5 52.1 64. As a result. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.1 31.7 12.
.6 138.8 51.1 44.14 Financial Ratios of All Listed Firms.14). Generally. however. was the headlong deterioration of firms’ ability to meet their interest payment obligations.0 145. Short-term debt accounted for most of the increase. minimization of transaction and interest costs.8 5. The TIE ratio declined from its peak of 7. US.0 28.1 16. followed by bank loans.1 144.2 49. 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. After the crisis. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.4 51.8 65.5 38.1 16. bond issues. 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 8.3 31.6 7.15. especially from 1994 to 1996.8 151.
3 42.2 percent in 1986 to 251.8 29.2 124. US.4 percent to 46 percent during the same period. 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 34. Their average annual growth rate declined from 28.5 percent of external debt in 1996 (Table 4.8 14.6 11. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. peaking in 1994 at 84 percent. Additionally.9 percent in 1997. is even more telling. From only 34 percent in 1986.1 High 6.16).5 4.8 66.5.4 27. Nonbank private debt increased from 27. continued to slide from 1985 to 1997.3
Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.5 148. however.Chapter 4: Thailand 261
Table 4.4 52.5 percent between 1985 and 1990 to 8.
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. such as direct equity and portfolio investment. From 45 percent of total net capital movements in 1985. The proportion of nondebt-creating capital flows.4 13.6 30. and a preponderance of short-term debt liabilities.8 Medium 7. the proportion of short-term debt increased from 15. The proportion of external debt as a percentage of GDP consequently increased from 42. unhedged foreign exchange liabilities.7 percent from 1991 to 1996. private debt accounted for 84. The composition and term-structure of this debt.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.15 Financial Ratios of Listed Companies by Ownership Concentration.0 64.5 126.
.8 28.2 49. This decline was accompanied.8 percent in 1986 to 52 percent in 1995. on the other hand.4 63. debt-creating capital inflows rose to 65 percent in 1990.8 49.
8 12.9 6.4 — — — — — — — 1.0 13.6
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
0.8 3.8 3.16 External Debt.6 — 0.9 11.2 2.1 0.9 10.6 Total 18.9 10.2 0.4 2.7 23.0 11.3 105.Table 4.2 10.5 12.9 6.0 4.0 21.7 10.5 4.7 1.4 15.2 2.9 31.0 0.2 14.7 0.3 0.9 1.3 0.3 10.3 2.9 100.3 0.5 12.1 5.3 0.6 52.4 10.1
Source: Bank of Thailand.9 13.1 30.1 23.0 11.6 18.5 16.8 13.9 3.8 31.6 1.8 10.8 108.3 — — — — — — — 6.2 0.3 0.3 0.7 2.7 109.5 1.3 20.9 7.1 95.3 37.7 24.3 16.4 5.
.3 12.5 19.9 5.0 8.1 0.3 3.1 34.9 29.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.3 0.2 2.9 3.0 3.4 18.1 0.9 1.4 3. 1986-1999 ($ billion)
Private Nonbank Long-Term Short-Term 3.1 64.1 2.7 20.9 4.5 4.7 13.2 15.3 3.1 0.5 14.6 7.3 7.8 0.1 22.9 35.0 6.2 32.1 12.3 0.9 43.2 0.
suggesting that serious investors have not returned to the market. exposing the companies to disaster when the baht started tumbling on 2 July 1997. reaching 45 percent of total outstanding credit in December. the index declined to 1. according to the Bank of Thailand.281 in December 1995 and to 831. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. Similarly.360. leaving domestic investors with large capital losses. 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. Trading volume has since been thin. the number of newly registered companies dropped to a 10-year low in 1998. closures. If lending rates remained high. At the end of 1994. Meanwhile.Chapter 4: Thailand 263
This shows that although banking and finance companies suffered most because of their short-term exposure. 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. Due in part to liquidity problems on the one hand. Even before the crisis. outstanding credit also declined throughout the second half of 1998.17). SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. banks would be recording more of such NPLs. Foreign investors retreated from the market.6 in December 1996. and (iii) bankruptcies. the liquidity problems faced by the corporate sector are likely to continue for some time. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. It hit a 10-year low in the second quarter of 1998. trading activity at SET had been on the downturn. the SET Index stood at 1.6 billion from the 1996 level of B201 billion. and drastic decline in the number and capital of newly registered companies. With easy access to foreign funds. Most of these foreign debts were not properly hedged. and poor business confidence on the other. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. The effects of the crisis were felt across all industry sectors.
. The value of public offerings sank in 1997 to B56. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. On average. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. based on the three-month past due definition. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. After that. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. Aside from the problem of NPLs.
410 5.096 22. It also explains the higher dividend yield ratio. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997. But when assistance from other sources did not materialize.095 14.5.334 4.2 Responses to the Crisis
Initially. A steady price decline over the past few years has dragged down the ratio of market price to book value. 4. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. Thailand. As part of the assistance package.288 35.312 25.915 37.080 9.792 7.218 3.777 11.409 6.410 37.052 36.201 24.307 4. Vol.112 9.066 19.264 Corporate Governance and Finance in East Asia.797 4.925 12. II
The price-to-earnings (P/E) ratio deteriorated from 19.902 3. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures. The IMF financial package was a credit facility of $17. the Government was left with no choice.224 4.2 billion for balance of payments support and buildup of the country’s reserves.
.105 4.933 25. 1985-1999
Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. Ministry of Commerce.904 20.677 Bankrupted/Closed 2.17 Number of Newly Registered and Bankrupted/Closed Companies.407 28.977
Source: Department of Commercial Registration.134 31.6 in 1997.5 at the end of 1994 to 12 in 1996 and further to 6.695 3.
The old law allowed only creditors to file bankruptcy suits.Chapter 4: Thailand 265
The terms of the agreement required the Government to maintain tight monetary and fiscal policies. creditors seldom succeeded in obtaining payment against bankrupt borrowers. and Credit Foncier Businesses. In early 1998. and if necessary. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. also aimed at institutionalizing legal and regulatory reforms. These include repeal of the Commercial Bank Act. There were many options for solving debt repayment problems. For example. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. The Bank of Thailand also improved banking standards. and restore solvency. Regulatory Response by the Government The IMF program. and worked on revisions to the Secured Transaction Law. Strict loan classifications. debtors could drag out the process for many years. The assets of the other companies were liquidated by auctions. it was widely interpreted as “having debts more than assets. Creditors could negotiate to reschedule debt repayments. however. While no definition for “insolvency” could be found in the bankruptcy law. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. secured creditors had to obtain the court’s approval before starting proceedings
.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. drawn up with World Bank and ADB assistance. Under the old bankruptcy laws. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. and the Act Regulating the Finance. and income recognition were implemented. the Civil and Commercial Code. and did not recognize debtor-initiated bankruptcy declarations. Many believed that the process was inefficient. increase profitability. Securities. By invoking procedural loopholes. loan provisioning. only two companies emerged intact from the suspension. follow through with a civil or bankruptcy suit. 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. IMF relaxed these key conditions.
The amended law also introduced the concept of automatic stay. which means that a debtor could continue in business while the reorganization program was being implemented. For one. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. Companies need
. The amendment added reorganization provisions to the Bankruptcy Act of 1940. Under the old Bankruptcy Act. The amended legislation also includes voluntary bankruptcy as a new feature. If the process fails to revive the business. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. 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. The model for Thailand’s amended bankruptcy law was the US Chapter 11. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. In Thailand. thereby allowing court-supervised corporate restructuring. In effect. Vol. the judges and court officers have yet to learn and master the new bankruptcy procedure. II
for the recovery of debt through the realization of any collateral. Chapter 11 is the main tool in restructuring bankrupted companies in the US. and expensive process. the company shall be declared bankrupt and liquidation of assets shall follow. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. The original Bankruptcy Act dealt only with liquidation and composition. Enforcement of the new law is bound to be ponderous and lengthy. To make matters worse for creditors. (ii) management of the company reverts to the borrower. time consuming. it covers only the court-supervised reorganization of distressed companies.266 Corporate Governance and Finance in East Asia. But more important. 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. and (iv) the debts shall have been settled within a five-year period. The reorganization process is successful if (i) the debts shall have been discharged. There are other potential problems. the amended law limits the rights of secured creditors. In 1999. (iii) shareholders regain their legal rights. 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. but it is a complicated.
namely “liabilities exceed assets. Consequently. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. minority shareholders’ rights are not adequately protected. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. 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. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. Without the necessary corporate restructuring. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. however. corporate governance) that caused the bankruptcy in the first place. SEC also examined the possibility of an amendment to the Public Company Act of 1992.Chapter 4: Thailand 267
to solve the problems (e. only tangible assets were the norm. has not been satisfactory. after determining the legitimacy of the request. and (ii) processing of default cases within four to six months of filing of a court claim.
. questions have been raised regarding the appropriateness of the 1992 Act. Under the new law. Replacing the Public Limited Company Act of 1978.” The Foreclosure Act Amendment was likewise passed in 2000. the court. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. the test for insolvency still uses the balance sheet criterion.” as opposed to the more appropriate criterion of “ability to pay when the debt falls due. Still pending Parliament approval is the amendment to the Secured Transaction Law. The amendment also remedies the slow process of executing or disposing of assets in a public auction. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers.. 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. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations.g. shall have the power to call the extraordinary general meeting. In the past. The result. Most important. In case the board of directors does not comply. 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. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting.
e. who are also the managers. in turn. the dominance of controlling shareholders. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. without cumulative voting. The proposal for the amendment of the Public
. subject only to approval by the board of directors. they face the prospect of being unable to compete for the scarce funds available in the equities market. But because this is the assumption embedded in the regulation. it permits directors. disrupts the company’s management and decision making. The proposal clearly delineates duties of care and loyalty for directors of public companies. Most companies decide against cumulative voting. Because of high ownership concentration. claiming that it creates fragmentation in the board of directors. i. minority shareholders have no chance of being represented in the board. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. and determine voting results on virtually any matter. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. the main problem is overlooked. the controlling shareholders have the exclusive domain to appoint or exercise management. This may be true in countries where publicly traded companies are widely held. Consequently. vis-a-vis the minority shareholders. However.268 Corporate Governance and Finance in East Asia. Otherwise. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. II
Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. which. this is not so in publicly traded companies in Thailand. Where equity will come forward. Vol. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms.. In the absence of such a stock market boom now. 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. 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. 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. with the approval of the board. In addition. The regulators are drafting a proposal to amend the provisions on related transactions. But as demonstrated.
and manufacturing sectors. accounting for B1. 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. In particular. The first bankruptcy court in Thailand opened on 18 June 1999.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. By October 2000. methods.6 trillion. Considerable progress has been achieved on this front. although since then. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance.1 trillion of outstanding credit. will be settled by the courts. accounting for B1.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. personal consumption. the court had more than 80 cases for disposition. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies.147 cases (B1. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. 322.1 trillion in outstanding credit. Some 82 percent of these cases have been successfully restructured.764 debt restructuring cases involving B1. In response. Another 77. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. In addition. with the majority of the debtors coming from the commerce. and procedures for debt restructuring. CDRAC’s target debtors comprised 10. However.767 cases involving outstanding credit of B2. the number of cases has abated. Within three months. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. Cases for which negotiations were unsuccessful. As of November 2000. the Government introduced debt restructuring-related measures to help resolve bad debts. as well as those that did not cooperate with CDRAC’s restructuring process.068 cases involving B475 billion are undergoing restructuring. contributing to the unprecedented rise in the corporate sector’s bad debt.8 trillion had been completed. This point is crucial because compared with
. Commercial banks initiated 74 percent of these cases. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. only 7. where bankruptcy procedures are swift and effective.
Summary.6. It required listed companies to establish their own audit committees by the end of 1999. and even Indonesia. Examination of corporate ownership. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. the Government protected certain corporate sectors through tariffs and regulation. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. and performance during this period helps understand the causes of the crisis. 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.6 4. For this reason. the Thai Government managed its economy with the corporate sector as the main engine of growth and development.270 Corporate Governance and Finance in East Asia. 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. and promoted key industries through incentives. behavior. Such improvements in disclosure standards are part of the efforts of SET and SEC. 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. to push companies to harmonize their accounting with international standards. Vol. and Recommendations Summary and Conclusions
This study has provided an overview of the corporate sector and governance in Thailand. Conclusions.
. 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. II
Malaysia. In the next three decades. Financial information from listed companies will also soon be required to conform to International Accounting Standards. Philippines. The study covers the period 1985 to 1996. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt.
Although there are some variations across industries. there was a marked increase in the number of public corporations. At the onset of the 1997 financial crisis. foreign debt in the Thai corporate sector increased continuously. In 1992. The number of newly registered companies in 1997 dropped by almost 10. reaching its peak in 1996. On average. Subsequently. the number and value of public offerings of securities accelerated. After 1992. the Public Company Act of 1992 and the SEA of 1992. Minority shareholders. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. The study examined the impact of ownership structure on corporate governance and financing patterns. Meanwhile. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. One of the major findings is the high ownership concentration among Thai companies listed on SET. At the same time. The impact of the crisis was felt across all industries. at a time when most of them were already experiencing declining profits and high leverage. Consequently.000 from the previous year’s level.Chapter 4: Thailand 271
importance of bank financing continued throughout the 1990s. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. the increase in long-term debt more than compensated for the drop. Nonbank private corporations accounted for most of the increase. In 1995 and 1996. the numbers of bankruptcy cases and company closures reached alltime highs. The SEA of 1992 also marked the beginning of an active bond market in Thailand. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. This implies that the control of an average Thai company is typically in the hands of a few persons (founders or their associates) who own a majority of total outstanding shares. the profitability of publicly listed companies abruptly declined and their financial leverage increased. Although there was a decline in short-term foreign debt. the overall corporate sector was seriously affected. Because most of these debts were not hedged. the overall pattern of ownership concentration seems to have been stable for the past 10 years. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. Thai companies were vulnerable to exchange rate risks. During 1992-1997. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. the corporate sector entered a new era with the enactment of two major pieces of legislation. even after the development of capital markets.
. the top five largest shareholders hold about 56 percent of total outstanding shares.
there is a clear lack of outside monitors for these publicly listed but family-controlled companies. The implications of ownership structures that are concentrated to such a high degree are serious. the Public Company Act of 1992 and the SEA of 1992. The investing public holds the rest of the outstanding shares. foreign and domestic. Thus. averaging 46 percent. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. contribute to the lack of external controls on the corporate sector through the capital markets. Nominally. along with a highly concentrated ownership structure. are not active.272 Corporate Governance and Finance in East Asia. The rules in both Acts governing
. the mutual fund industry has entered the picture but with limited roles and activities. Individuals and insiders hold the second largest proportion at about 19 percent. These laws stipulate rules and regulations concerning the activities of all public companies. through the use of holding and affiliated companies. II
although larger in number. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. Among the five largest shareholders of Thai companies listed on SET. they have little influence over management decision making and control. With financial institutions playing limited roles in the capital market. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. protect the interests of all shareholders of public companies. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. It remains to be seen how reforms in bankruptcy procedures—including the increased threat of creditor control—could shift the incentives of controlling shareholders toward greater acceptance of equity finance and its consequent accession of control to new shareholders. the existing legal and regulatory framework suggests otherwise. The key laws. Financial institutions hold a very small proportion. Vol. hold only a small portion of total outstanding shares. Institutional investors in Thailand. Recently. The highly concentrated ownership structure weakens the protection of minority shareholder rights. The absence of external market controls on the management of publicly listed corporations is dangerous. the government pension fund was the only major institutional investor. All these. Consequently. In the past. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners.
these companies tend to become overleveraged. 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. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. Consequently. an aim that can be achieved mostly through legal reforms. the main challenge is not how the board can control management to maximize shareholder value. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings.2 Policy Recommendations
There are three major policy issues and recommendations that could improve corporate governance in Thailand. Certain provisions. For example. In view of this.Chapter 4: Thailand 273
minority shareholders’ participation in decision making and in initiatives against management conform to international standards. In this third area. The third issue involves creating external market controls through better regulation and development of the capital markets. moreover. 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.
. The second issue involves the protection of shareholder rights. before the crisis.6. The ownership structure of Thai listed companies also significantly affects company behavior. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. posed formidable barriers in the minority shareholders’ exercise of their rights. Rather. Specifically. However. Ownership concentration appears to have little impact on corporate profit performance. because there are shared interests between the controlling shareholders and key management personnel. key reforms that will strengthen the regulation of financial institutions. but is significantly related to financing patterns. because there is no separation between ownership and management. making them vulnerable to economic shocks. For instance. 4.
If the principal shareholder is in fact chair of the board. The best approach may entail establishing a single. II
encourage market competition. In this setting. Under the current system. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. SET. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. this is a problem in Thailand. SEC was established as another supervisory agency. and after the enactment of the SEA in 1992. with control delegated to professional managers. The owners of a firm rely on a board of directors to supervise the managers. Once the roles and responsibilities are clearly defined. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. Consequently. he/she often has the decisive vote. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. The board therefore plays a pivotal role. In reality. three major government organizations (the Ministry of Commerce. SET was mandated to supervise listed companies. It is important that the roles and responsibilities of each agency are clearly defined to the public.274 Corporate Governance and Finance in East Asia. If this were the situation.
. in most of Thailand’s publicly traded firms. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. As in other crisis economies in the region. the supervisory system is fragmented and not as effective as it should be. the supervisory agencies also need to be empowered to enforce the laws. in 1975. and SEC) are involved in corporate supervision. This is due to the historical development of the Thai corporate sector: before 1975. voting only on major decisions. Vol. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. activate the market for corporate control. and increase the participation of institutional investors are imperative. the Ministry of Commerce had the sole supervisory responsibility. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. Only then will these agencies be able to act promptly and effectively. There is also supposed to be separation of ownership and control.
SEC has been trying to lay the foundations of good corporate governance by espousing fairness. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. The slow improvement in the legal framework has likewise obstructed progress in this area. accountability. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. increasing penalties for directors engaged in misconduct. there has been much progress in this area.Chapter 4: Thailand 275
There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. the Government can change the shareholding limit for controlling shareholders. 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. Since the Asian financial crisis. and a prohibition of connected transactions by directors or management. Through an amendment in the Public Company Act. 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. To ensure a level playing field. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. Because these holding companies control a number of large public companies in Thailand. transparency. This move is expected to be unpopular among founding family members and original owners. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. The second recommendation is to dilute ownership concentration through the use of regulatory power. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. they should be monitored and regulated. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. and
. requiring cumulative voting for the election of directors. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. SEC is exploring the possibility of amending the law toward this direction. 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. regulators must increase transparency and step up enforcement. The situation prompts two specific recommendations.
will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. Accounting standards have also been under review.
. The same goes for improvements in the bankruptcy system. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. aimed at ensuring that banks finance only creditworthy projects. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. Vol. In an environment of highly concentrated ownership. in turn. it will be difficult to improve corporate governance in Thailand. Further. 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 SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. A well-developed domestic debt market will provide corporations with an alternative to bank financing. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. The first step is to establish an active secondary Government bond market. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. Capital Market Development and Regulation Another important issue concerns the development of capital markets. for instance. In the stock market. Without a strong and efficient capital market.276 Corporate Governance and Finance in East Asia. which. II
responsibility among companies. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. the power of the capital market to discipline inefficient management is almost nonexistent. especially in the area of connected lending. This may not be possible without reforms in the banking sector itself. there is a need to increase market disciplinary power through market competition. However. while a strong domestic debt market will also offer protection from foreign exchange risk. will lead to the emergence of a reference yield curve. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet.
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