Corporate Governance and Finance in East Asia

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

Country Studies

Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank

© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBank’sregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term “country” does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines


List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51

2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance

53 53 55 55 60 62 65

iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214

v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226

4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References

229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277

3 GrowthandFinancialPerformanceofPubliclyListed Companies.6 GrowthandFinancialPerformanceofState-Owned Companies. 1986-1996 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates.20 ROE of the Banking Sector. 1996-1999 Table 1. 1992-1999 Table 1.2 Foreign Capital List of Tables 1.8 OwnershipConcentrationofPubliclyListedCompanies.18 GDP Growth by Sector.1 Growth of the Banking Sector.21 Nonperforming Loans by Type of Bank. Republic of Korea Table 2.5 Financial Performance of Publicly Listed Companies by Sector.12 CharacteristicsoftheBoardofDirectors Table 1.4 Development of the Stock Market. 1997 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization.4 Growth Performance of Publicly Listed Companies by Sector. 1992-1997 Table 1. 1988-1996 Table 1.7 Growth Performance of the Top 300 Conglomerates. 1992-1997 Table 1.2 KeyMacroeconomicIndicators Table 2.13 Presence of Board Committees in Listed Companies Table 1. 1992-1998 Table 2. 1996-1998 2.1 Listed Firms with Positive Economic V alueAdded. Indonesia Table 1.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.19 DER and ROE of Publicly Listed Companies by Sector.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1992-1995 Table 1. 1992-1997 Table 1. 1996-1998 Table 1. 1990-1997 Table 1. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .3 Subsidiaries of the 30 Largest Chaebols Table 2. 1990-1998 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.14 Banking Sector Outstanding Loans. 1992-1999 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1. 1992-1997 Table 1. 1993-1999 Table 1. 1993-1997 Table 1.

1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.21 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols.15 Table 2.20 Table 2.7 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries.17 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size. 1995-1997 Ownership Composition of Listed Companies.26 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio.23 Table 2.19 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 . 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies.14 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.5 Table 2.11 Table 2. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.vii Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.10 Table 2.8 Table 2.25 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.18 Table 2. 1997 Ownership Concentration ofAll Listed Firms. 1999 InternalShareholdingsofthe30Largest Chaebols.6 Table 2.29 Table 2.30 Private Capital Flows to Korea. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.24 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.13 Table 2.22 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.16 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.12 Table 2.27 Table 2.28 Table 2.9 Table 2.

1997 Table 3. 1989-1997 Table 3.1989-1997 Table 3. 1989-1997 Table 3. 1988-1997 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1985-1997 Number of Firms with Dishonored Checks.20 Financing Patterns by Industry.33 Net Profit Margins of Chaebols. 1988-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.32 Table 2.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. 1978-2000 Table 4.Profitability andFinancial . 1990-1999 Table 3. 1988-1997 Table 3.1 Public Companies Registered.14 Philippine Stock Market Performance.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.12 Control Structure of the Top 50 Corporate Entities.18 Financing Patterns by Control Structure.31 Table 2. 1989-1997 Table 3. 1997 Table 3. 1988-1997 Table 3. 1988-1997 Table 3.2 Public Offerings of Securities. 1989-1997 Table 3. 1997 Table 3.000 Companies.19 Financing Patterns by Firm Size.1 GDP Growth of SoutheastAsian Countries. Flagship Company.16 CorporateFinancing PatternsbyOwnershipType. 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 3.15 Financing Patterns of the Corporate Sector.8 Ownership Composition of Philippine Publicly Listed Companies by Sector.3 TheCorporateSectorandGrossDomesticProduct. 1988-1997 Table 3.22 Foreign Investment Flows. 1992-1999 . 1997 Table 3. Leverage Table 3. 1992-1996 Table 3. andAffiliated Banks of Selected Business Groups.2 Growth and Financial Performance of the Top 1. 1986-1998 Nonperforming Loans of General Banks. The Philippines Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.21 OwnershipConcentration.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. 1983-1997 Table 3.17 Composition ofAssets and Financing of the Publicly Listed Sector.viii Table 2.SectorOrientation. Thailand Table 4. 1997 Table 3. 1995-1998 4.11 TotalandPerCompanySales.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.

1992-1999 Offerings of Debt Securities.8 Table 4.6 Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies.3 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand.5 Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.1 Figure 1. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies. 1992-1999 Common-Size Statements for Companies Listed in SET.9 Table 4. 1990-1998 Merger and Acquisition Activities. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability. Ownership Concentration. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.12 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.16 Table 4.13 Table 4.11 Table 4. Leverage. 1993-1999 Size and Composition of the Thai Financial Sector. 1985-1996 Average Key Financial Ratios by Company Size. 1990-1996 Financial Ratios of All Listed Firms.14 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.15 Table 4.4 Table 4.ix Table 4.1 Figure 3.10 Table 4.2 Figure 3.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .7 Table 4. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1990-1996 External Debt.


Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADB’s financialsectorworkinitsdevelopingmembercountries.

Arvind Panagariya ChiefEconomist


Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudy’sfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.


ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholders’meeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers’ Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter

xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobin’s Q won UnitedStates

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

1 Indonesia
Saud Husnan1



The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation

Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.

these controlling families had political connections that allowed their companies to enjoy special privileges. except utilities. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. Malaysia. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. no doubt. the currency composition and term structure of corporate foreign indebtedness were causes for concern.2 Corporate Governance and Finance in East Asia.2 presents an overview of the Indonesian corporate sector. In this setup. Lending activities of affiliate banks that were not sufficiently backed by owners’ equity and the reliance by foreign lenders on the strength of political connections paved the way for risky investments. Foreign creditors. contracting by 36. regulatory framework. the Indonesian economy seemed to be in generally good shape. short-term loans were used to finance long-term investments. These banks were allowed to operate even if they violated minimum capital adequacy requirements. 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. and analyzes their importance to the corporate sector in Indonesia. prior to the financial crisis. and how it contributed to the crisis. and responses to the financial crisis. this left the Indonesian economy extremely vulnerable. Section 1. particularly those with large foreign loans. Foreign debt reached more than $100 billion. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. To facilitate even easier access to credit. posted negative growth. and . In many instances.5 percent. patterns of financing. The study also identifies family-based companies and corporate groups. followed by finance (-26. how it has affected corporate financial performance and financing.5 percent. patterns of ownership and control. On the other hand. Section 1.3 looks at patterns of corporate ownership and control. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. However. were the ones most affected. placed a high premium on these political connections in assessing the chances of being repaid. It analyzes the weaknesses of corporate governance in Indonesia. The construction sector was the worst hit. 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. or Thailand.6 percent) and trade (-18 percent). Vol. II rate reached 58. highly leveraged companies. All sectors. This study reviews the Indonesian corporate sector’s historical development. When the crisis hit the country.

Not all items in the questionnaires were answered by the respondents. textiles. while Chinese and indigenous entrepreneurs ran some large businesses in trading. Up until the mid-1960s. However. how it was affected by the crisis.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. substantial volumes of private investment entered the scene. . a gradual shift in public investment away from manufacturing took place. and tobacco industries. and its response. medium. Subsequently.2. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI).2 1.1 Overview of the Corporate Sector Historical Development The marked permeability between the State and business in Indonesia goes back to the country’s struggle for independence. Section 1.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Despite the oil revenues. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. in the course of the fight for nationhood from 1942 to 1950.4 analyzes corporate financing patterns.2 Section 1. The industries that emerged were highly import-dependent and reliant on tariff protection.5 examines the corporate sector during the financial crisis in terms of its role. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. In the early 1970s. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.and large-scale companies were dominated by state-run industrial concerns. Section 1. 1. It also examines the statistical relationship between corporate performance and corporate governance characteristics.

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

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

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.9 27 113.4 34 12.9 304.6 240 1996 1997 1998 1999 141. 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.6 34 14.3 201.9 31 9.5 528.8 391. banks could earn profits even when they did not gather and process information about risk.8 29 6.9 762.8 10 19.4 789.9 39 18.6 7 12.6 164 144 130 92 387.9 248. 1993 100.9 10 11. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). Of these.2 10 14.8 31 10.8 27 200.4 10 35. Vol.5 27 88.2 161 214.7 27 37. II Table 1. .6 7 7.5 27 66.3 30 7.6 Corporate Governance and Finance in East Asia. Because regulation was weak.1 240 1995 122.7 351.5 165 308. The other banks among the top 10 were state banks. the 10 largest were all affiliated with major business groups.0 234 1994 104.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group). while BUN has been closed down by the Government. Bank Danamon.1 Growth of the Banking Sector.3 10 17.8 10 37.8 27 147. Both BCA and BUN have shareholders linked to the former President Suharto. Among private domestic banks. and Bank International Indonesia (ranked 9th). Bank Danamon (ranked 7th).5 7 9.1 10 47.9 291. In terms of assets. But the banking system proved incapable of performing its intermediation function.5 7 7 7 5 15. BCA.8 166 248.3 27 51.

09) 1.2 Foreign Capital Flows.50 (0. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.00 2. when the financial crisis hit Indonesia.63) (1. From the mid-1980s until July 1997. In 1994.33 (13. November 2000.59 billion in 1996. there was a phenomenal growth in direct borrowings by Indonesian corporations. initially from Japan and the Republic of Korea. Between 1990 and 1996. Source: IFS CD-ROM. foreign investment also had a strong presence in the services and infrastructure sectors. the Government allowed foreign investors to own 100 percent of an Indonesian company. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.01) (0.59 4. Net FDI flows increased to $5. textiles.2. such as metal goods. 1.74 5. they still amounted to a large sum for the economy to absorb. But FDIs were only one form of foreign capital inflows to Indonesia. FDI flows were strong. .81 3. In the 1990s. Successive policy deregulation facilitated FDIs in various light manufacturing industries. 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. and footwear.78 2. In effect. Table 1.11 3. except in certain strategic sectors. September 2000.09 1.15) — = not available.40) (0.88 4. Indonesia received capital inflows averaging about 4 percent of GDP.48 1.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).2. foreign creditors were eager to provide financing to Indonesia.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. Increasingly.01 (2. Most FDIs came in through joint ventures with business groups having strong political connections.10 5. Until the onset of the crisis.88) — — — — — — 8. especially through bank loans. IMF. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).09) (0.87 7. as shown in Table 1.

plus 4 percent for the depreciation of the rupiah. and conglomerates. the average borrowing rate for dollar loans was 9 percent. The external corporate debt owed to foreign commercial banks was $67 billion. the average foreign ownership of listed companies was 21 percent. foreign investors began to dominate daily trading. 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. Due to data constraints. especially the short-term ones. total corporate debt reached nearly $118 billion. 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. increasing the total trading value from Rp8 trillion in 1992 to Rp120. 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. Between 1989 and 1992. state-owned companies (SOCs). allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. the analysis focuses only on publicly listed companies.4 trillion in 1997. with the onset of the Asian crisis. of which two thirds were rupiah-denominated. Private borrowers preferred foreign loans since these were relatively cheaper. but declined to an average of 25 percent during 19951997. From 1987 to 1996. In September 1997. The following section looks at the growth and financial performance of the corporate sector. II Up until the late 1980s. foreign banks became a significant source of financing for the corporate sector. In November 1998. Vol. This increased to 30 percent by the end of 1993. participation in the Indonesian stock market was exclusive to domestic investors.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. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. 1. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. . The Government relaxed this restriction in 1988. Consequently. By the end of 1997. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations.8 Corporate Governance and Finance in East Asia. Domestic corporate debt was about $50 billion equivalent.2. In the 1990s.

1993.5 37. a Value added was assumed to be 30 percent of total sales.4 38.7 — = not available. 1996. b Asset turnover is defined as sales over assets. Table 1.6 24.4 1997 7.2 1995 37.3 3. 250 firms.7 — 250. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines. although the contribution increased over time. Asset turnover was above 30 percent until 1996.8 percent between 1992 and 1996.0 12. 246 firms.5 240.5 34.1 percent in 1997 when the crisis began to buffet Indonesia.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. but declined to 0.8 6. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. The growth of listed companies was sustained by continuing investments.0 64.4 31. During 1992-1997.6 percent in 1997. 1995. there were 204 firms.6 48. but dropped to 1.6 1994 50.8 230.4 percent.0 3. 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 — 3.5 3. averaging 3. 1994. 174 firms.3 shows the growth and financial performance of Indonesian publicly listed companies. but fell to 24. When the crisis battered Indonesia in 1997. Average return on equity (ROE) of listed firms was 11.2 7.0 1.1 220.1 0. publicly listed companies as a group contributed less than 10 percent to GDP. and 1992. 248 firms.0 12.6 3. 226 firms. In 1997. but turned negative in 1997.3 Growth and Financial Performance of Publicly Listed Companies. the average DER increased to 310 percent from 230 percent the .0 33.8 220.0 6.5 34.2 30.9 310.7 percent in 1997. while total assets grew at 43 percent.7 3. ranging from 220 to 250 percent between 1992 and 1996.4 1993 45.4 1996 18.0 12. Source: JSX Monthly (several publications). total sales of listed companies grew at an annual average rate of 31 percent. Despite such rapid growth.9 37. Return on assets (ROA) was also relatively stable during 1992-1996.0 10. Note: The number of firms is not identical for each year.1 4.0 11.3 6.

Before the crisis. indicating its reliance on equity to support growth.4). property. the mining sector had the highest ROE. consumer goods.10 Corporate Governance and Finance in East Asia. real estate. increased from 0.73 percent in 1992 to 1. and services. averaging 17. When interest rates increased. But the sector’s ROE fluctuated a lot. II previous year. basic industry and chemicals. Meanwhile. still posting a positive but lower ROE. finance. Vol. Overall. meanwhile. the mining sector ranked first. real estate. infrastructure. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged.5 presents the financial performance of listed companies by sector. and building construction. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. when the property sector was booming during 1993-1997. the property sector was severely affected by the crisis. and trade) even posted . However. the mining sector had the lowest DER.64 percent in 1997. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. helped in part by the relatively strong demand for consumer goods. with ROE falling to -11. and trade.7 percent during 1992-1996. miscellaneous industry.3 percent between 1992 and 1996. mining. During those years. For instance. and services. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. investment. followed by agriculture (Table 1. the companies in the sector did not operate with a high leverage. averaging 21. in terms of growth of sales and assets. Table 1. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. the banks eagerly provided credit to property development companies. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. and property. In terms of share of value added to GDP. The finance. The consumer goods sector ranked second in terms of ROE. The finance sector’s contribution to GDP. although asset turnover was slow.2 in 1997. This sector was less affected by the crisis. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. Four sectors (basic industry and chemicals. ROE fell drastically because the sector had one of the highest DERs. From 1995. In terms of sales and asset levels in 1997. the dominant sector was the finance sector. due mainly to the domination of the International Nickel Company of Canada. property. investment. trade. The same applied to the trade sector. which operated in nickel and copper mining in 1992 and 1993. ROA of all sectors dropped in 1997. only two sectors (mining and finance) showed a consistently increasing trend from 1992. miscellaneous industry. Also.

and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.7 54.3 0.0 22..4 44.4 170.7 1995 51.0 0.6 133.0 64.1 1.5 (11. Constn.4 0.6 22.2 5.4 77. Industry Consumer Goods Industry Prop. Investment.4 30.6 135.7 62.9 123.8 51.4 30.7 133.5 23.3 1. and Bldg.1 0.1 0.9 25. Industry Consumer Goods Industry Prop.1 0.0 (20.3 0.6 85.0 31.6 (0. Constn.3 31.2 59.9 (7.7) 17.6 0.8) (12.8 (76.7 112.6 0.0 (28.5 95.8 50.8 1.Table 1.8 27. Constn.1 (11.5 28.9 36.5 9. Real Estate.2 0.6 24.3) 39.2 41.1 — 39.9 0.6 15.6 (41.4 64. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.1 67.3 17.1 (41.7 43.7 40.9 59.2 35.0 16. Real Estate. Infrastructure Finance Trade.7 90.7 28. Source: JSX Monthly (several publications).0 0.9 8.5 53.9 54..0 0. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc. Infrastructure Finance Trade.5 61.6 83.1 1.1 0. Investment.4 31.3 (203.3 0. and Services — = not available.7 0.1 71.0) 46.6 0.4 38.3) 53.7 21.3 340.4 1.6) 25.7 34. Real Estate.1 16. Infrastructure Finance Trade.8 0.1 28.4 1993 155.6) 19.3 31.8 1.8 28.6 0.8 24.6 51.7 (82.7) (27.4) 6.5 1. Industry Consumer Goods Industry Prop.6 1.0 0. Investment. Constn.5) 6.0 68.6 26.7 — — 11.5 1.5 92.5 45. Infrastructure Finance Trade.1 35.1 0.7 — 36.3 92..9 1.9 31.6) 119.9 64. and Bldg.5) 13.2) 0.1 0.8 66.7 0.1 1.4) 8.1 0.0 (192.5 (8.9 0.5 0.6 1994 (75.7) 26.8) 0.9 .4 (149.2 11.6 28.1 0.3 0.7 17.2 13.0 1. and Bldg.4 43.5) 49. Real Estate.9 54.0 0.4 1. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.0 18.8 29.1 0.0 0..4 21.2 0.4 1.7) (113.5 68.5 13.3 51.1 32. and Bldg.4 Growth Performance of Publicly Listed Companies by Sector.2 41.2 14.1 42.9 53.1 0.0 43.9 14.0 24.1 1.8 62.4 103.0 1996 1997 58. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.5 0. Investment.3 0. Industry Consumer Goods Industry Prop.5 1.1 23.8 32.7 24.1 1.

and Bldg.0 19.7 (3. Investment. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.7 10.6 74.0 8.6 14.9 29.2) 7.5 4.0 100.8 479.1 (3. Industry Consumer Goods Industry Prop.2) 15.4) (1. Industry Consumer Goods Industry Prop. Constn.1 10.1 4.1 9.2 53.8) 8.0 70.4 71. Industry Consumer Goods Industry Prop.0 80.8 168.0 110.2 3.9 4.9 40.4 46.0 130.0 190.7 10.7 1.6 13.9 42.0 190.1 10.0 150.3 1.7 1.8 3.0 11.1 63.6 19.4 20.4 6.0 70.7 26. Infrastructure Finance Trade.1 (5.2 11.3 73.0 160.0) 7.0 120.5 5.7 5. 1992 20. and Bldg.1 65.9 7.4 79.3 38.5 43.0 630.7 5..8 16.4 1. Infrastructure Finance Trade.2 1993 130.6 13.6) 18.8 81.0 100.8 382.8 20.6 8.0 120.0 17.0 180.2 15.6 (11.2 7.0 110..0 150. Investment.0 140.5 1995 80.2 39.1 2.0 150.6 23. Constn.0 140.0 60.1 11.8 44.2 13. Industry Consumer Goods Industry Prop.0 39.0 700.4 4.8 25.7 9.0 66.9 38.1 3. Investment.7 12. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 160. and Bldg.7 10.1 4.4 46.0 210.1 4.9 10.3 17.9 14.0 3.4 5.8 9.3 17.0 69.0 650.7 12.8 5.0 190.1 1. Infrastructure Finance Trade.7 71. Investment.0 110.0 110. Constn.0 110.2 8.4 35.0 170.0 560.2 30.9 38.8 67.0 100.2 (4.5 56.7 8.1 9.7 61.0 380.Table 1. Infrastructure Finance Trade.6 18.8 11.5 14.5 17. Constn.0 120.0 90..7 46.3) 5.1 10.6 8.9 87.1 1996 100.8 11.0 220. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.9 41.5 4.1 13.4 13.0 15.0 46.5 Financial Performance of Publicly Listed Companies by Sector.4 35. Real Estate.0 3.0 100.8 8.5 11.3 18.3 5.6 1.1 89.0 12.3 13.0 110.0 8.1 8. Real Estate.2 111.0 (0.0 180.6 (2.0 650.1 6.3 7. and Services Source: JSX Monthly (several publications).0 680.2 3.0 110.2 23.5 19.7 4.0 50.7 12.3 0.3 7. Real Estate. and Bldg.0 86.2 7.0 9.0 120.1 1994 80.3 64.4 6.3 33.4 13.7 4.7 13.0 80.0 80.0 14.0 180.0 160..0 1997 230.5 13. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.4 .6) 36. Real Estate.2 6.1 7.5 7.9 17.7 4.0 70.4 17.7 8.

The finance and miscellaneous industry. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. SOCs diversified into many businesses.1 percent in 1992 to 28. Just like private companies. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.1 percent in 1993. the Department of Finance supervised 30 SOCs. and basic industry and chemicals sectors had relatively stable ROA before the crisis. ROA had been at high levels from 1992 to 1995. . there were 58 SOCs with subsidiaries and affiliates. averaging 24 and 31 percent.8 percent between 1992 and 1995 (Table 1.6 to 8.6). SOCs’ ROE ranged from 6. Trade had the highest ROA of 39. the ratio decreased from 8. This was due to large sales by the National Oil Company (Pertamina). and finance company (four companies). Only the agriculture sector showed an increase in ROA in the couple of years before 1997. By 1995. However. SOCs’ sales growth fluctuated during 1990-1996.7 percent. which collectively had the largest assets. there were 165 state-owned companies (SOCs)3 in Indonesia. For instance.Chapter 1: Indonesia 13 negative ROA. This was relatively high compared to the 3. The DER was slightly higher than for listed companies.3 trillion. indicating SOCs’ declining contribution to GDP. registering an average annual rate of 10 percent. These growth rates were low compared to those for listed companies during the same period. SOCs actively operated in various sectors4 under the supervision of “technical” departments. respectively. growth of net profits and assets was erratic. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. Six SOCs were listed in the Jakarta Stock Exchange. Similarly. between 1993 and 1995.3 percent in 1995. increasing from 21. much lower than that of companies listed in the stock exchange. the subsidiaries and affiliates number 459 with total assets of Rp343.7 to 7 percent for publicly listed companies. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). Asset turnover rates were lower relative to those of publicly listed companies. Taken together. but dropped dramatically to 4. State-Owned Companies At the end of 1995.7 percent in 1990 to 6 percent in 1996. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control.4 percent the following year. insurance (11 companies). Assuming a fixed ratio of value added to sales. banks (seven companies).

1992 — 7.3 250.6 28. a Value added was assumed to be 30 percent of total sales.1 12. Table 1. Source: Indonesian Data Business Center.6 percent in 1994. Source: Indonesian Data Business Center.7).8 11.7 (2.7 13.4 percent in 1992 to 28.3 12. 1992-1995 (percent) Indicator Growth Indicators Sales Growth Share of Value Added in GDPa Assets Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb — = not available.0 24. In 1997. SOCs’ asset turnover rates showed a downward trend from 32.7 1994 (9.1 trillion in 1990 to Rp234 trillion in 1997.14 Corporate Governance and Finance in East Asia.0 8. but climbed to 30.0 7.4 13.0 28.4 1993 16.6 Growth and Financial Performance of State-Owned Companies.1 30.4 13.766 business units. Assuming a constant ratio of value added to sales.2 — 370.5 3. Table 1.1 6.2 18.1 310.7 16.1 32.1 19. Vol.2 percent in 1997 (Table 1.7 Growth Performance of the Top 300 Conglomerates. a Value added was assumed to be 30 percent of total sales.8 21. mostly private companies.2 23.5 percent in 1995.4 7. but dropped to 11.1) 5. .6 28.0 8.3 30.6 1995 25. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17. the contribution of conglomerates to GDP increased from 12. these conglomerates owned 9. Their total sales increased from Rp90.4 16.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.2 — = not available.8 12. b Asset turnover is defined as sales over assets.4 percent in 1994.8 percent in 1990 to 13.0 12.0 6. II companies consistently declined over time.6) 260.4 13.0 17.

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

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

. the viability of a project).Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. holding companies. capital adequacy. or financial institutions. the collateral could take the form of nonphysical assets (e. or 20 shareholders. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. whether they are individuals. 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. states that a bank is not allowed to provide credit without collateral. For instance. Ownership concentration is usually measured by the proportion of shares owned by the top one. for instance. 1.3. 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. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. A Commercial Court was also set up to deal with bankruptcy cases. The two most important elements of ownership structure are concentration and composition. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. However. It aimed to protect creditors by providing easier and faster access to legal redress. A new bankruptcy law was passed in August 1998. It reveals characteristics of controlling shareholders. families. net open positions. etc. amended in October 1998. the Banking Law (1992). five.. Discussions on corporate ownership cover listed companies and conglomerates. 1.3 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.g.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study).

II Publicly Listed Companies Table 1.8 Ownership Concentration of Publicly Listed Companies. respectively.6 4.0 0.6.9 0.5 72.0 4. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). This is because a few companies in the transportation sector issued high proportions of shares to the public. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.6.6 3.9 percent of total outstanding shares.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.0 1. 3. The pattern of ownership concentration changed little over this period. The percentage owned by each of the five largest shareholders was 48.5 1997 48.0 67. the founder usually continues to own the majority of shares through a . 13.5 16.5 12.1 1. issued 93. Table 1.6 3.1 13.6 68.9 14. Vol.7 1996 48. and 0.6 percent.9.9 2. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. 2.2 1. Table 1. for instance. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.7 3.6 13. Meanwhile.1 0. the five largest shareholders owned 68. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.4 2.0 0. On average. mining.18 Corporate Governance and Finance in East Asia.5 percent.3 1995 47.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.9 Source: The Indonesian Capital Market Directory. This preserves the pro rata share of existing shareholders. consumer goods.4 percent.2 67.1 4.8 1.8 68. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. the controlling shareholders usually act as standby buyers.0 2. When a company makes a rights issue.7 1994 48. and basic industry and chemicals sectors than in others.8.9 2. Rig Tenders Indonesia (shipping services) issued 51. When a company goes public.5 Average 48.8 68. Zebra Nusantara (taxi services).2 11.

9 1.0 5. Real Estate.6 2.3 2.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).4 6.4 44.1 1.6 8. and corruption. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.1 2. the rule of law. and Services Average Source: The Indonesian Capital Market Directory.1 1. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.7 9.9 0. Infrastructure. the top family controls 16. which shows that in 1996.6 percent were widely held.6 percent of total market capitalization while the top 15 families control 61. and the efficiency of the judicial system. in a cross-country study.5 58.6 1.9 50. two thirds (67. and Bldg.1 2. Constn.6 9.9 44.7 percent of the market.3 48.3 0.1 0. Investment. that the correlation between the share of the largest 15 families in total market capitalization.5 1.2 15. on the one hand.4 1.2 This is confirmed in Claessens et al.1 1. on the other..9 44. as well as the existence of corruption.1 percent) of Indonesian publicly listed companies were in family hands.1 1. (1999).1 13. In fact. and Transportation Finance Trade. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.3 0.9 3.1 2.1 11. (1999) also found. In terms of capitalization. The findings suggest that the concentration of corporate control in the hands of few families is a major determinant of the evolution of an inefficient legal and judicial system.6 0.4 54.3 36.7 4.2 0. is strong. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.7 1. Util. Industry Consumer Goods Industry Prop.2 46. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .2 2. Indonesia has the largest number of companies controlled by a single family.7 6.8 14. Table 1.5 4. and only 0.9 Ownership Concentration of Publicly Listed Companies by Sector.1 0. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc. Claessens et al..7 13.4 11.4 4.3 14.2 10.

numbering 162 in 1988 and 170 in 1996. the onset of the crisis negated this development. Indian. their number increased to 5 In 1997. In September 1997. Indigenous businesspeople include the Javanese. The nonindigenous businesspeople are usually Chinese. political affiliation. In 1993. the legal system is less likely to evolve in a manner that protects minority shareholders. Coordination is easier because informal communication channels exist. resulting instead in a decline in the proportion of foreign investor ownership. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. most were established during the New Order Government. foreign ownership increased to 21 percent. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. and family origin. Batak. During 1988-1996. Vol.20 Corporate Governance and Finance in East Asia.5 Conglomerates Table 1. II the small number of families and the tight links between companies and the Government. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Sundanese. or other ethnic groups. However. 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.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. However. with all its regulations. ethnicity. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. accounting for 64 percent of total conglomerate sales in 1988-1996.55 percent in August to 25. This may indicate that the New Order Government. In Indonesia. and Padang. But these benefits are few and often dubious compared to the high costs of concentration. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. conglomerates established before 1969 dominated in terms of sales. but later declined and steadied at around 25 percent. the Government allowed foreign investors to buy up to 100 percent of listed shares.42 percent in December. . it rose to 30 percent. the proportion of foreign ownership declined from 27. Among the top 300 conglomerates. From 193 in 1988. was able to create a favorable environment for business development.

1 41.0 58.1 46.8 38.4 59.8 Source: Indonesian Business Data Centre.7 64.9 trillion.9 42.9 35.8 28.8 30.9 137.8 36. While they supplied 20.10 Anatomy of the Top 300 Indonesian Conglomerates.3 43.4 19.8 12.4 32.4 22.5 21.6 77.1 21.8 49.1 179. its sales reached Rp1.0 44.3 120.6 17.4 57.4 37.6 trillion in 1988 to Rp137.7 40.0 31. Their total sales also increased from Rp38.2 76.4 59.1 percent of total .5 120.3 80.6 95.1 33.2 33.2 29.4 69. due to their “go public” activities.2 159. Meanwhile.4 15.7 49.4 18.3 101.0 116.7 106. the number of mixed groups declined from 86 in 1988 to 68 in 1996.7 95.4 86.3 134.9 13.4 16.2 23.0 18.6 34. sales of the Bakrie group before it went public in 1990 were only Rp369.3 20.6 12.0 58.8 57.6 54.1 52. 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 9.7 28.4 68.9 47.8 68. For instance.2 12.2 48.9 77.1 58.4 trillion in 1996. Conglomeration Indonesia 1997.0 15.4 31.4 48.5 22.3 36.7 89.5 106.1 87.6 114.9 73.7 24. In 1996.9 14.1 25.2 30.0 28.9 billion.4 31.1 103.4 81.1 42.8 25.1 46.Chapter 1: Indonesia 21 Table 1. more than five times its 1988 level. 204 in 1996.4 52.

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

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

Simeon Djankov. Financial Sector Practice Department. World Bank. and Larry H. Who Controls East Asian Corporations? Financial Economics Unit. P. . 1999). (Feb. 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 Bank Utamar 17 firms with control over 20% Bimantara Group (son Bambang) TPI Andromed Tripolita 8 firms with control over 20% Kabelindro Kiani Murmi Sakti Source: Stijn Claessens.Figure 1.

. if necessary. including the boards. management and managerial compensation. request a shareholders’ meeting. both controlling and minority. and. and accounting and auditing procedures. Figure 1. role and protection of minority shareholders. the BOC supervises the work of directors. The managers execute the BOD’s decisions and lead employees in their departments. The BOD leads the company and makes strategic and operational decisions.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia Shareholders Board of Directors Board of Commissioners M a n a g e r s Employees The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed companies. one possibility is that legal lending limits had been violated. This is based on the Dutch system. seek an audience with directors.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. Shareholders are at the top of the organization.3. Therefore. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange.2. As the owners’ representatives. 1. the BOC has the right to obtain any information concerning the firm. The typical structure of a publicly listed company in Indonesia is shown in Figure 1.Chapter 1: Indonesia 25 problem is inconclusive. the directors.


Corporate Governance and Finance in East Asia, Vol. II

Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4

Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer

Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.

In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders

Chapter 1: Indonesia


was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8

Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders

Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.

Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.


Corporate Governance and Finance in East Asia, Vol. II

Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.

BOD 5 5 5 23 38

BOC 1 1 3 35 40

Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies

Chapter 1: Indonesia


provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.


Corporate Governance and Finance in East Asia, Vol. II


External Control

Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were

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

new instruments have been introduced to the corporate sector. including bonds.6 4. equities became available to the corporate sector.6 3.14 Banking Sector Outstanding Loans.7 18.5 108. However. bank credit surged from Rp122.3 9.2 6.0 93.4 56. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.6 150.7 112.5 42.6 percent in 1997. however. From 34. when the Government reactivated the stock exchange. Bank Credit As shown in Table 1.7 122.5 80.3 188.4. . Vol.9 trillion in 1992 to Rp487.32 Corporate Governance and Finance in East Asia.4 trillion in 1998.5 7. jointly providing almost 90 percent of loans until 1997.6 6. Private national banks and state-owned banks were the biggest domestic creditors.1 220.6 48. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).4 225.4 86. and others offered by nonbank financial institutions or finance companies.4 percent in 1992. this market was not well developed.3 60.2 71. private national banks overtook state banks as the dominant credit source.2 27.1 Corporate Financing Financial Market Instruments Prior to 1977.6 292.0 6.0 487. the share of private national banks in outstanding total loans increased to 44. remain the major financing instrument for the corporate sector.14.8 193.7 50.9 234.4 24.3 14.3 66. Data from Bank Indonesia show that from 1994 to 1997.9 378.9 150.0 3. Bank loans. companies considered alternatives to bank loans.3 111. stocks. Table 1.2 5. Since then.9 153. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.0 168. II 1.1 Equities In 1977. 1992 1993 1994 1995 1996 1997 1998 1999 68. because of the restrictions discussed below.4 1.

9 406. capital adequacy ratio.5 1995 35.1 10. thus increasing the role of the capital market in raising long-term funds.6 310.6 91. Prior to 1995. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.6 123.4 1996 1997 1998 50. During the 1990s. factoring.e.1 18.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.2 16.5 333. They were not.9 1999 76.0 70. The ratio reached 8. allowed to accept deposit accounts from the public. 1992 1993 11.7 14. credit cards. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.15)..15 Value of Stocks Issued and Stock Market Capitalization.1 1994 26.8 48. and net open position).0 15. when foreign investors were not yet allowed to purchase listed shares. the Government issued regulations to supervise and promote prudential practices in finance companies. the stock market has gained a bigger role in corporate sector financing (Table 1. In 1988.. 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. It gradually increased again starting in 1991.6 859.g. shooting up to 18. Table 1. finance companies were increasingly used as channels for the inflow of foreign loans. Overall. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. legal lending limit. however. and consumer credit.4 207.7 percent in 1997. i.6 301. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. .Chapter 1: Indonesia 33 Some companies went public.7 15. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. In 1995. offering services such as leasing.0 206.1 17.7 9.

16 Financing Patterns of Publicly Listed Nonfinancial Companies.1) 23. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.8 17.8 7.4.7 22. While banks had some exposure to these instruments. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings). have been popular in Indonesia since 1990.6 12. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.6 8. This is in contrast to the lower share of borrowings during the same period.5 21. short-term borrowings were greater than long-term debts. Table 1. respectively.5 percent and 36.3 (0. .1) 23. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.0 100. at 81 percent of total borrowings.5 — 26.8 percent.4 23.6 100. In terms of composition.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.5 (0.3 14. Vol.4 13. otherwise it would be classified as a loss in the banks’ books. In the second half of the 1980s.3 37. 1.6 23. 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). Thus in November 1995.5 11.0 39. which are unsecured negotiable promissory notes with a maximum maturity of 270 days.2 Patterns of Corporate Financing Table 1. they were not rated by a rating agency. averaging 26. 1996.3 16.4 8.0 — = not available. PACAP Research Center.0 1986-1996 17.2 26.6 100.0 1991-1996 16. II Commercial Papers Commercial papers.34 Corporate Governance and Finance in East Asia.0 3.9 16.

17 compares the DER of listed firms by degree of ownership concentration. corporate debts accounted for 39. Corporate debts grew over time. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. The results indicate that firms with higher ownership concentration tend to have a higher DER. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds.Chapter 1: Indonesia 35 In the 1990s. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. . This amount doubled in 1997.9 trillion in 1996. in the context of Indonesia and some other countries.3 Corporate Financing and Ownership Concentration It has been suggested. Hence. also suffered from foreign exchange losses but managed to post profits of Rp0. Most corporate charters require commissioners to approve debt issues or sign debt agreements. Bank loans also surged when the banking sector was liberalized in 1988. Of the various financing sources.3 percent during 1991-1996. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.4 trillion in 1993 to Rp112. 1. rising from Rp54.2 trillion.9 trillion. which was masked by the rapid growth in investments. the pattern changed. that ownership concentration may be associated with heightened risk-taking by companies. was due largely to a rapid rise in long-term debts. the corporate sector’s high leverage. For instance.2 trillion (mostly foreign exchange losses).6 trillion and Rp1.1 trillion. Indosat and Telekom.4. Table 1. while Semen Cibinong’s losses reached Rp2. All companies in the cement industry suffered from foreign exchange losses. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. except Semen Gresik (an SOC). They also do not want to dilute corporate control and are more likely to finance growth with debt. with longterm debts increasing rapidly. reaching Rp229. These liabilities grew significantly because corporate expansion was largely financed by debt. Indofood registered losses of almost Rp1. Two telecommunications companies. 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. respectively. which managed to post significant profits due to low exposure to dollar-denominated loans.

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.36 Corporate Governance and Finance in East Asia. 1. The test of the difference between the two means found the t-value of 1. the borrowings swelled. and high ownership concentration among families with political affiliation. heavy reliance of companies on bank credits to finance investments. ultimately. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. since commissioners represent the controlling party. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.0 386. Controlling parties rely on external financing to maintain their equity share and.56 significant at the 10 percent level. As a result.0 351. to maintain control of the company. Between 1987 and 1996. aided . Vol.5.358. Table 1. II However.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 699.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders.5 1.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. Source: Author’s estimates. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inadequacy of the regulatory framework under the financial liberalization. the private sector borrowed heavily in unhedged dollars.0 1. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. In addition. decisions on debt are made with the implicit endorsement of owners.

. It was doubly difficult to exercise supervision when groups with political clout owned the banks. 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. They were. those with high DERs) established their own banks. averaging about 4 percent of GDP. A lot of short-term foreign funds were used to finance long-term investment projects. only created to serve the companies to which they lent. to circumvent these banking regulations. However. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. It was only in 1995 that some regulations on the activities of finance companies were contemplated. did finance many viable ventures. Conglomerates that had difficulty in getting loans (i. The Government later specified the legal lending limit and the net open position that banks had to follow. 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. As a result. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. and the negative net open position (short position in dollars) continuously rose to precarious levels. The large supply of foreign funds.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. many firms became highly leveraged. A director at Bank Indonesia revealed that in 1995. the level of corporations’ foreign debt could not even be ascertained. after all. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. This often led to the violation of prudential credit management practices. It is not known if these regulations had an effect on nonbank intermediaries. There was also a smaller demand for equity compared to external debt financing since controlling shareholders preferred the latter to maintain their control of the companies. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers.e. However. In the process. large amounts of credit were directed to the companies within the group. The supervising agency was caught unprepared..

Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. partly because they used nominee accounts to register ownership rather than set up a holding company. This was often the case in the banking industry. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. Since the Government could not afford to undertake these projects. Collusion between big businesses and the political elite was widespread in Indonesia. as they had done so in the years before the crisis. and power generation) require huge capital. or both. and investing shares among nonfinancial companies within the group and in other groups’ companies. Vol. and in the process maintain control of the company. politicians. In early 1998. total private sector foreign debt stood at $72. but on the basis of who the borrower was. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. This fact was usually not disclosed in financial statements. toll roads. Corporations were certain that they could roll over short-term loans when these fell due. Families retain control by keeping the majority percentage of outstanding shares. . Projects involving massive capital investments and long-term operating deals (in telecommunications. 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.5 billion. by setting up their own banks. of which $64. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. They enhance their control over companies through cross-shareholdings. banks did not lend on the basis of the soundness of the project.38 Corporate Governance and Finance in East Asia. 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. most often to people who were close to the ruling regime.5 billion was owed directly by corporations. In many cases. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. II By mid-1997. there was also almost universal confidence that the economic growth would continue indefinitely. contracts were granted to the private sector.

6 13.Chapter 1: Indonesia 39 1. Livestock.4) 2. Forestry.1) (26. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. followed by the finance and trade sectors. This continued in 1998. Sectors with lower ROE generally had higher DER.8 1997 1.6 (36.8) (11. followed by property.4 7. and Water Supply Construction Trade. Using the financial statements as of 30 June 1998 of 161 publicly listed companies. real estate.8 7.19.6 12.3 Source: Central Bureau of Statistics (Biro Pusat Statistik.7) (8.0) 1999 2. Only 86 companies reported profits. The consumer goods industry reported the lowest ROE.0 3. and Restaurants Transport and Communications Financial.18 shows that growth in most sectors significantly fell in 1997. The average DER was found to be 1.52 trillion.7 6. 1996-1999 (percent) Sector Agriculture. Table 1.0) (15. Hotels.370 percent.8 0.1 6. 53 companies reported negative equity of Rp6. indicating a rapid rise in .24 trillion for the first six months of 1998.6 8.2 8. Most sectors showed significant increases in leverage. and Business Services Other Services GDP 1996 3. DER and ROE were calculated per sector.18 GDP Growth by Sector.6) (3.2 (1.8 8.3 11.7) (2.9 3.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. when all sectors. and Fisheries Mining and Quarrying Manufacturing Electricity. Real Estate.4 5.3 12. and building construction.7) 2. posted negative growth rates.8) (13.7 1998 (0. BPS). and 128 companies reported a total loss of Rp46.5) (18. except utilities. much higher than the 307 percent registered in December 1997.1) 1. as shown in Table 1.1 (1.0 2.0 5.4 7.58 trillion (meaning their losses were greater than the paid-up capital).6 4. Gas.5.1 5.4) (0.6) (0. The construction sector was the worst hit.

from only 8. As the rupiah weakened and interest rates increased. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.0 97.5 8.0 108. a Actual data for 1st semester only.19 DER and ROE of Publicly Listed Companies by Sector. several publications.0 65.1 (5.0) (78.8 17.1) 7. but annualized to approximate full year values. foreign exchange losses came about with the use of unhedged foreign debt.1 (3.21.0 177.1 (124.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.6) (115.7) 6.0 2.0 1.4) 8.6) 15.2 23.0 193.8) 36.7 percent in July 1998.0 2. Second. the NPL ratio had reached more than 60 percent.0 1997 234.0 163.1 30.0 631.0 205.0 307. This figure further increased to 47. Mostly suffering from a liquidity squeeze.395.0 105. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.0 a ROE 1996 1997 1998a 14.0 229.4) 18.0 191.0 1998 186. Financial and banking analysts estimate that by September 1998. Vol.7 1. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. small foreign banks enjoyed the highest profits.0 12.3 7.0 108.2) (264.6 (11.0 72.0 92.271.0 111.8 percent in 1996.9 12. losses in operation were due to declines in sales and increases in the cost of imported inputs.0 697.2 13. as shown in Table 1.370.0 158. First. .8 (373. Source: JSX Monthly.4 (6. Impact on the Banking Sector Table 1.0 1. the NPL ratio rose to 25.1 1.0 219. Third.20 reveals that the banking sector’s ROE decreased significantly in 1997.625. private banks posted negative ROEs in the same year. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.0 1.0) 10.0 177. and would have kept on increasing if interest rates had not declined.40 Corporate Governance and Finance in East Asia. II Table 1.1 (92.0 864.4 5.097.2 (4.0 635.5 percent in April 1998. The huge losses suffered by most companies were caused by three factors.

0 129.9 — 11. The high and increasing NPLs.24 (4.1 30.44 15.37 19.1 198.9 297. In July 1998.73 30.89 27.81 13.34 16. however.0 — 32.4 7.09 11.2 — 19.86 11.1 274. coupled with negative spreads (deposit rate was higher than the credit rate).3 361.2 — 8.2 8.5 128.45 21.25 22.06 20.2 37.7 29. July No.07 13.9 percent.69 14.2 1.84 27.8 14.68 1996 1997 8.6 — 1.15 20.21 Nonperforming Loans by Type of Bank.67 8.1 13.8 8.3 Private National Banks — 179. 1992 7.30 5. .24 15.72 16.6 — 13.9 Regional Foreign and Development Joint Venture Banks Banks — 9.2 10. put pressure on the banking sector.7 106. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.5 222.3 22. 227/1998 and October No.3 445.8 11.20) Table 1.0 — 4.5 31.70 1995 7.38) 11. Source: Infobank.6 6.50 9. private national banks overtook State-owned banks when their NPL ratio jumped to 57.28 5.45 — 1993 15.43 10. 1996-1998 (Rp trillion) State-Owned Banks — 140.5 34.5 57.9 11.7 Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998 Total 331.7 4.Chapter 1: Indonesia 41 Table 1.6 — 4.1 47.91 21.7 — = not available.2 8.39 13.7 — 1. Source: The National Banking Association. State-owned banks initially had the highest NPL ratio.8 3. 230/1998.2 47.2 48.09 (11.07 1994 14.47 20.5 2.1 1.0 622.8 187.12 15.20 ROE of the Banking Sector.

the scheme failed. companies were not servicing their debts. such as Garuda (a national flag carrier). and Ciputra (property business). Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. few companies were in a position to resume interest payments. In June 1998.42 Corporate Governance and Finance in East Asia. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. Unfortunately. By end-November. 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. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Astra International (automotive). none of the 2.2 billion debt.000/$1) in debt from domestic commercial banks. have been subject to restructuring deals under the initiative. Corporate debt accounted for 46. The scheme encourages negotiation between creditors and debtors. assembling the legal and policy framework to facilitate corporate restructuring. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. the committee launched the Jakarta Initiative. the Government and private sector formed a committee to help corporates deal with the crisis. particularly in terms of debt resolution. Thus.5. 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. Since September 1998. about 80 percent of which was private.7 billion of foreign exchange debt. While the process of restructuring was in progress.4 trillion of domestic debt and $6. Vol. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. only a . the corporate sector had more than Rp600 trillion ($75 billion at Rp8. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. In November.7 percent ($64. a more comprehensive scheme to tackle domestic and foreign corporate debt. However.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. a number of prominent companies. II 1. On 9 September 1998.000 eligible firms had signed up for the scheme.6 billion) of Indonesia’s total external debt in March 1998. In addition. by mid-September 1998. Aside from being described as overly complicated.

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

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

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

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

The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. As the rupiah weakened and interest rates increased. NPLs rose and capital adequacy ratios fell.1 trillion in 1997 from Rp13. financed by issuing nearly $80 billion worth of bank restructuring bonds. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. the corporate sector was in quite good shape in terms of growth and profitability.Chapter 1: Indonesia 47 without diluting their control. Impact of the Financial Crisis Prior to the crisis. Meanwhile. particularly those with large short-term foreign loans. were the most adversely affected. At the height of the crisis. and strengthen prudential regulations and supervision of the financial sector. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious.21 trillion in 1996. ROE dropped from 1.1 percent in 1997 to -124. 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 Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative).24 trillion in the first half of 1998. facilitate debt restructuring. The Government introduced reforms to improve bankruptcy procedures. DER increased to 307 percent in 1997 and further surged to 1. and the rapid decline in equity due to losses. corporate-initiated debt restructuring . The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. although at a declining rate.1 percent in 1998. the consumer goods industry was the worst hit. the high domestic interest rates that prevailed from 1998. On the other hand.370 percent in 1998. the highly leveraged companies. The financial crisis led to the closure of several dozen banks. Bank Indonesia extended emergency loans to many banks. When the crisis hit Indonesia. and registered a net loss of Rp39. Sales of conglomerates as well as those of publicly listed companies were increasing. To restructure the corporate sector. followed by the property sector. Total profits of publicly listed companies dropped to Rp3. The Government and the private sector responded with measures to mitigate the negative effects.

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

with necessary legal sanctions for violations. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. the Court has been slow and ineffective in processing bankruptcy suits. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. in contrast to the Republic of Korea and Thailand. Further. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations.Chapter 1: Indonesia 49 financial institutions. However. When finance companies were used to channel offshore loans in lieu of commercial banks. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. the Government lost monitoring and control powers over foreign fund flows. and liquidation of corporate assets. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. The Government should also continue strengthening the monitoring system for foreign exchange transactions. Because foreign creditors are faced with more information asymmetries than domestic creditors. Consequently. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies. orderly restructuring. Protecting Creditors’ Rights To protect creditors’ rights. In the first place. most of banks’ NPLs resulted from credit to companies within the same group. Banks should be required to provide data on such transactions and charged penalties for noncompliance. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. it has been difficult to implement standstills. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. The regulatory framework was also weak in supervising and monitoring foreign transactions. recapitalization. This is a significant factor in .

. Only when creditors have the confidence that their rights are protected will they resume financing companies. Vol. The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing. II explaining the greater depth of the crisis in Indonesia. despite the smaller level of capital inflows (as a percentage of GDP).50 Corporate Governance and Finance in East Asia.

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

David Edwards. Business managers and controlling shareholders were maximizing firm size at the expense of profits. or capital market discipline. Chung-Ang University. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. 1 Professors. 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. both of ADB.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. Department of Economics. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. Seoul. the Korea Stock Exchange for its help and support in conducting company surveys. As the Korean currency. timely exit of poor performers from the market. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. the Republic of Korea. This has been the crux of the corporate governance problem in Korea. Chung and Yen Kyun Wang1 2. the Government and business sector had good reason to reflect on the causes of the crisis.1). internal control mechanisms. a practice that was not checked by creditors. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. Further. markets. The authors wish to thank Juzhong Zhuang. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2. The country’s winners would then emerge based only on economic efficiency. 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. . It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits.2 Republic of Korea Kwang S. and corporates were sent reeling. Korea) in November of that year. and Graham Dwyer for his editorial assistance.

T. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange.4 1993 513 174 33. June 1999.1 1997 518 104 20. Vol.1 1998 490 164 33.54 Corporate Governance and Finance in East Asia. Weaknesses in the overall corporate governance system in Korea had many ramifications. the corporate sector. especially chaebols.9 1994 531 165 31. Government reform goals for the corporate sector include enhancement of corporate transparency. . Koller.1 Listed Firms with Positive Economic Value Added. Copeland. Source: Korea Stock Exchange. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. accountability of controlling shareholders and boards of directors. 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. which distributed and collected the questionnaire. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. capital market discipline. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Many firms left some questions unanswered. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. II Table 2. and individual companies.1 1996 561 163 29. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. and improvement of bankruptcy procedures. Self-dealings by controlling shareholders—crosssubsidization and cross-guarantees among member firms within a chaebol (a conglomerate/large business group)—and the lack of transparency hindered the development of an efficient capital market capable of mobilizing low-cost equity funds. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. This study collects and analyzes data on the Korean economy. and J Murrin (1995).5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. The EVAs are the same as the economic profit as explained in T. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance.

4 contains analyses of corporate financing and its relationship to performance. Section 2.2. clothing. Major economic indicators for some of these periods are shown in Table 2. Section 2. The evolution of the modern Korean economy can be divided into four periods. and employees and their role in shaping corporate governance practices. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. the board of directors system. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. Section 2. It reviews such elements as shareholders’ rights.2 presents an overview of the corporate sector.2 2. which account for a substantial portion of the Korean economy. The Government tried to produce food.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. creditors. 2.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. and naturally adopted an import substitution policy. Section 2.2. It then presents recommendations for further reform in corporate governance and financing. corporate control by the Government. Section 2. From 1948 to 1961. . reviewing government policies responsible for the development of the modern corporate sector. and Yim (1998).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. Yang. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. This chapter is composed of six sections. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. In the period 19481961. and other necessities domestically. It traces the country’s economic development.

0) 492. 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. International Financial Statistics.9b 15.4 24.2 1980-1989 8. IMF. and large current account deficits. the Government was not successful in solving the problems of slow growth.1a 21. and inconsistent economic policies.8 15.7 37.1 15. This goal required very high savings and investment rates.8 24. However.0 27.1d 9.0) (297. a Refers to 1971.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries. d Refers to 1997.7c 11.9 794. the Government called for an unprecedented average annual economic growth rate of 7.0 41.7 30.8 12.2 32.949.5 38.3 8. In the Plan. high unemployment and inflation.8 (724. II Table 2.1 — = not available. e For maturities of one year or more.7 14. lack of strong drive.9) 1. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).753.56 Corporate Governance and Finance in East Asia.4 (1. c Refers to 1989.8 (8.447. The Government tried .1 35. largely because of political instability.5) 8.2 Key Macroeconomic Indicators Annual Average (percent.9 — — 21.4 29. 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 8.2 6.855. Source: Bank of Korea.2 30.2 314.1 29.4 29.5 250.4 1990-1997 7. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy. and implementing new budget and tax measures.9) (7.102. Export Drive: 1962-1971 Between 1962 and 1971.265.2 1. Vol.5) (1.332. b Refers to 1979.2 31.6 11.1 9.4 10. modernizing the industrial structure.2 452.2 757. Economic Statistics Yearbook.

resulting in high real interest rates. In 1964. Also. During the first five-year plan period. the Government tried to provide exporting firms with a free trade environment. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. The average growth rate of the economy from 1960 to 1964 was 5. However. 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. This change raised the import liberalization rate from 9. which laid a solid foundation for a steady growth path. but tariff rates were raised to 40 percent in the 1960s. imports of consumer goods and luxury items were highly restricted. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate.4 percent. and cheap labor force was well utilized by the export-led growth strategy. In 1971.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). Exports increased sharply from $41 million in 1961 to $2.5 percent. .3 percent to 60.2 billion in 1972. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. But the liberalization trend turned out to be short lived as current account deficits continued. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. up from 30 percent in the late 1950s. The exchange rate system was a kind of crawling peg until 1974. Bank deposits increased rapidly. During this period. due to continuous current account deficits. boosting internal investment resources. but the average growth rate for 1965-1969 shot up to 10 percent. In 1963-1964. and maximizing mobilization of domestic savings on the other. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. channeling funds from curb markets into the banking sector. while the average tariff rate was 39 percent. abundant. a modest improvement over the 4. The well-educated. the growth of gross domestic product (GDP) raised domestic savings. 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 import liberalization rate was 55 percent.

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

including forced liquidations and mergers and acquisitions (M&As). low . met increased difficulty. Macroeconomic policies became hostages of the industrial strategy. exacerbated the overcapacity problem. the Government restructured some large businesses through forced liquidation and M&As. coupled with political uncertainty due to the assassination of President Park in 1979. The incentives available became more market-based. including denationalization of banks. with many turning into the now well-known chaebols. and the large excess capacity of HCIs. especially between 1979 and 1985. The plan of the 1970s was thought to be successful in the long run. the Government adopted comprehensive measures to promote economic stabilization. fiscal expenditure maintained zero growth. Such an approach gave the Government increased control over the economy. Economic Liberalization and Globalization: 1980-1997 In 1979. In order to improve economic efficiency. imports were further liberalized while tariff rates were lowered. Firms that followed the Government expanded greatly. Evaluations of HCI promotion policies are mixed. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. such as widespread underutilization of capacities of HCIs and related plants. The growth rate of the money supply was reduced drastically. various measures to increase competition were taken.2). However.Chapter 2: Korea 59 through state-controlled banks. Cheap credit and distorted prices resulted in overexpansion in the HCIs. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. the policy wasted substantial amounts of resources in the short and medium terms. Meanwhile. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. This required industrial restructuring by the Government. In 1986-1989. however. The two important ones were import liberalization and deregulation of the financial sector. as it had to control only a few large chaebols. a heavy foreign debt burden. faced with high inflation. and their utilization ratios were very high. Meanwhile. New start-up firms. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. The severe world recession caused by the second oil shock. price controls were abolished.

II world interest rates. Meanwhile. which gradually widened. 46. The official rate fluctuated within a band. and total workforce.9 percent.9 percent. Korea adopted a market average exchange rate system. In 1988.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. and declaring that it would follow Article XI of GATT. and low oil prices.2 percent. .3 percent. 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. The Government tried to adjust economic policies and regulations to meet global standards. total debts. The most important element characterizing chaebols is the concentration of ownership. 47. The birth of chaebols can be traced to the selling of Japanese colonial properties that were reverted to the Korean Government after World 4 The historical review of chaebols draws substantially from the paper of Lee and Lee (1996). giving up its foreign exchange controls related to the current account. In 1993.2. the Government committed itself to further liberalization of the goods and capital markets. In 1990. 45.9 percent.1 percent. total assets. total sales. Korea began participating in many multilateral trade negotiations during the Uruguay Round. The low value of the dollar led to a low won and high yen. and acceded to the World Trade Organization (WTO) in 1994.” A large-scale business group is called a chaebol. Industrial and trade policies were modified to be consistent with WTO. 2. whose business activities are controlled by an identical person. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. the import liberalization ratio reached 98. 4. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. but it chose to liberalize gradually.1 percent and average tariff rates 8. Vol. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. with the 30 largest in the total economy in 1997 standing as follows: value-added.60 Corporate Governance and Finance in East Asia. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. further increasing its pace of import liberalization. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. 13. the importance of chaebols was increasing. while continuous and large current account surpluses saved Korea from the foreign debt problem.

after the financial crisis. This galvanized the fast growth of chaebols. financial assistance. reaching 669 in 1996. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. chaebols that maintained a close relationship with the political authorities were able to grow fast. From the standpoint of the Government. In the mid-1970s. the number of subsidiaries declined drastically due to corporate restructuring.8 22. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. and they are aided and supported by one another. and tax breaks to key industries to promote exports and industrial upgrading.Chapter 2: Korea 61 War II. In this sense. The Government provided subsidies. of Subsidiaries per Chaebol 20. However. One reason for this controlling power is inter-company shareholding among subsidiaries. 1993-1996 Year 1993 1994 1995 1996 No.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993.3 Subsidiaries of the 30 Largest Chaebols. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. Table 2.1 20. it was more effective to deal with a small number of companies to secure tangible outcomes.when the Government put a great deal of emphasis on development of the HCIs. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital.3 Source: The Fair Trade Commission. of Subsidiaries 604 616 623 669 Average No. . This policy contributed greatly to the expansion of chaebols. Chaebols have a history of substantial concentration of ownership. Chaebols are also excessively diversified. Important managerial decisions are made primarily by owners. the ownership and management of a chaebol’s subsidiaries are not separate. Since the Government controlled most business activities.5 20. Since the 1960s. Table 2.

This could ensure their stable growth and enhance their investment abilities. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. 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. Vol. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. Under this law. chaebols can benefit from synergies. in addition to the usual economies of scale. profitability. etc. II Theoretically. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. they can reduce uncertainties and dilute risks through sharing of information and diversification. For example. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. Since chaebols are engaged in many different businesses. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. Meanwhile. They had to meet certain requirements in terms of firm size. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. 2.2.62 Corporate Governance and Finance in East Asia. In the early years after the enactment of the law. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. The law also contained provisions to afford tax and other benefits to firms that went public and to impose tax-related penalties on those that refused to comply with government recommendations. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. 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.3 Role of the Capital Market and Foreign Capital In the 1960s. . diversification can make chaebols stable through the portfolio effect. which may ultimately lead to the decline of social efficiency. On the other hand. However. years since establishment. including the “economies of organizational size” inherent in multi-product and multiplant firms. there are many negative assessments of organizational structures and practices of chaebols.

Third. especially those paying small or no dividends. Beginning 1990. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. The policy to expand the size of the stock market. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. was established to invest in domestic shares beginning in September 1985.4.4 Development of the Stock Market.7 934. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. First.9 833. Because of government policies and the booming economy.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. In this regard. several important policy measures were implemented to promote the development of the stock market.5 406. the stock market grew rapidly during the 1980s.020 151.217 141.370 70.6 747.1 30.989 137. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997.151 117.476 79.0 49. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.9 34.0 965.2 44. Inc. a country fund.9 918.4 654. 1985-1998 No.1 Market Capitalization (W billion) 6. continued until 1989.798 Market Capitalization as a Ratio to GDP (%) 8. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.. 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.570 95. the Government announced the gradual opening of the capital market to foreign investors in January 1981. 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).4 40.Chapter 2: Korea 63 During the 1980s and 1990s. Also that year.0 79. The aggregate Table 2.1 16. Second. however. The Korea Fund. As shown in Table 2. .

Bank of Korea.500 7.183 12.413) 56.2 percent by 1989.785 (1. and stayed at the 30-40 percent level up to 1996.694) 2.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.440 1.910) 2.944) 8. II market value of all listed firms represented only 8 percent of GDP in 1985.255 2.326 1.571 2. but increased sharply to 79. The growth in the number of listed firms also slowed in the 1990s.553 8.737 (333) (297) (607) (2) 218 2. trade credits. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries. due to declining stock prices.352 471 3. and other liabilities.433) (9.546 (2.858 4. Source: Balance of Payments. but rose again to 34.085 2. Table 2. The relative size of the stock market diminished to 44 percent in 1990.924 (1.542) (1.455) 13. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis. 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 1986-1989.338 4.642 21.59 percent in 1998 and to more than 50 percent in the early months of 1999.953 10.817 16.868 (518) (418) 63 1. Other investments include loans.123 3.150 5.453 (2.017) 1.650 (1.382 Permit basis.64 Corporate Governance and Finance in East Asia. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2. and 1993. Vol.347 3. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.875 21. .008) (3. Table 2.239 19.149 13.800 (7.287 (340) 73.5 Private Capital Flows to Korea.870) (1.852) (2.264) (3.450 24.141 4.296) (6.714 1. The aggregate market value of listed shares bottomed at 16.126 (1.339) (9.86 percent of GDP in 1997.001 4. However.534) 1.742 (3. currency and deposits.414) 5.942) 42.583 25 10.658) (3.

The same categories will be analyzed in later sections. Of this.9 billion.2 percent in 1987. The growth rates of total assets. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. This indicates that a substantial proportion of debt was denominated in dollars. Corporate sector net proft margins increased from 1993 to 1995.6). increasing to 76 percent in 1997. excluding FDI.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. (ii) listed firms.7 billion and loans $42.5). and high production costs were the main reasons for low FDI in Korea. Profit rates of Korean firms were relatively low compared to those of Taipei. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. This would lay the foundation for evaluating the effect of corporate governance on performance. portfolio investments amounted to $73. Between 1986 and 1989. the growth rates of equity and sales dropped sharply in 1996 and 1997. but dropped in 1996 and were negative by 1997. weak incentives for attracting FDI. Japan’s was consistently higher. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. Table 2.China and the US. Taipei. and (iii) chaebols.2. In addition to FDI. 2. other net private capital inflows amounted to $130 billion during 1985-1998.6 percent in 1997. Net private capital inflow. following the sharp depreciation of the won. Return on equity (ROE) and return on assets (ROA) showed similar patterns. and sales of the aggregate sector during this period were very high (Table 2. The contribution of the corporate sector to GDP was 73. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. However. Korea had substantial current account surpluses and experienced net private capital outflow. The dismal performance of the Korean corporate sector compared to the . The ratio is generally in the same range for Japan and Korea. but between 1988 and 1993. equity.Chapter 2: Korea 65 Complicated government regulations.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. and US.China.

8 3.7 3.2 13. Note: Ratio of ordinary income to sales = (ordinary income/sales). .8 1.5 0.6 318. Financial Statement Analysis Yearbook.9 2.9 3.8 8.5 4.0 6.2) (0.5 4.1 5.3 308.9) DER = debt-to-equity ratio.1 2.7 4.6 424.0 305.5 2.7 1.2 13.7 325.7 15.3 3.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.6 2.6 4.0 4.4 4. Source: Bank of Korea.5 1.6 13.2 1.7 15.4 — 6.3 21.9 2.6 9.3 312.3) 5.7 3.5 3.9 5.2 18.6 1.2 1.9 4.3 6.9 5.0 8.9 13.7 4.4 1.9 8.5 1.4 2.2 1.1 2.9 5.4 1.9 2.9 16.4 1.0 13.5 (0.3 335. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities). Financial Statement Analysis Yearbook.1 2.3 21.3 1.8 1.0 7.9 3.4 19.4 2.1 8.7 4.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.2 19.1 — — — = not available.Table 2. ROA = return on assets (ratio of net income to total assets).6 3.5 7.8) 297.9 16.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.7 2.5 1.3 14.0 (0.8 21.2 9.0 10.0 13.4 2.3 — 3.6 1. ROE = return on equity (ratio of net income to stockholders’ equity).3 17.3 11. 1990-1997 (percent) Growth Performance Year Total Assets Equity Sales Financial Performance Net Profit Margin DER ROE ROA 1990 1991 1992 1993 1994 1995 1996 1997 23.9 18. Source: Bank of Korea.4 10.0 0. Net profit margin = ratio of net income to sales.8 2.6 (4.0 3. Table 2.8 22.9 18.1 6.

Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. this may be an indication of the bias toward large firms in terms of access to credit. ROEs. . construction.9). sales of listed firms grew 18. The other financial ratios follow the general pattern of the aggregate corporate sector. with the wholesale and retail trade sector and the construction sector having the highest figures.5 percent while the aggregate sector recorded only 13.10). Net profit margins. Profit rates of most industries are also quite low. The growth performance of large firms for the 1988-1997 period was better than that of medium. However. trade.4 percent. the exception being the electricity. It is notable that the construction sector’s profit rate began its decline in 1995.6). Small listed firms were hardest hit by the financial crisis. 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. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. gas. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. while their average net profit margin was lower than that of medium firms. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. In most years. This may be related to its having the lowest DER. A comparison of performance by firm size reveals some interesting results. both ROA and ROE were lower for the listed firms compared to the latter.and small-scale firms (Table 2. The manufacturing. However. and transport sectors recorded negative profit rates in 1997. In 1997. All sectors experienced a sharp decline in equity and sales growth in 1997. This preference of Korean firms has its roots in the structure of corporate governance.8). followed by mediumsized firms and large ones. a year ahead of the other industries. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. Performance followed similar patterns across different industries (Table 2. Growth rates of total assets are generally high. the average ROE was lowest for large firms. Again. but higher than that of small firms.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. and steam supply industry. with equity in wholesale and retail trade even contracting.

2 315.1) (3.8 12.1 10.4 .7 317.8 616.9 25.6 16.8 562.3 31.4 9.5 6.3 11.1 16.0 (0.5 1.8 10.9 0.5 5.5 1.8 22.9 (0.0 1.5 3.2 0.5 1.1 396.4 740.0 1.0 5.7 1.2 15.3 15.1 0.1 1.2 0.5 28.2 20.1 2.1 22.6 14.4 10.5 14.9 2. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.9 9.8 1.8 17.1 28.4 2.8 3.7 16.6 6.7 10.4 3.4 14.3 25.9 16.9 10.2 16.8 2.6 12.3 11.8 Growth and Financial Performance of Selected Industries (percent) Growth Performance Year Assets Equity a Financial Performance NPM b Sales DER ROE ROA Manufacturing 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 13.7 228.6 3.0 18.2 423.0) 1.6 5.7 22.0 3.8 23.5 1.4 5.6 3.7 5.8 0.8 10.2 5.5 19.2 241.7 294.4 1.1 0.8 16.1 27.8 2.0 18.8 1.9) 1.9 1.6 15.2) 15.9 2.3 8.5 27.0 24.2) 22.0 1.6 1.8 302.0 15.1 2.7 7.8 22.8 34.1) 0.2) 6.5 30.0 9.7 0.4 2.6 375.9 3. Renting.0 22.1 296.8 12.0 2.3 2.4 1.6 0.5 4.3 8.9 538.8 526.8 461.3 8.2 5.4 17.5 286.3 14.9 16.1 20.1 290.2 12.3 15.7 17.8 3.2 20.4 (0.0 2.0) 4.5 (1.6 17.0 1.0 37.2) (0.5 5.1 1.4) 0.5 1.5 239.5 306.1 0.0 2.5 6.3 10.8 32.1 (0.0 22.0 (4.1 1.4 5.4 10.3 1.8 13.4 2.7 9.8 14.0 1.2 36.8 16.7 21.9 (0.6 7.6 318.3 15.3 1.1 1.4 0.8 24.7) 2.0 254.7 520.9 13.6 14.0 15.8 16.0 16.6 1.4 10.5 432.Table 2.2 7.5 473.0) 0.5 (0.4 15.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.2 6.0 245.5 23.9 (0.4 474.4 348.5) 0.7 514.1) 3.4 2.6) 3.0 22.3 18.3 14.9 5.2 18.4 458.4 2.4 12.2 5.5 338.3 13.6 2.9 428.8 345.0 (0.4 291.6 14.2 6.8 24.4 4.1 17.3 285.0) 0.7 4.5 270.0 16.0 1.0 1.9 340.2 2.7 (0.7 30.0 5.0 24.9 19.8) 0.3 10.3 288.3 8.1 (0.2 0.8 2.2 24.3 15.9 29.5 16.8 Real Estate.6 0.4 5.3 2.8 35.4 10.7 (3.6 12.0 21.6 17.0 7.0 2.3) (1.9 14.0 19.0 23.8 7.6) (6.5 569.9 16.5 483.6 655.5 1.6 11.5 (5.6 24.8 0.0 12.1 21.4 0.9 31.5 13.2 25.2 16.2 (1.9 10.8 14.4 350.1 7.

1 3.7 16.7 11.5 462.6 172.0 89.6 19.7 — = not available.6 8.4 12.6 16.2 3.9 (10.3 1.4 9. Source: Calculated using data from Bank of Korea.7 2.3 18. .9 Electricity.9 8.5 30.9 12.2) 9.8 15.0) 1.8 6.2 — — — — — 2.6 14.3 17.0) 1.6 3.5 14.5 14.8 12.1) (0.3 8.2 1.7 187. Gas.7 14.1 6.4 7.7 116.2 10.8) (12.7 510.0 921.5 117.6 15.0 2.4 2.4 14.Table 2.9 (11.6 6.5 612.7 15.1 11.1) 1.8 14.6 12.3 12.5) 22.9 9.5 344.3 (2.4 7.6 20.0 5.6 (2. a New equity does not include capital surplus.7 7.6 1.4 10.5 539.8 0.1 15.5 11.4 13. Financial Statement Analysis Yearbooks.0 98.4 (0.4 16.1 11.8 3.8 4.2 18.2 10.8 9.7 12.5 16.6 9.5 (2.5 14.5 26.0 (1.3 4.3 8.9 7.3 19. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.7 7.8 529.0 106.1 (11.6 18.9 17.9 3.0 13.2 122.4 0.5 2.3) 11.2 90.5 12.1 15.3 1.7 2.2 143.6 6.4 633.8 0.7 20.0 14.6 6. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.4 0.1 12.8 3.2 18.7 11.4 21.0 21.8 (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 4.3 23.0) (0.5 13.4 3.8 12.6 8.3) 15.5 15.2) 13.6 4.2 7.9 456.7 0.4 (2.4 169.5 0.4 1.4 367.9 8.4) (1.1 8.1 2.4 30.4 6.6 9.2 2.2 15.3 0.6 1.3 125.1 14.3 34.1 21.7 19.5 307.3 4.9 18.6 2.4 2.9 332.1 4.0 1.6 — — — — — 0.9 10.6 — — — — — 17.5 14.1) (0.4 0.9 1.2 14.1 17.5 4.6 8.9 12.4 3.2) 0.0 2.1 323.0 Transport.3 3.9) (8.1 1.9 9. Storage.8) 1.2 698.4 1.3 740.1 15.3 18.3 4.2 10.9 10.0 1.1 (0.6 4.9 6.9 321.7) 0.3 2.3) 4.6 0.3 524.1) 5.0 5.6 12.4 1.2 18.6 9.9 17.3) (1.3 — — — — — 10.0 7.8 111.3 9.7) (4.4 15.4 — — — — — 448.8 14.8 11.8 6.4 3.0 14.2 11.3 112.3 0.0 (15.9 4.6 (2.1 (2.7 11.4 12.6 34.9 18.5 11. b NPM denotes net profit margin.6 19.7 — — — — — 14.7 0.0 1.4 6.5 15.6 512.4 11.4 341.062.5 47.8 7.8 8.1 16.5 8.5 482.3 543.6 21.2 14.

1998.4 2.6 and 2.6 0.5 19.6 22.70 Corporate Governance and Finance in East Asia.9 26.1 1.9 21.3 4. The criteria for selection of largest chaebols have changed a few times. it is the chaebols’ large firms that are listed.6 2.12). II Table 2.1) 4. Kis-Fas. Between 1993 and 1997.8 24. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.2 9. Generally.6 3.2 0.11).3 15.2 2.7 (5.1 percent of the economy’s total value added (excluding the financial sector). 1985-1997 (percent.9 6.9 11. In 1995.7 1.6 23.3 percent).2 6.5 ROA 0.9 2.8 0.4 1.8 5.12).1 1. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.0 3.4 1.9 Growth and Financial Performance of Listed Companies. and close to half of total assets (46.7 percent) of the corporate sector.6 1.4 0.4 22. of which 16 were publicly listed (Table 2.3 (0. Performance of Chaebols This section uses available data on the top 30 chaebols.7 Net Profit Margin 0. Chaebols have been the most important actors and engines of growth in the Korean economy. but the number of designated groups has been fixed at 30 since 1993. of which four were listed.3 0. It should also be noted that when the financial crisis struck in 1997.3 2.1 6. and net profits (46.5 19.6 (1.8 6.9 0.9 percent). Hyundai Group.0 18.7 1.4) 1.9 percent). In 1997. the top 11-30 chaebols experienced a decline of . debts (47.5 ROE 3. the largest chaebol.3 20. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.0 0. The number of Hyundai member companies rose to 57 in 1997. The smallest group had 16 members in 1995.5 0. sales (45.9 Source: Constructed using data from Korea Investors Service.7) 0.4 1. Vol.2 9. The top five chaebols registered the highest growth rates. followed by the top 6-10 (Table 2.5 5.9 1.9 2. had 46 member companies. the 30 largest chaebols accounted for 13.

9 (0.7 (1.6 (0.9 6.8 0.8 0.8 0.4 2.6 5.0 1.5 5.3 (0.5 2.2 13.7 1.9 0.0 16.9 3.0) 1. .7 3.9 2.8 6.6 0.9) (6.6 2.10 Growth and Financial Performance of Listed Companies by Size. 1998.3 9.0) 0.5 5.2 Small 13.4 16.1) 5.5 17.4 Medium Small Large Medium Small ROA Growth Performance Large 17.0 1.6 1.2 (0.5) 1. Others are medium firms.6 6.8 6.2 3.6 2.3 11.1 2.2) (1.8 0.3 1.6 2.3) 5.2 13.2) 0.9 14.7 4.4 3.9 22.3 15.6 1.7 18.7 (0.6 0.8 10.5) 1.8 16.1 11.1 8.6 9.0 4.9 2.4 1.4) 1. Kis-Fas.6 13.5 0.4 6.5 3.6 7.9 25. 1988-1997 (percent) ROE Large 9.2 1.8) 6.0 19.6 8.8 17.0 (4.2) (1.9 6.0 17.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.7 (1.4 11.0 15.5 25.0 1.8) 1.8 1.3 3.3 6.9 0.4 1.Table 2.2 12. Source: Korea Investors Service.9 0.2 10.1 0.5 (1.0 10.0 6.1 1.8 7.8 3.2 2.3) 0.6 (1.8 (5.6 1.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.5 1.2 7.3 (0.1 2.2 0.2 2.7 2.6 3.4 3.6 3.0 1.9 1.9 1.9 5.6) 0.7 2.4 5.3 Medium 14.3 15.9 2.

929 12.395 31.457 14.309 14.967 7.996 1.117 4.303 3.180 2.995 2.158 1.501 13.090 6.364 5.445 4.246 11.597 351.287 10.131 3.574 3.690 3.798 — No.158 7.370 6.853 1997 53.910 3. 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.129 2. Source: Fair Trade Commission.743 40.Table 2.924 2.346 3.475 2.11 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 43.376 35.956 3.486 6.756 5.177 — 6.927 16.873 2.990 2. of Listed Companies 1995 16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4 — = not available.433 3.427 9.398 — 2.951 3.761 31.640 4.458 6.766 3.651 38.935 2.677 3.313 14.774 7.455 22.147 5. .423 5.599 — 2.

8 0.7 1.5 19.5 27.3 9.2) (0.6 4.2) (2.5 32.4 12.Table 2.3 14.7) ROE 5.6 18.1) 0.3 11.2 (5.8 Assets 12.4) 1.2 0.3 1.7 15.1 2.1 27.5) (0.2 (2.4 0.7 4.9 17.2 11.4 (2.8 27.0 2.3 0.8 18.2 1.9 1.9 3. .2 20.2 3.7 10.9 20.3 1.0) 12.6 (0.0 2.6 25.3 16.5) (0.7) Source: Bank of Korea.3) 0.7 0.9 24.1 (3.7 10.2) 1.4 26.12 Growth and Financial Performance of the 30 Largest Chaebols.1 10.0) ROA 1.3 0.1) (0.6 Financial Performance Net Profit Margin 1.0 2.2 0.1) 0.7 13.3 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 12.3 3.7 15.6 1.4 30.6 19.0 0.4 38.2 (16.0 0.1 19.2 (2.1 (2.0 31.5 20.9 20.4) (14.5 (0.0) 3.9 18.1) (1.3 27.9 3.1) (0.5 2.5 5.3 15.1 (1.2 0.0 6.5) (0.0 19.4) (0.0 1.0 17.

more important. However. 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. Vol. Only the top five chaebols registered a positive net profit margin in 1997.95 percent. II 2 percent in their sales and a very low 4.” This “identical person.7 percent growth in total assets. the average DER of the 30 largest chaebols reached 519 percent. However. By the end of 1997.3. 5 While “ownership concentration” can be defined and measured differently in different contexts. and led to a high concentration of ownership. except for 1995. from 190 to 3.13). resulted in the chaebols’ excessive leverage. The Commercial Code stipulates the basic governance framework and applies to all corporations. There has been a wide range in DER among chaebols.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. 2. In general. in this instance.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. chaebols had a higher average DER than the corporate sector as a whole. includes the largest shareholder.765 percent (Table 2. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. . The better showing of the top five chaebols was a direct result of their dominance in human resources. his/her relatives. weak corporate control. Ownership patterns. internal and external control mechanisms. loopholes and inconsistent policies spawned strategic behavior and agency problems. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. coupled with weak corporate governance. it refers to the degree of concentration and shareholdings in the hands of an “identical person. and access to credit. a pyramidal structure of corporate ownership is prevalent. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. and government intervention interacted through a set of laws and regulations to bring about the existing structure. 2. technology.74 Corporate Governance and Finance in East Asia.” in Korea’s legal and regulatory framework. The absence of a well-developed equity market and the provision of subsidized credit. and the companies that are under the control of the largest shareholder. and vulnerable balance sheets.5 Founding families are mostly still the largest shareholders and. Their worst year was 1997 when ROE hit -15.

7 354.2 292. Hanwha 10. Hyundai 2.4 622.0 486.3 297. Halla 17.1 477. Kolon 21.2 346. Kumho 12. Kumho 12.8 313. LG 4.2 924. Kohap 25. Dongah 14.2 471.3 572.1 190.3 328. Daewoo 5.1 3. Doosan 13. Kukdong Construction 29.7 416. Byucksan 1996 1. Ssangyong 7.6 .8 336. Dongbu 24.7 267.7 620.9 321. Hanjin 8. Dongkuk Steel 19.2 328. Hanwha 10.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.8 312. Hanbo 15. Dongah Construction 16.4 556.4 192. Jinro Debt-to-Equity Ratio 376. Daelim 16. Samsung 3. Ssangyong 7.0 436. Dongkuk Steel 19.244.1 278.0 506.5 343. Sunkyung 6. Hyosung 18. Sunkyung 6. Hanjin 8.764. Hansol 23. Tongyang 22. Doosan 15.6 936.3 315.7 688. LG 4.4 175.Table 2.6 409. Sammi 27. Hanil 28.6 516. 1995-1997 (percent) Chaebols 1995 1. Kia 9.5 337.7 621.4 205.0 218. Hyundai 2.2 423.5 464. Lotte 11.855.5 3.1 385. Haitai 26. Hyosung 18.5 2.065.6 2. Halla 13. Kia 9.9 751. Daewoo 5.441. Samsung 3.0 370. Lotte 11. Jinro 20. Hansol 17.1 674. Daelim 14.2 2. Newcore 30.5 383.

Doosan 15. Dongbu 23. Samsung 3. Hansol 16.6 424. Hanjin 7.5 386.8 647. Keopyong 29. Halla 13.8 590.5 (893. Daelim 14.1 375.1 438.4) 513.501. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Keopyong 29.0 305. Kohab 18.0 419. Kolon 19.5 323. . Jinro 23.8 658. Financial Statement Analysis Yearbook.13 (Cont’d) Chaebols 20.7 944.0 505.6 Sources: aFair Trade Commission. Tongyang 24.214.3 399. Kolon 21.1 433. Hyosung 17.5 576. Anam 22. Newcore 28. LG 5.8 399. bBank of Korea.8 307.225.4 1. Daewoo 4.9 216.3 1.7 1.784.5 (1. Kamgwon Industrial 30.8 468.5 1.9 1. Newcore 26.9 578. SK 6. Ssangyong 8. Daesang 27.3 347.6 478. Haitai 25.3 676. Kumho 10. Miwon 30.8 347.9 472.1 472.600.6 590. Shinho 1997 1.8 338. Tongyang 24. Hanil 28. Hyundai 2.9 465.6 416.Table 2. Anam 27. Hanwha 9.9 490.7 370.5 261. Dongah 11. Haitai 25.5) 404. Lotte 12.0 907.498. Dongbu 21. Shinho 26. Kohab 22. Dongkuk Steel 20.1 359.5 519.6 335.

14). However. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. From 69. and insurance companies increased during the period. fluctuated widely during the period. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. and state-owned companies and securities companies declined.” foreigners. the percentage of holdings by individuals slipped to 60. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. the year the stock market was in a frenzy due to buying sprees. that is.e. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. the extent of ownership by these individuals declined gradually after 1988.7 percent by 1997..Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. Beyond that range.” followed by banks. the entrenchment effect outweighs the incentive effect. including banks and other financial firms. Among listed nonfinancial companies. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. The percentage of shares owned by “other corporations.1 percent. including investment trust companies. Composition of Ownership Among listed companies. resorting to extensive use of pyramiding to maintain control. managerial entrenchment becomes more likely. The reduction can be . the Government. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. individuals were also the largest shareholder group. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. the incentive effect once again dominates. The next important group was “other corporations. i. but their shares declined to 21. Theoretically. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. the ownership structure can bring about an incentive effect. Thus. with a given range of managerial shareholdings (for instance. 10 to 30 percent). and then steadily declined after 1993. The pattern of distribution changed little through 1992-1997. large ownership can also bring about the entrenchment effect. while those owned by banks. However.6 percent by 1997. The holdings of financial institutions.

4 Insurance Firms Other Corporations Foreigners Individuals 39.0 5.7 6.7 14.6 22. merchant banks.1 2.6 Year No. c Data from Korea Stock Exchange.0 27. .5 4.8 59.6 19.5 60.9 17.6 9.4 13.5 1989 498 0.2 7.0 5.4 34.4 18.3 1996 570 2.9 2.1 11.7 59.3 17.1 60. etc.2 1.6 16. b “Banks.6 20.3 5.2 8.7 4.3 17.2 B. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.9 26.5 12.8 5.4 5.9 1.8 17.9 1.2 5.1 1.5 18.6 9.9 5.2 3.4 5.1 3.0 9.0 7.6 13. Listed Nonfinancial Companiesd 1988 406 0.6 2.3 1.6 12.8 2.” includes commercial banks.9 15.9 2.2 9.0 4.2 4.2 17.7 3.6 1991 505 0.5 7.9 36.4 13.2 9.5 16.1 18.2 5.9 4.4 6.3 18.3 18.8 5.3 26.8 2.2 1993 511 2.Table 2.1 4.3 1.7 9.1 10.8 1995 548 2.0 8.7 9.2 8.5 Note: Ownership is based on number of shares.3 5. d Constructed from data files of the Korea Listed Companies Association.5 1.b A.3 39.9 19.7 8.5 1.1 21.0 28.5 7.14 Ownership Composition of Listed Companies. mutual savings.0 60.1 21.8 17.9 37.5 1992 508 2.6 16.3 2.1 18.6 36.6 8. of Firms The Statea Banks.5 6.4 14.8 4.8 69. and finance companies. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.7 1990 531 0.7 7.2 2.7 18.3 8. investment trust companies.6 16. a The State covers the Government and state-owned companies.5 6.4 1997 551 1.1 17.0 59.5 62. etc.2 18.1 68.8 59.1 8.1 8.3 1994 521 1.

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

Paper.0 — 39.5 0.9 52.0 7.3 1. and Printing Pulp.5 4.7 64.0 9.1 0.2 1.0 9.4 0.1 10.7 63.5 6. Paper.2 9.2 9.9 59.7 1.5 7.2 1.8 3.0 9.3 7.3 57.8 7. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.6 11.4 8.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.3 0.3 1. Etc.0 2.4 56.7 22.6 18.Table 2.4 56. and Printing Chemicals.5 — — 0.7 17.3 6.2 2.5 3.4 2.5 17.7 2.8 Individuals 83.9 0.1 0.6 3.7 20.9 1.2 0.8 8.8 7.2 — 0.9 10. Rubber.0 0.8 7..6 5.7 22.4 7.4 5.7 2.2 17.3 4.2 64.8 5.1 27.9 8.7 20.3 11.2 22.5 85. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.5 0.0 8.4 1.6 — — 2.1 8.9 55.3 62.2 54.9 42.5 — 0.4 Banks.2 7.8 3.3 0.9 23.4 8.8 7.5 19.4 1.2 9.1 4.1 8.8 6.1 88.5 0.5 0.9 16.4 14.7 14.7 6.3 2.3 13.0 9.9 66.1 0.4 62.2 0.0 1.1 19.7 14.6 8.4 — 0.9 60. and App.1 65.8 73.6 1.3 38.6 24. Gas. 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 .4 8.1 1.7 2.5 12.9 1.2 — — 0.3 9.9 4.3 10.1 0.9 19.5 — 1. Motor Vehicles Electricity.0 20.7 29.9 15.8 7.3 0.15 Ownership Composition of Listed Nonfinancial Firms by Industry.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.8 1.0 — 0. Elecl Mach.2 0.3 2.0 10.7 59.1 7.2 0.

mutual savings.0 11.1 — 0.7 17.8 2.0 7.5 63.9 2.7 2.4 2. and App.5 6.4 4. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics. etc.6 6.5 7.3 57.5 59.4 1.6 1.8 12.4 58.8 54.0 3.2 4.1 1.3 6. investment trust companies.6 5.3 65.9 18.8 5.9 1.4 68.1 2.9 0.8 2.9 6.3 0.3 31.6 59.7 5.8 4.3 60.0 43.8 0.5 3.6 20.4 2.9 6.6 60.3 6.6 14.3 1.1 2.5 4.6 3.2 13.0 1.9 20.9 5.1 18.2 49.” includes commercial banks. 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 27.1 6.7 4.0 8.8 2.2 3.1 3.2 5.6 0.8 5.9 5.3 15.9 57.2 4.4 1.1 — 1.6 2.4 43.5 5.1 54.2 5.3 8.5 4. b “Banks.9 69.4 3.9 2.3 2.9 1.7 19.0 6.6 — = not available.2 6. Gas.7 2.6 7.4 45.9 7.2 23.1 9.1 4.6 2.7 1.9 2.0 5.0 6.8 11. and finance companies. Note: Ownership is based on number of shares.4 0.4 20.9 1.4 6. merchant banks.6 18. and Printing Pulp.7 23.4 2.4 9.2 1.9 7.4 — 1. Rubber. Paper. Motor Vehicles Electricity.2 0.78 81. Source: Constructed from data files of the Korea Listed Companies Association.3 7.1 9.2 7.5 12.5 3.7 2.9 2.4 16.2 1. Elecl Mach.2 4.8 57.7 2.4 76.7 6.6 75.0 60.3 1.2 4.8 6.0 4.1 25.1 1.5 3. a The State covers the government and state-owned companies.8 3.2 0.9 78.2 8.6 0.4 1.4 58. Paper.4 4.6 2.1 3.6 6.8 0.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.5 0. .5 3.9 20.5 — 2.5 1. and Printing Chemicals.

5 6. and finance companies.8 1. The State covers the government and state-owned companies. 1997 (percent) The State 1.4 61. c “Banks. 1997 (percent) The Stateb Foreigners 4. etc.8 2.c Securities Firms Insurance Firms Other Corporations Individuals 58.4 21.” includes commercial banks.4 1. .4 5.8 4.1 6.0 1.1 2. investment trust companies.7 8.1 Banks.9 2.8 3.4 2.7 0. mutual savings.4 61. b Table 2.9 5.16 Ownership Composition of Listed Nonfinancial Firms by Size. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.0 Other Corporations 16. etc.4 17. of Firms Large Medium Small Total 211 208 80 499 a Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.5 16.Table 2.1 8.7 Control Type No.4 4.4 Firm Sizea No.8 4.9 4.5 18.5 4.3 Banks. Source: Constructed from data files of the Korea Listed Companies Association.8 6.7 6.4 5.5 19.4 2.2 1.0 6.6 16.5 2. etc.5 Individuals 60.7 1. merchant banks.5 8.6 60.7 Foreigners 4. Securities Firms Insurance Firms 2.7 4. Others are medium firms.5 62.8 60.3 6.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.

1 8. 1997 (percent) Country Japan Korea Taipei.China United Kingdom United States Source: Stock Exchange of Korea.5 45.20).8 56. investors (Table 2. Institutional Investors 42. and the companies under the control of the largest shareholder. Foreign holdings of Korean shares were 9.1 financial institutions’ establishment of corporate pension fund accounts. minority shareholders. At the moment.4 26. But these may .6 Individuals 23. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. This has had profound implications for corporate governance and the market for corporate control in Korea. the majority shareholder group in all listed companies consists of the corporate.6 39.7 16. corporations held 70 percent of the controlling blocks of shares.3 47.19).3 6. 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. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. In 1997. for example. while family members accounted for only 30 percent. only closed-end investment companies and traditional investment trust companies are allowed.5 20. Generally. rather than the individual.Chapter 2: Korea 83 Table 2.8 10.18 Ownership Composition of Listed Firms in Selected Countries.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.6 Foreigners 9. including those of the largest shareholder. his/her family members. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.3 54.8 9. Among nonfinancial listed firms. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. defined as those holding less than 1 percent of shares.

7 6.6 22.9 Individual 2. .1 37.9 2.6 73.0 1.4 7.19 Ownership Concentration of All Listed Firms.0 25.1 5.6 46.9 7.5 43. and the companies under the control of the largest shareholder.0 69.1 21.8 73.7 7.0 4.6 2.2 Minority Shareholders Subtotal 71. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.7 18.2 2.1 32. his/her family members.8 8.6 26.7 Note: The majority shareholder includes the largest shareholder.1 4.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.3 Subtotal 5.0 22.8 72.3 30.3 2.7 44.4 5. Minority shareholders are those holding less than 1 percent of shares.1 15.9 6.Table 2.2 2.7 16.1 28.1 23.6 5.0 2.9 3.0 66.2 26.1 14.0 29.4 3. Source: Stock Exchange of Korea.9 33. 1992-1997 (percent) Majority Shareholders Corporation 15.1 5.3 18.8 Individual Subtotal Other Shareholders Corporation 3.9 32.

Chapter 2: Korea 85 Table 2. the Government has retained a large number of shares. thereafter.5 60.6 58. ownership was relatively diffused due to government regulation.8 12.20 Ownership Concentration of Listed Nonfinancial Firms. rubber and plastics. It was highest in medium-sized firms before 1993 and.5 13. 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. Across industry.9 48.9 12.8 28. Majority ownership is also high in the chemicals.7 18.4 28. In most industries.8 57. Meanwhile. The practice of hidden shares seems to have been less prevalent in recent years.3 25.9 27.21]).8 54.1 50.8 25.22). 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. Ownership concentration tended to be lower in large compared to medium and small listed firms.9 29.0 22. the majority owner held more than 20 percent of an average firm. and mining categories. . In such cases.9 25.2 15. which held less than 1 percent of a company’s outstanding shares as of 1997.6 57. minority shareholders. 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 2.9 Other Shareholders 18.0 20.8 Majority Shareholders 27. in the small firms. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.5 12. Besides.5 23. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.3 62.0 58. In telecommunications. hiding shares offers no additional tax or other benefits.6 11.4 23.4 Source: Constructed from data files of the Korea Listed Companies Association. collectively owned less than 50 percent of an average firm.

6 53.0 54.4 53. and Printing Pulp.0 21.1 19.8 51. and Plastics Basic Metal Fabricated Metal and Machinery Electronics. Motor Vehicles Electricity.2 37.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.7 27.4 16.5 41.2 46.7 36.2 48. Paper.9 44.9 10. and Printing Chemicals.2 22. .8 21. Paper.0 51.2 20. 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. Rubber.7 17.6 19.8 55.8 44.5 52.8 41. Gas.1 17..8 24.5 20.6 50.2 19.7 26.7 21.8 25.0 30.7 24.0 39.6 34.2 23.5 19.4 11.3 19.5 47.7 29.6 25.5 21.8 29.9 Minority Shareholders Majority Shareholders Other Shareholders 12.2 34. Elecl Mach. and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total Source: Constructed from data files of Korea Listed Companies Association.6 38.3 39.5 16.Table 2.1 43.5 23.2 26.5 44. and App.8 31.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.3 26.1 49.9 26.

8 52.2 32.9 17.6 24.6 62.1 15.5 19.6 11.5 21.3 26.7 14.3 27.7 28.9 26.0 26.1 16.5 28.9 23.5 19.3 55.4 30.5 51.Table 2.9 55.2 Majority Shareholders 26.2 Source: Korea Listed Companies Association.8 11.7 16.9 56.0 59.4 47.8 52.2 21.1 20.2 12.2 26.5 49.6 15.0 55.0 66.2 55.9 53.6 65.5 10.0 24.4 29.8 50.6 59.5 12.1 58.9 21.2 11.4 21.6 31.8 28.8 17.3 25. .7 57.4 30.5 26.8 62.7 22.2 52.9 22.1 27.2 21.8 56.6 27.7 57.7 31.2 18. 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 53.9 28.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.7 17.4 51.3 21.2 50.8 27.9 16.1 48.3 19.7 15. 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.5 33.4 30.2 21.9 60.5 27.2 56.9 12.5 Other Shareholders 19.6 55.5 12.

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

59 parent companies collectively had investments in 759 firms. In the case of the 30 largest chaebols. For the same year. standalone setups. the top five shareholders consisted of 2. Among the subsidiaries or firms receiving investments. Until recently. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally.5 percent as of 1997. In Table 2. or an average of 13 firms per company. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. or about five subsidiaries each.5 percent.9 percent of shares. Of the 81 respondents. Among the 81 listed firms in the ADB survey. Partial results are shown in Table 2.14. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. In many instances. If we define the internal shareholdings of a . financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. the top 30 chaebols’ shareholding by subsidiaries was 34. 59 were parent firms with one or more subsidiaries.4 corporations. although they are likely to be insignificant. For the whole sample. 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. Thus. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. The extent of pyramiding can be seen in some of the previous tables. the average shareholding of the controlling owners and their families was 8. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. 53 percent were domestic nonfinancial firms.Chapter 2: Korea 89 guarantees from other members of the group at no cost. 34 percent were foreign companies. Among chaebol affiliated firms. and 319 foreign subsidiaries. 62 percent (16 out of 26) had a corporation as the largest shareholder.5 percent of shares. together having a total of 292 domestic subsidiaries. not individuals. together owning an average of 38. there are instances of direct cross-shareholding in Korean firms. for example. and about 11 percent were domestic financial institutions. or about four firms each.5 corporations and two individuals. together owning an average of 37. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms.23. Thus. The fact that corporations. Twenty-two of the 81 respondents were independent.

9 29. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.5 24.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.5 4.4 11.0 3.8 18. A few companies reported less than five largest shareholders.5 2.5 2.7 37.8 8.6 3.1 22.9 5.0 1.4 42.4 18.4 25.6 34.0 3.2 25.5 31.9 34.0 17.4 1.6 3.0 1.8 31.9 21.0 21.5 2.1 1.Table 2.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.5 4.3 26.2 37.7 39.1 3.8 38.0 2.5 18.8 37.5 38.4 38.4 21. .6 3.5 1.7 5.0 13.7 0. a Number of shareholders.7 19.6 16.5 2. 1999 Five Largest Shareholders No.4 2.3 12. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.

1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. Chung and H.2 12. Jae Woo.6 33.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group.5 percent and member companies. New York: Praeger.2 1994 42.” Paper presented at the Annual Conference of Financial Management Association.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. 15 October 1998. As of 1997. edited by K. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.5 34. Table 2. Lee.7 9. 6 7 Hattori. 1998. C.4 10.4 1990 45. The family and member companies’ shareholdings have been declining over time. the ownership patterns can be described as follows. H. Based on these studies. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols.5 percent.0 8. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. the controlling families owned 8.2 15. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. Table 2. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held. 79-95. 1987 56. Lee. 1997.4 13.24 Internal Shareholdings of the 30 Largest Chaebols. . pp.8 33. it appears that the chaebol families have had a strong desire to expand their business bases.” In Korean Managerial Dynamics.24 shows the average internal shareholdings in the 30 largest chaebols. 1989.4 1993 43. Chicago.2 33. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.1 1997 43.5 Judging from the historical record. Hattori (1989) identified three patterns based on data in the early 1980s.7 31. Tamio. “Japanese Zaibatsu and Korean Chaebols.7 1992 46. 34.8 40. 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. Ungki Lim.

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

One condition requires that the DER of the holding company should not exceed 100 percent. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. This was the reason why chaebols chose to employ pyramidal structures. Until the end of 1998. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. The prohibition of holding companies was also abolished in 1999. following the amendment of the law. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. It remains to be seen whether they will adopt the holding company structure in the future. Also. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. They hindered early exits (liquidation. Existing guarantees had to be resolved by March 2000.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 first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. These amendments prohibited holding companies and direct cross-shareholding. bankruptcy reorganization. This limit was also applicable to banks and insurance companies. Initially. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. thus hurting the shareholders of stronger firms. and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets. the Fair Trade Act). A third disallows multiple layering of holding companies. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. 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. However. The Government is also considering whether to allow consolidated taxation for pure holding companies. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. 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. At this early stage. . only operating holding companies were allowed to be established.

planned for capital raising and allocation on a groupwide basis. boards of directors.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. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. These offices were legally informal and functioned as the headquarters of chaebols. The 30 largest chaebols are now required to publish “combined” financial statements. Despite chaebols’ decision to dismantle the chairman’s offices. usually in the rank of a company president. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. until urgent restructuring is complete. Some chaebols have disintegrated or shrunk in size. and transferred funds generated by one firm to another. 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.) 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. In 1998.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. The staff of these organizations were employees of member firms. Vol. II etc. and the capital market was almost nonexistent until the recent reform . It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents.94 Corporate Governance and Finance in East Asia. The chairman’s office had its own chief executive officer. there have been no significant changes.3. which put together the accounts of all members of a chaebol. Since the economic crisis. 2. Chaebols maintain that the restructuring headquarters will exist only for a limited period. Their operating costs were borne by the member companies rather than by the controlling shareholder. The office established strategies for the group as a whole. who is universally called the “group chairman.

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

the attendance rate of outside directors. . In the 1999 annual shareholders meetings. they were virtually under the full control of the CEOs and in practice functioned only as management councils without any decision-making power—at least until 1998. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. However. all of whom were managers. Recent Reform Efforts on the Board System In 1997. 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. were supposed to be outside directors. Vol.96 Corporate Governance and Finance in East Asia. other than the representative director(s). Further. Moreover. Despite the qualification requirements. and their positions (accept or reject) on matters voted on in board meetings. In order to address this concern. members of the board. However. With the boards consisting only of insiders. companies have to disclose in their annual reports the frequency of board meetings. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. The exchange is also expected to recommend company charters to have provisions that allow for information demanded by outside directors to be promptly supplied to them. the listing rules of the Korea Stock Exchange were revised to require that listed companies have one or more “independent outside directors” by the 1998 annual shareholders meeting. almost all companies succeeded in adopting cumulative voting. 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. II When the Commercial Code first introduced the corporate board system in the 1960s. A few large companies had more than 50 directors. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. 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. 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.

are required to have a majority of outside directors. they had a parent/child relationship in 20 percent of the cases. Where the chairperson was not the CEO. These results are in accordance with the new listing rules introduced in 1998. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. this committee adopted the Code of Best Practice in Corporate Governance. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. he or she held 6. an audit committee. On average. the Corporate Governance Reform Committee. Among others. The average board had 8. although some banks recently have established board committees.5 percent of the shares. Meanwhile. In 78 percent of the responding firms. In September of the same year. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange.2 percent and the CEO 14. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. The controlling shareholder of some banks is the Government. which had extended financial support in their recent recapitalization efforts. Where the two were separate. Among the firms with no outside directors. In March 1999. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. inside directors owned 16. the chairperson of the board was also the CEO and on average held 10. the Korean Code recommends that large listed firms should have at least three independent directors. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. a blue-ribbon committee. This is because most banks. having no controlling shareholders. 88 percent had plans to hold elections in the near future. who would comprise at least 50 percent of the boards.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies.4 directors.1 percent of outstanding shares of a listed company.1 percent and outside directors 1. and a nominating committee. Directors were also chosen on the basis of their relationship with the controlling .9 percent on average.

The current chairperson has been in office for 6. including stock options. Vol. one person was sitting on nine boards and this person was the CEO of a chaebol firm. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). relationship with controlling shareholders (21 percent). The board or the management then determines compensation packages for individual directors. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. Most frequently. In some instances. founders of the company acted as the chairperson (22 percent). a total of 562 directors were sitting on two or more corporate boards. 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. the board had a nomination and an audit committee. According to the Commercial Code.98 Corporate Governance and Finance in East Asia. 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). Less frequently. In one case. About five directors per firm have been in office for more than one term. In most firms. in 23 percent. among the 81 sample firms. . The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. in some firms. In 91 percent of the sample firms. II shareholder (30 percent). Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). In 1997. and fixed fees plus performance-related pay. These were established only recently.2 years on average. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. the management determines the remuneration. In 13 percent. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. and shareholding (10 percent). the management nominated director candidates (64 percent of the directors). However. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. As discussed earlier. This rather long tenure must be due to their status as controlling shareholders in most firms. the term of appointment of directors and board chairpersons is three years. In a very small number of firms. the board had no committees.

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

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

Only 10 percent of the respondents have followed all international accounting standards. but 49 percent confessed that they have not followed international standards at all. 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. Thus. however. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. they also have the power and duty to monitor the activities of executive directors. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Consolidated reporting was introduced before the outbreak of the crisis. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. 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. In the ADB survey. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. In practice. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. 41 percent of the companies believed that they have followed some international accounting standards. 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. Under the Commercial Code. The primary sources of reference in the revision were International Accounting Standards and US 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. 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. the internal auditor is considered to be a subordinate of the . The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities.

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

Thus. and dismissal of directors and internal auditors require a “special resolution.93 percent of the shareholders but 26.79 percent of the shareholders. for some firms. small shareholders do not attend the annual meeting and that. Internet. However. One common share should have one vote. Approval of mergers and major divestitures. the Depository is instrumental in getting resolutions passed. No companies have so far introduced voting by mail. the Depository is subject to “shadow voting.77 percent of the shares. amendments of the articles of incorporation require a “special resolution.53 percent of the total shareholdings.3.” Companies can increase the number . However. in general. A total of 326 shareholders per firm. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. About one fifth of the listed firms issued nonvoting preferred shares. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions).Chapter 2: Korea 103 2. charter amendments. 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 Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally. The above results indicate that. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. respectively. attended the last annual general meeting. This shows that a relatively larger number of shareholders send in their proxies. The securities companies and banks are the second and third. corporations cannot issue common shares without voting rights. or telephone. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. The Depository represented 20 percent of the shares attending the meetings.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. representing 62. These voters represented only 5. or 10.” The survey shows that the Korea Securities Depository holds 69. Under the Commercial Code.21 percent of total shares issued. The management is the most important proxy.

the Tiger Fund. Shareholder Protection Before the economic crisis. or block charter amendments considered harmful to minority shareholders. It also attended the shareholders meeting of several companies to present the views of outside shareholders.104 Corporate Governance and Finance in East Asia. was able to force a change in the charter of SK Telecom. Those that are most likely to be rejected relate to election of directors.01 percent. from 3 to 1. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. Vol. Proposals put forward by management are rarely rejected at the general meetings. However. Due to the changes in rules for investor protection. Changes in the authorized capital require an amendment of the articles of incorporation. Various measures have since been taken to improve investor protection. For recommendations for dismissal of directors and internal auditors. II of votes required for a resolution to amend the articles. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. and for access to unpublished accounting books and records. an institutional investor based in the US. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. 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. demand changes in business policy. the board of directors decides on issues of shares within the limit of the authorized capital. The company also agreed to the right of the fund . Shareholders have preemptive rights. the requirement was lowered from 1 to 0. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. Only two out of 62 respondents to this question have had cases in which proposals were rejected. As an example.0 percent. mergers and acquisition plans. The amendment included a provision requiring the company management to get prior approval of shareholders to undertake major investments and raise capital in international markets. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. dividend proposals. and major investment projects (only five firms answered this question). but these can be waived by an amendment of the articles of incorporation. In four out of 62 respondents. In February 1998 and again in March.5 percent.

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

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

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

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

Companies have also utilized share repurchases. an acquirer of shares wishing to own more than 25 percent of the issued shares was required to make a tender offer to buy at least 50 percent). The reasons for failure are diverse. more than half of these attempts failed. hostile takeovers by tender offers began to appear in the capital market. However. In one case. For takeover defense. . Privately placed CBs cannot be converted into shares in one year. a total of 13 hostile takeover attempts occurred. 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. Takeover Activity As soon as the Act was amended. 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. Stock purchases by tender offer were also exempted. Unlike the UK. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. As far as institutional arrangements are concerned. Between 1994 and 1997. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. and announcing competitive tender offers by the controlling shareholder. Publicly issued CBs require three months before their owners can convert them to shares. A company cannot issue new shares to a third party without first amending the corporate charter. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. 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. turning to white knights. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. 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. corporations cannot limit the voting rights of large shareholders to a given maximum. Unlike Germany. listed firms rely mainly on shareholdings by the largest shareholder.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission.

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

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

but 27 percent of them felt that it was strong. In actuality. they delegate their voting rights to plans’ representatives. the council meetings have been superficial.9 in 1980. The relevant regulation was amended recently in order to facilitate voting by individual employees. Trade unions are organized on an enterprise basis. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. In 1987. 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. which were generally much lower than estimated values. the management usually consults the union on major issues relating to the management. Local unions in the same industry have established industrial labor federations.5 in 1990. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. The typical collective bargaining agreement has a one-year duration. union members account for 54 percent of the employees.654 employees per firm on average. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. and development of the company. in principle. employers are required to meet with representatives of labor unions at least once every three months. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. The percentage of shares held by the employee stock ownership plans in listed companies was 1. and 2. and 66 percent manual workers. The respondents of the ADB survey had 2. The union had no influence on the management in 17 percent of the firms. operation.1 in 1997. In 70 percent of the firms with organized unions. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. In these firms. About half of these firms considered the influence of the union on the management of the company to be weak. Collective bargaining is. Vol. Two thirds of the respondents had an organized union. of which 2 percent were senior managers. 32 percent technicians and professional staff. 2. At the national level.112 Corporate Governance and Finance in East Asia. Under the Labor Management Council Law. carried out at the enterprise level. there are two federations of labor unions. II shares of their companies through employee stock ownership plans. . Under the Capital Market Development Act of 1968. Under another law enacted in 1972 to induce private companies to go public.

Chapter 2: Korea 113

2.4 2.4.1

Corporate Financing7 Overview of the Financial System

The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7

The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.

114 Corporate Governance and Finance in East Asia, Vol. II

counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.

Chapter 2: Korea 115

Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump

116 Corporate Governance and Finance in East Asia, Vol. II

after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the

Chapter 2: Korea 117

total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage

and organization of commercial banks. Moreover. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. implementing the first stage in November 1991. Meanwhile. II Interest Rate Deregulation Plan. finance companies.2. It included such important issues as interest rate deregulation. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. Korean firms have been allowed to issue CBs in international financial markets. .5 percent in November 1981. In June 1993.1). which resulted in the establishment of a number of new banks. development of the money market. Since 1985. the Government simplified various directives and instructions regulating personnel management. the business scope of financial institutions was greatly widened from the early 1980s. 2.118 Corporate Governance and Finance in East Asia. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. was liberalized drastically in 1998 after the financial crisis. the Korean Government announced its Financial Liberalization and Market Opening Plan. Some policy loans were also abolished. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. In addition. especially the domestic bond market. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. Internal funds include retained earnings. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3.2 Patterns of Corporate Financing Corporate Financing Practices In this section. and liberalization of foreign and capital transactions. The capital market. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. Vol. listed companies. revision of the credit control system. With the privatization of nationwide commercial banks. On the basis of flows of funds. and the 30 largest chaebols. Also.4. mutual savings. etc. as a first step toward liberalization of capital account transactions. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. depreciation. The Government adopted a cautious approach. short-term finance companies. budget.

particularly in the 1990s in response to the liberalization of the capital market. The corporate sector used . except in 1991. 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. This means that internal funds after dividend payment were insufficient to finance growth in total assets. particularly in the short term. and 1997. Table 2.4 percent in the precrisis period 1988-1997. In securities finance. the corporate sector’s most important source of external finance was bank borrowings. depreciation. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. It measures the degree of financing growth in total assets by additional debts. Equity capital represents the shareholders’ commitment to the business. The share of external financing. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. capital surplus. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. Meanwhile. and allowances) and new equity capital. except for the stock market boom of 19871988. the proportion of foreign borrowings in total finance rose steadily. In 1988 when the stock market boomed. was 71 percent during the period. It measures the degree of financing growth in total assets by additional equity. on average. The SFR averaged 28. financing by corporate bonds and CPs was more significant than by new equity. comprising internally generated capital (retained earnings.25. and government transfers. depreciation. Securities finance became a more important source from 1988 onwards.26 shows the four measures of corporate financing calculated from Table 2. but it remained less than 10 percent of total financing.Chapter 2: Korea 119 and net capital transfers from the Government. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. Before 1988. including all sources other than retained earnings. 1994. Financing Patterns of the Aggregate Corporate Sector Table 2.

2 26.9 34.4 0.3 1.3 10.2 13.9 72.0 3.6 9.2 1.8 1.3 27.8 15.8 27.0 0.0) 12.6 11.0 (0.1 1.0 10.3) 15.1 — — — — 12.3 6.5 16.7 7.0 3.8 1.4 21.4 27.7 4.3 72.4 11.6 0.7 11.7 32.5 0.2 14.1 12.0 1997 26.4 1.5 2.7 10.1 3.7 12.5 29. depreciation.9 28.2 6.8 56.9 9.25 Flow of Funds of the Nonfinancial Corporate Sector. .3 — 30.0 3.5 2. 1988-1997 (percent) 1988 43.6 4.1 3. Source: Understanding Flow of Fund Accounts.8 30.8 8.6) 5.9 10.0 2.4) 13.6 14.3 6.3 2.7) 11.3 3.2 34.0 11. and Flow of Funds.8 17.7 14.6 3. 1994.0 9.1 1.6 9. and Public Bonds Commercial Paper Corporate Bonds Stock Issuesb Equity Other than Stock Foreign Loans Foreign Current Bonds Trade Credit Direct Investment Others Others Government Loans Business Credit Other Financial Debts — = not available.6 4. Bank of Korea.7 2.7 1.4 9.2 (0.6 2.6 3.7 8.3 5.Table 2.9 10.4 27.7 1.2 13.6 4.1 3.3 6.2 — 28.1 0.0 1.8 — 26.2 10.5 0.0 22.7 73.0 — — — — 8.0 5.2 15.6 9.1 2.8 4.3 30.3) 11.7 15.0 16.1) 6.5 9.4 1.3 — — — — 8.7 1989 1990 1991 1992 1993 1994 1995 1996 22. a Includes retained earnings.4 (0.4 2.1 (1.8 1.7 2.1 — 27.4 8.6 5.7 (0.6 0.4 27.2 2. which is the excess of current value over issue value of stock.9 6.6 0.4 10.1 0.4 (2.4 15.5 13.1 2.1 (0.0 9.1 36.0 17.1 17.5 2.4 0. Bank of Korea.9 38.1) 4.7 6.7 8.4 2.1 23.5 2.0 70.3 3.8 -2.6 8.7 2.5 0.3 1.8 (0.9 2.6 10.7 71.7 — — — — 9.7 10.8 1.9 73. b Includes capital surplus.6 0.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.1 10.9 0.8 1.2 0.2 — — — — 9.6 11.6 25.3 1.1 1.4 2.7 10.3 25.4 3.0 0.1 72.1 8.3 16.6 77.1 27.2 5.2 6.8 0.7 14.7 13. and net capital transfers from the Government.4 2.7 4.6 1.1) 4.5 16.4 — 28.4 71.6 (0.

Incremental financing from equity was 40.8 10.0 27.2 IDFR 36. the corporate sector relied heavily on external financing for its expansion.4 12. additional equity to finance 12.0 42. Source: Calculations from Understanding Flow of Fund Accounts. On average.7 9. IDFR reached 73. Bank of Korea.6 62. respectively.7 28.1 39. and Flow of Funds.7 percent in 1997.0 57.4 IEFR 63. and IEFRs were declining. declining to 26. respectively.6 percent over the 10-year period. an average of 59. higher than the aggregate 28.7 30.0 11.4 percent (Table 2.1 17.0 5. 1994. indicating a high financial risk position.9 60.6 26. The balance.4 27.8 28. Bank of Korea.7 40.1 percent in 1988 during the stock market boom.6 Excludes capital surplus.5 percent in 1997. In periods of high economic growth such as in 1988.9 46.6 percent. Its IEFR and NEFR dropped to 23.7 40.8 62.1 12. While SFRs.9 28.3 percent in 1997. in the manufacturing sector. was financed by additional debts. Manufacturing financed 54.1 26.9 percent by 1997 when net profit margins were negative.Chapter 2: Korea 121 Table 2.5 and 76.4 NEFRa 20.5 12.9 22. NEFR registered 20.2 percent of the growth in total assets. dropping to 26.5 68.8 percent of its total asset growth through debts.26 Financing Patterns of the Nonfinancial Corporate Sector.4 percent.3 11.3 12.1 53. 45.3 59.3 73.7 26. It dropped to 28 percent the following year.3 27.3 60.4 37.6 percent and 1. NEFRs.5 31. and the total debt ratio was much higher in 1996 and 1997 at 62. . There were significant time trends. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43. Lower income diminished the industry’s equity position toward crisis year 1997.5 percent.6 percent. higher than the aggregate 40. average SFR was 37.4 percent.2 percent of incremental asset growth was financed by equity.27). SFR peaked at 44 percent. Across industry.7 40.2 37. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.3 59. but also continuously fell. but plunged to 5.

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 50.2 5.8 50. Total debt financed an average 74. Vol.7 47. On the other hand.4 46.5 1. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.2 percent in 1993.8 4.0 30.8 percent in 1990.6 53.9 percent of asset growth.2 21.5 76. gas. the two sectors also had low equity financing ratios and high debt financing ratios.3 28. Categorized according to company size. Financing patterns of the wholesale. one year ahead of the other industries.4 3. and hotels sector and realty/renting/business activities sector were similar.0 42.5 7.6 62. their average SFR was higher. and steam) and the transportation.3 52.6 54.8 IEFR 65.9 6. Table 2. explaining partly the collapses of several construction companies in 1995.6 3. In 1997.6 36. storage. and low total debt and short-term borrowing ratios.2 62.6 45. large firms showed more cyclical patterns in these financing ratios than small.8 percent in crisis year 1997.4 63.6 37. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.0 42. and communication sector had relatively high incremental equity ratios.2 3.0 57.9 IDFR 34. retail. Equity financed an average 25.1 percent of total asset growth for the period.4 37.1 29.7 37. the utilities (electricity.4 54.9 percent.6 53.4 45. It had the highest average SFR in 1988 at 31.and medium-sized firms.7 37. then increased to 20. which decreased to 8. from 17.5 NEFRa 9.0 3.7 47. this dropped further to 15. Since 1992.5 23.2 .4 47.122 Corporate Governance and Finance in East Asia. II The construction industry showed the most cyclical pattern in annual asset growth.6 37.7 percent in 1996.6 4. the proportion of short-term borrowings in total financing has been high. and fell to about 10 percent in 1997. Since large firms were more profitable.

7 6.3 57.3 84.0 60.6 37.0 1992 24.8 29.9 47.1 59.3 10.7 78.3 8.5 62.2 18.2 46.5 87.4 28.9 9.2 29.1 84.8 70.8 2.0 74.8 9.1 19.3 4.3 19.0 40.5 1993 22.3 1996 16.9 80.4 1995 53.5 1996 42.5 1.6 71.4) 2.8 54.0 .8 81.8 4.1 25.7 Wholesale/Retail Trade.1 69.0 1.6 14.2 10.3 47.6 9. Household Goods.1 Trasport.6 1997 29.5 76.2 5.5 70.5 12.0 0.9 1992 56.8 74.0 10.9 33.0 82.7 15.1 4.9 1.0 17.8 1991 51.4 IEFR 46.27 (Cont’d) Year SFRa NEFRa IDFR 53.7 1997 8.5 21.2 1995 16.0 31.1 70.7 80.0 1990 12.7 42.2 8.5 29.6 9.6 4.3 7.0 65.9 Average 19.7 1989 26.6 73.0 68.5 20.Table 2.7 53.9 29.9 1.8 25.0 1990 50.9 52.7 1994 53.4 2.9 1.2 70.6 2.7 7.3 4.0 34.9 1989 63.2 20.9 16.2 74.0 3.5 23.6 37.8 76.9 30.2 23.3 21.7 15.4 26.2 25.6 8.1 1991 14.8 1994 15.9 20.2 4.6 7.7 78. Hotels 1988 33.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.9 2.9 15.6 8.3 (9.7 41. and Communication 1988 64. Storage.1 66.2 3.0 4.2 Average 53.9 1993 63.4 62.

0 0.3 85.4 1.6 Real Estate.0 33.124 Corporate Governance and Finance in East Asia.0 21. The trend was reversed in 1996-1997.1 34.6 1.4 1994 72.3 31. Their average IEFR was also higher and IDFR smaller.6 52.3 62. Renting.1 71.2 1992 18.6 1990 82.5 77.0 1.4 47.3 29.0 1997 24.1 0.4) 3.1 1991 56.0 56.7 14.8 Average 22. SFR = self-financing ratio.4 7. and Steam Supply 1988 118.5 8.7 1996 18.3 81.6 IDFR = incremental debt financing ratio.0 43.9 64.0 79.3 3.0 67.3 92.and short-term borrowings of these firms shot up in that period.4 (107. .8 36.8 135. and Business 1988 51.0 (0.9 Average 75.4 1996 45.7 1994 8. however. when large firms had much lower equity financing ratios and higher debt financing ratios than small.6 1989 118.6 1997 23.0 1992 51.1 1993 55. Vol.1 42.9 29. Financial Statement Analysis Yearbooks.4 IEFR 69.27 (Cont’d) Year SFRa NEFRa 6.2 63.7 37.7 69.6 1991 18.3 7.4 5.9 28. II Table 2.9 45.8 1993 11.0 0. a Excludes capital surplus.1 1989 34. The large firms had a higher proportion of external financing in 1996-1997.0 53.9 57.4 0 0 0 0 1. Long. Gas.4 1995 62.9 65.4 0.1 70.3 207.8) 7.9 IDFR 31.6 1995 17.6 7.3 Electricity.8) (35. Source: Calculated using data from Bank of Korea. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.1 54.0 46. IEFR = incremental equity financing ratio.1 35.8 1990 19.7 18.5 22.and mediumscale firms.7 70. NEFR = new equity financing ratio.8 17.

The proportion of their short-term financing averaged 72.1 percent of their equity capital.6 percent. Financing Patterns of Chaebols For chaebols. for listed companies. 91. compared with the entire corporate sector’s 35 percent and 65.5 percent and their total external financing. the lowest ratio of 58. at an average 70.8 percent of their total finance in 1997.6 percent of total asset growth.30). The average IEFR and IDFR were 10. Group-member firms borrowed less.4 percent. In 1996-1997.29).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. and higher than that of listed companies (Table 2.8 percent. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.5 percent is lower than that of the corporate sector in general. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. 153. Cross-payment guarantees have been declining since 1993 and reached 91. the IDFR of listed companies increased to 93.3 and 89. . The debt financing ratio of listed companies was high since they relied more on external financing. They were able to borrow easily from banks by issuing corporate bonds and CP. The largest borrowers were the top 11-30 chaebols. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. the top 6-10 chaebols.7 percent.9 percent.7 percent.2 percent. respectively. The average IEFR of the top 30 chaebols of 29.3 percent of their equity capital in 1997 (Table 2. about the same as that of the corporate sector as a whole.9 percent. External financing reached 94. All of the top 30 chaebols relied heavily on short-term borrowings.7 percent for all listed companies. In 1997. the average SFR was 28. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. but higher than that of listed companies. The chaebols’ drive to expand their empires resulted in heavy borrowings. and the top five chaebols. and using cross-payment guarantees among affiliated companies. compared with 89. In 1997. Their shortterm borrowings accounted for 86. the top 11-30 chaebols had the highest guarantees commitments at 207.28). and were large borrowers.

7 13.6 61.3 IDFR 57.1 1.4 12.6 IEFR 42.2 36.9 NEFRa IEFR 14.3 1.3 28. Korea Federation of Industries.5 91.4 29. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.1 8.5 8.4 88.29 Financing Patterns of the Top 30 Chaebols.3 86.28 Financing Patterns of Listed Companies.9 7. .7 1.6 1.5 8.6 11.2 NEFRa 1.2 23. Source: Calculated using data of Seung No Choi.4 38. Table 2. Largest Business Groups in Korea.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.8 22.6 0.2 1. 1994-1998 (percent) SFRa IDFR 85.8 76. 1994-1997 (percent) SFRa 41.Table 2.4 1.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.1 93.3 5.7 12.8 89.5 2.5 2.6 70.9 6.2 10.

0 207. According to the ADB survey.3 58. Few firms ranked loans from NBFIs as their first preference. and reserves and retained earnings. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. so that the firms engaged in lobbying to gain access to them. Financial institutions did not strictly screen their loan projects and monitor their debtors. loans from banks. First. Factors Influencing Corporate Financing Choices Until recently.Chapter 2: Korea 127 Table 2.1 — = not available. Second.3 64. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. Third. bond issues. .9 153. inefficient investment and excessive diversification of corporations. the Government applied high tax rates on net profits of corporations.0 1997 91. the Government provided implicit guarantees on bank lending and large businesses. and extended loans based on cross-payment guarantees. Firms now prefer internal funds and new equity capital. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. And fifth. Further. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control.1 — — — 1995 161.9 — — — 1994 258. Source: Fair Trade Commission and the Federation of Korean Industries. Korean firms preferred debt financing (bank and nonbank borrowings). Interest payments on debts were considered a loss when calculating taxes.9 — — — 1996 105. rights issues. and loans from NBFIs. in order of ranking.3 200. the Korean economy was plagued with high inflation.30 Cross-Payment Guarantees of the Top 30 Chaebols. especially in the 1970s when real interest rates of bank loans were negative. There were several reasons for this. and underdevelopment of the stock market. These are followed by loans from banks. company preferences in financing investment projects before the crisis were. Fourth.7 150. bond issues. poor financial and corporate governance resulted in overlending by banks. more than half of bank loans were priority loans with low interest rates. This change implies that firms now give more attention to financial risks.

4. in order of importance. Nonetheless. the percentage of foreign currency denominated debt in the portfolio was 14. maintenance of the existing ownership structure. more than half (53 percent) hedged against exchange rate fluctuations. II In seeking external financing. some (36 percent) thought that a hedging facility was not available or not working properly. ensuring the liquidity of the company. For these firms. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Diversification. Among the responding companies that had foreign currency denominated loans. Korea now provides a better environment for financial risk management. 2. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. many firms (or 42 percent) never considered hedging. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. 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. Vol. Among those that never hedged against exchange rate risks.5 percent at the end of 1997. they survived for two to three . in selecting financing sources. This preference has changed little after the crisis. and futures and other financial derivatives. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. and others (29 percent) expected the local currency to appreciate in value.36 percent on average for these companies.3 Financial Structure. even with a heavy debt burden. According to the survey. Other factors include. Only a few firms sought foreign loans because domestic loans were not available. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. 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.128 Corporate Governance and Finance in East Asia. and reduction in tax burden. firms give their first consideration to minimization of transaction and interest costs. A futures exchange launched in 1999 trades foreign exchange options.

the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. except in 1991. In order to determine the relationship between financing patterns and corporate performance. 1999). Table 2.3. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period.13). They were also higher than those of the top five chaebols until 1991. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. They were also higher than those of the top five chaebols until 1992. except in 19931995 when semiconductor prices were extraordinarily high. (iv) In terms of EBITDA to total assets. However. These findings indicate that independent firms have had a lower leverage and performed better financially. the top five chaebols’ ratios were much higher. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. as well as lax financial supervision (Nam et al. 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. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. (ii) In terms of net income to total assets. the top five chaebols and the top 6-70 chaebols had similar ratios. .2..Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. But since 1992. Among the main findings were the following. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. (i) In terms of total borrowings to total assets. The ratios of the top five chaebols were similar to those of the top 6-70 chaebols until 1991 when the top five chaebols’ ratios shot up. but the ratios of independent firms were much lower. Nam et al.

Vol. second highest in the top 6-30. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings.130 Corporate Governance and Finance in East Asia. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. and easier access to cheap credit. or outright transfer of resources due to poor corporate governance practices. larger research and development expenditure. The differences in the degrees of diversification among the three groups are substantial. except in the recession years of 1996-1997. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. its profit rate declined. rising nonperforming loans (NPLs) and falling . But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. During 1985-1997. court receivership.31). Meanwhile. In terms of the net profit margin (the ratio of net profits to sales revenue). and lowest in the top 3172 chaebols. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. however. 2. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. Government intervention. The diversification of chaebols under workout was much lower than that of the top 6-30. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. the degree of diversification was highest in the top five chaebols. had a significant role. The diversification of the top five chaebols remained at about the same level within the period. Indicators such as increasing debt-to-equity ratios. too. The degree of diversification of chaebols that fell into default. 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. had easier access to credit than the top 31-72 chaebols.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. Their subsidiaries. debt guarantees for free.

6 0.3) (1.6 7.9 0.9) (9.6) (0.1 1.7 3.1 1.2 (1.7 0.4) (1.6) 0.7 (4.5 1.4 0.4) (1.4 1. Court Receivership.2 (0.2) 1.8) (1.1) (5.4 (0.4) (0.6 1.7 1.7 1. 1998.1 (4.3 0.7 0.1) (2.2 (0.3 1.8) (20.8 3.6 0.2 1.0 0.4 (1.4 0.4 (0.6) (20.3) 0.7 0.7 — (0.0) (0.6) (12.5) (2.9) 0.7 0.7 2. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.2) (13.6 (0.2 0.5 (6.6) 0.8) 0.3) 1.3 1.3) 0.0) (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) (2.4 1.2) (13.8 (0.1 0.1) (1.3 1.1 1.1 (3.1 (1.0 0.7) 0.6) 0.5 1.0 (7.1 1.2) 1.3 1.3 3.2 1995 3.6 1989 1.3 1. p.5 1.2) 0.4) (6.4 (1.4) (2.3 (0.7 0.2) 2.1 0.3) 0.6 1.8) (4.3 (0.6 0.2) (4.1 (4.8) (11. .8 (0.0 1.4 0.9) (8.2 (0.3) 0.7) (1.1) 0.5 (0. Source: Whan Whang.6 0.5) (7.3 1.5) (0.5 (0.6 0.8) 0.7) (0.2 (17.7 (1.8 0.6 (10.2) (0.4 1.8 3.9 (0.5) 0.1 0.5 (0.1 1.9 1. Management Research Institute.5 4.6) 0.8 0.0) (4.1 4.1 (0.4) (1.9) 2.1) 1.3 1.3) 0.0) 0.8) 0.1 0.1) 0.7 1.5) (1.5 1.9 1.1 0.6 0.7 (0.8) 0.4 (2.7 (0.6 5.1 1.0 1992 1994 1.8) 1997 0.0) (3.6 1.2 1.3 0.7 0.6 1.4 0.6) (12.1) — = not available.2) 1.0) 0.7 1.3 0.2) (4.4 (0.1) 2. Beyond the Limit.3 1.0 6.2 1.0 1.31 Net Profit Margins of Chaebols.0) 0.1) (6.3) (12.2) 2.9) (1.2) (3.8 0.6 0.6 1.4 1.1 2.1 1.8) 1.3) 0.0 4.4 (1.8) (37.5 (4.3 (0.11.3 1.1 0.8) 0.4 1996 0.8 0.5 1.3) 12.1) (1.8) (0.8 0.3 0.4) (4.3) 1.8 (0.0 1987 1.Table 2.4 2.9 0.1 0.0 (2.8 1.8) 2.1) 1.9 0.9) 2.9 1.3 0.9 8.1) 2. Chung Ang University.8 1990 0.5 2. Background and Task of Structural Adjustment.7) (0.9 1.8) (1.3) 0.2 (0.2 1.6 (0.1 (9.3 1.2) (0.6 0.6) (0.2 1.3) (0.3) (0.7) 0.3 1.6 3.1 0.2 4.9) 2.2 1.5 0.9 0.3 (0.3 (3.8 1.8) (3.0 (0.1 0.5 (0.2) (4.

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

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

and a high degree of inefficiency in the economy. Financing preferences changed drastically after the crisis.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. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. capital. However. and other individual markets. The new preference ordering is as . Further. as the latter are well established in most business areas. prevalence of rent-seeking and morally hazardous behavior by economic decision makers.134 Corporate Governance and Finance in East Asia. and internal funds. bond issues. share issues. As mentioned earlier. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. The Government’s supervision and regulation of financial institutions were poor. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. 2.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. the typical chaebol firm had an extremely high DER. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. financing choices of listed firms in order of preference were bank loans.5.5. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. Vol. while (non-chaebol) independent firms had much lower borrowing ratios. 2. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. II strong financial links among its member firms through investments and cross-guarantees. Such problems may eventually cause ripples through the entire economy. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol.

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

000 in September 1998 (Table 2.6 percent in June 1998.200 in 1997. and shareholders’ equity of all industries. legal and other barriers prevented the exit of financially nonviable firms.000 from December 1997 to February 1998. the NPL ratio of commercial banks increased rapidly from 4. and there is collateral. without strictly evaluating the creditworthiness of businesses and the profitability of projects. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. then 20.32). The Government could hardly help them because of the number and magnitude of business failures. Before the crisis. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans.136 Corporate Governance and Finance in East Asia. Meanwhile. has given rise to various types of self-dealings by the controlling shareholder. and estimated losses. These were the definitions until 30 June 1998. Further. and the pursuit of growth through excessive diversification and inefficient investment. starting 1 July 1998. Following the “three months” definition. the NPL ratio reached 7. the ratios of net profits to sales. and returned to about 1. Financial Sector Vulnerability Because of financial losses in the corporate sector. In 1997 they became negative. It jumped to 17. especially chaebols. The inevitable result of inefficient investment was a fall in corporate profits. total assets. and there is no collateral. However. reaching highs of 6 percent in 1997 and 8. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. Doubtful loans are those for which interest is not received for six months or longer. 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.7 percent in 1997. Fixed loans are those for which interest is not received for six months or longer. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. . Moreover. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11.000 during January-September of 1998. the NPL ratio8 of banks and other financial institutions began to increase. were low in 1996 and 1997. nine out of the 30 top chaebols failed. excluding the financial sector. The monthly number reached more than 3. decelerated from March 1998. Vol. they are defined as loans for which interest payments are overdue by three months or more. The banks and merchant banks lent to large businesses.000 per year starting 1992.1 percent in 1996. According to the “six months” definition.

850 3.657 3.856 7. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.890 4.751 1.32 Number of Firms with Dishonored Checks.544 2.759 6.979 8.133 3.673 Construction 380 354 242 195 294 585 1.210 1.637 6.135 1.457 2. The difference between the Korean and Western definitions of NPLs left foreign investors with suspicions that the size of NPLs in Korea might be much larger than the government-announced magnitude.244 3. and Taipei.250 2. This was mainly due to the high ratios of NPLs.027 Manufacturing 1.259 2.472 2.517 2.114 811 706 696 866 1. Meanwhile.985 Services 3. European countries.573 3. As a result they had largely overvalued currencies.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.553 3. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.386 5. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents. 2. and continuous and large current account deficits. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.754 3.502 11.992 11. low efficiency.China.159 10.131 1.855 6. those of domestic banks were lower in the 1990s. and declined to 4-6 percent in 1994-1996 (Table 2. The current account deficits in terms .417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.Chapter 2: Korea 137 Table 2. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.647 8.859 3. Compared to ROAs and ROEs of domestic branches of foreign banks.107 6. Source: Bank of Korea. the ratio reached 7-8 percent. and large government-directed loans.69 20.053 5.5.589 171.769 9.255 13.265 6.33). In 1990-1993. This speculation was said to be one of the causes of the financial crisis in Korea.238 4.

China. Related to this.0 7.652 29.584 2. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.827 289.475 143. II Table 2.160 11.910 1.556 118.138 Corporate Governance and Finance in East Asia.484 11.739 241.0 8.430 12.190 9.584 Fixed (A)a 5.266 10.33 Nonperforming Loans of General Banks.192 Doubtful (B)b 952 1. Thailand -8.310 6.116 1.705 160.176 7.4 5.639 1.221 8. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90. Korea -4.170 1. In addition to the overvaluation of the won. .237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7. because of the rigid labor market. Vol.6 percent (1995).600 10.954 9.997 9. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.832 337.537 10. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei. even in times of economic slowdown.0 7.1 7. which led to large corporate losses.390 12. Source: Bank of Korea. Businesses served as a social safety net.1 6.562 18.520 194.8 5.736 8.2 4. although per capita income in Korea was much lower. and 30 percent in 1996. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.874 22.929 11.6 percent (1995).China. and Indonesia -3.1 percent (1995).649 375. Meanwhile large businesses could not legally lay off workers. the ratio of short-term debt to foreign reserves was very high. of percentage of GDP were as follows: Malaysia -8. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. Mass layoffs became legally possible only after the economic crisis.077 NPL Ratio (%) 8.8 percent (1996).6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer. Land prices and real estate rents were also high compared to trading partners. In 1997. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.

A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. However. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. To achieve this. Nonviable firms and financial institutions. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. which were laden with huge amounts of debt and were on the verge of bankruptcy. . the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. including banks.6 2. They have also been urged to divest themselves of strategically ill-fitting businesses and sell equity holdings of attractive business units to foreign firms to reduce debts. They have been pressured to stop such practices as providing loan guarantees. Corporations. Downsizing by curtailing employment has been prevalent.6. although efforts to lay off thousands of blue-collar employees at Hyundai Motors encountered fierce opposition from labor and ended up in mediation after intervention by politicians from the ruling coalition. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. and subsidizing money-losing units. had been forced into bankruptcy proceedings or merged into healthier entities.Chapter 2: Korea 139 2.1 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. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions.

Noticing this disincentive. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets.281 in April to 2. Vol. More than 59 percent of potential buyers were foreign firms. More important. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure.140 Corporate Governance and Finance in East Asia. The reasons are manifold. Internationally. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. Banks did not have the incentive to force financially nonviable firms to liquidate. On the other hand. potential foreign buyers waited for the price of acquisition targets to come down further. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. 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. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. the number of potential sellers decreased somewhat from 2. The process of voluntary debt recontracting by creditors was prolonged because Korean lending organizations lacked experience and expertise when it involved a multitude of creditors. the creditor . II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. 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. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio.045 in October. In many cases. banks and other creditors were reluctant to absorb losses realized by debt compositions.138 by the end of October. In their first review. This number was at 779 firms in April and grew to 1. Locally. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. 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.

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

some of the acquisition agreements have been discarded for various reasons. Foreign investment—in the form of acquisition of controlling interests. vessel engines. However. the foreign buyer demanded specific protections against adverse developments in the business environment. This figure contrasts sharply with the total of $700 million for all of 1997. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. Korea adopted and implemented policies to open its capital market completely. These deals could eliminate excess capacity in such industries as semiconductors. most of the big deals have entered their final stages of negotiation. oil refineries. On 3 September 1998. aircraft. power plant facilities. In another. As of April 1999.142 Corporate Governance and Finance in East Asia. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. inducement of foreign direct investments was considered to be the most effective means of achieving that end. uncertainty over the future . railroad cars. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. purchase of divested assets. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Thus.5 billion on agreement basis during the 10-month period after December 1997. enable chaebols to streamline their overly diversified operations and focus on several core business areas. and petrochemicals. Vol. Big Deals Ever since the outbreak of the economic crisis. automobiles. In the case of automobiles. it is hoped. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. Big deals would. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. First. Big deals have been elevated to the status of the most important means of effective corporate restructuring. labor union demands of the seller were not acceptable to the transacting parties. and equity participation—reached about $8. In one case. Restrictions on foreign ownership of land were also abolished. In the early days after the outbreak of the crisis.

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

144 Corporate Governance and Finance in East Asia.” comprised of experts in the legal. In the past this stage usually extended for as long as two to three years. a “Management Committee. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. First. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. Second. accounting. Fourth. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. the right to revoke court receivership is allowed to the creditors. Also. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. Korea’s Economic Progress Report. 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. etc. (ii) legal changes have been made so that domestic accounting practices conform to international standards. the court may annul its previous decision and force the firm into immediate liquidation. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. Also. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. 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. number of creditors. . Vol. The changes in the reorganization procedures can be summarized as follows. Fifth. October 1998.01 percent in May 1998. and economics professions should be organized to provide for expeditious proceedings in court. (v) all listed companies are required to appoint outside directors beginning 1998 9 This and the following two subsections draw on the Ministry of Finance and Economy. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. The purpose of this rule is to shorten the reorganization planning period. Third.

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

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

As a pilot program. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. but it will also help improve financial institutions’ risk management.Chapter 2: Korea 147 monthly. According to the law. Twenty-five domestic financial institutions. including the Korea Development Bank. both domestic and foreign. It also opened the credit rating service market to foreign competition. and is promoting joint ventures between foreign and domestic agencies.6 trillion in these funds: W0. but may be extended as required. to establish closed-end investment companies. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. and W1 trillion divided equally between the three balanced funds. Related legislation was put into effect in September 1998. To ensure transparency and efficiency of the fund operations. In order to promote a greater market demand for government bonds. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. The Government established specific qualification criteria and selected the primary dealers in 1999. It is now easy for private investors. financial institutions . Mutual funds (or open-end investment companies) will be allowed starting 2001. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. If interest rates stabilize at a low level. Investment Companies Korea has developed an institutional framework for closed-end investment companies so that they function as a key instrument for long-term financing. they will be managed by foreign investment management companies. with only minor standard exceptions. and the demand for longerterm bonds increases in the future. Moody’s signed a joint venture contract with Korea Investors Service. This law will not only provide an effective institutional environment for the disposal of NPLs. a primary dealers system will be introduced for healthy financial institutions. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998.6 trillion for the debt restructuring fund. invested a total of W1. These are expected to operate for the next three years. Prior to the introduction of this system. In August 1998.

II and qualified public corporations. For instance. More important.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. 2.6. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . However. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. 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. then the regulation will inhibit efficient investment of firms. foreign business corporations with good credit standing are now also permitted to issue ABS. Selfdealings. when the limit is binding. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. which is the case for many chaebols. as stipulated by the government measure. A good governance system is essential for the healthy growth of corporations and financial institutions. Vol. is inevitable. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. there is another view that placing a maximum limit on interfirm investments. B investing in C.148 Corporate Governance and Finance in East Asia. such as the Korea Asset Management Corporation (KAMCO). In principle. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. greater efforts to improve corporate governance are preferable to regulation of interfirm investment. and C investing in D. this can only be a temporary measure. this regulation may not be effective in curtailing pyramidal structures. There must be stronger rules to control agency problems.g.. On the other hand. cross-subsidization. the role of the board of directors as the internal control mechanism must loom large in corporate governance. However. However. unless the limit is tight and binding. etc. As markets become more efficient.) and the level of interfirm investments is very high. can utilize ABS. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. A investing in B. 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.

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

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

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

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

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

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

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

The policy was crafted by the martial law regime at that time. Companies finance long-term investments with short-term debt. Vol. the Government overvalued the local currency and imposed high import tariffs. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries.156 Corporate Governance and Finance in East Asia. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. Companies were profitable because of protection from foreign competition. An industrial elite. therefore.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. composed mostly of families previously in trading businesses. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. patterns of ownership. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. on family-based and controlled conglomerates.2. This study reviews the Philippine corporate sector in terms of its historical development. their growth could not be sustained.2 3. But protectionist policies made labor relatively more expensive and. It analyzes the impact of corporate governance on company financial performance and financing. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. and on the financial crisis. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. 3. patterns of financing. To implement these policies. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. The Board of Investments (BOI) was created to draw up an investment priorities . which leads to their easing of due diligence and monitoring standards when lending to group members. While new manufacturing industries were successfully established. emerged to influence industrial policies. companies were necessarily large and capital-intensive. control by internal and external governance agents. Banks have significant presence as members of affiliated business groups. and responses to the financial crisis. usually with the acquiescence of bank creditors. These early industrialists naturally opposed any initiative to reduce tariffs. II Still. regulatory framework. Corporate financing relies excessively on bank loans.

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

8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.9 5.7) (10.6 7.8 8.1 5.000 Corporations covers financial and nonfinancial companies.3 7.1 8. Its growth rate began to catch up with others in 1996.2 7. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.0 8. .3 9. however.2 (0. which was taken as a representation of the Philippine corporate sector.2 Thailand 11. only nonfinancial companies were used. With economic reforms introduced in the 1980s and 1990s.000 Philippine companies grew 17.1 5.7 5.5 (7.2 7.9 7.1).3 8. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.5 8.9 6.5) 3.7 Malaysia 9.5) 5.2) 4.4 4.8 8.8 4.7) 10. Table 3.5 percent per year (Table 3. Rep.7 (13. In this section.0 7.2.1 4.5 8. net sales of the top 1.0 8.2 Source: ADB.158 Corporate Governance and Finance in East Asia.0 (6.2). of 9. 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. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. Key Indicators of Developing Asian and Pacific Countries 2000.0 (0.1 GDP Growth of Southeast Asian Countries.2 9.8 10.3 2.3 9. Vol.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 1.4 Philippines 3.2 8.8 5.8 5.9 (1.7 8.6) 0.2 Korea.000 corporations. 3.2 During 1988-1997.5 9.2) 0. only to be unsettled by the crisis of 1997. This rate of growth was sustained by a comparable 18. II market.

0 1.2 4.4 861.8 26.4 776.2 Compound Growth (%) 17.000 Corporations in the Philippines.6 5.6 149 12.5 Leverage = total liabilities/stockholders’ equity.561.8 5.6 35.7 903 0.8 902 1. turnover = net sales/total assets. .3 121 12.5 887 0.0 148.1 73 5.9 629.6 109 12.8 411. Source: SEC-BusinessWorld Annual Survey of Top 1.8 6.4 260.4 555.7 238.341.6 75 6.5 119 12.9 617.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.9 2.1 72.394.3 382.9 96.5 72 7.5 508.3 941.6 144.1 95.6 102 16.191.3 107 13.7 20.1 881.2 900.1 615.2 Average 146 12.6 900 1.2 338.5 14.6 954.2 707.5 1.5 446.9 149 6.6 1990 1991 1992 1993 1994 1995 1996 1997 1.5 51 4.1 714.4 63.8 77 7.7 1.000 Companies. return on assets (ROA) = net income/total assets.978.893.6 896 0.123.4 188.9 952.5 1.0 1.7 1.1 197 14.160.1 51.3 306.9 1.209.3 68 7.1 54 11. 1988-1997 1989 519. of Companies Sales per Company (P billion) 899 0.9 480.5 192.4 3.1 5.1 6.4 602.3 898 1.177.1 181 11.9 896 2.7 443.697.7 218.512.1 468.4 411.8 22.5 570.8 741.9 78 6.4 8.8 4.9 898 1.3 862.3 46.2 27.131.1 1.332. net profit margin = net income/net sales.2 2.225.1 33.1 66 12.5 4.2 2.317.4 898 1.1 4.2 378.2 1.8 618.2 136.7 73 6.5 193.5 64.2 Growth and Financial Performance of the Top 1.4 1.3 60 10.6 426.5 1.9 3.1 Other Indicators No.6 290.647.7 28.6 18.6 1.0 900 1.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464. return on equity (ROE) = net income/ stockholders’ equity.1 1.781.Table 3.

Sources: ADB. but the extent of the increase was not as dramatic as in other Asian countries. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.693 1.8 percent per year. Return on equity (ROE) and return on assets (ROA) averaged 12. II assets.1 Net Sales (P billion) 465 519 630 741 862 954 1. .178 1.5 Ratio of Estimated Value Addeda to GDP (%) 17.474 1.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.5 16. Assuming Table 3. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997. for the 10-year period.4 24.697 1. various years. 1988-1997 Top 1. These rates of return are high compared with other Asian countries. and the SEC-BusinessWorld Annual Survey of Top 1.6 percent and 5.979 17.4 20.394 1. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.7 percent. leverage increased from 109 percent in 1996 to 149 percent in 1997. Further. Vol.3 The Corporate Sector and Gross Domestic Product. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. respectively.000 companies averaged 7.172 2.248 1.906 2.1 19.077 1. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.8 19.8 17.9 21.160 Corporate Governance and Finance in East Asia.3).5 Value-added is assumed to be 30 percent of net sales. and by equity that grew at a higher average annual rate of 26.5 17.352 1.3 percent.427 13.9 23.000 Corporations in the Philippines.2 percent.9 percent for the period. This is high compared with developed countries but compares favorably with other Asian countries. Net profit margins for the top 1. Asset growth was funded by debt that grew at an average of 20. Total assets grew at an average annual rate of 22. Key Indicators of Developing Asian and Pacific Countries 1999.

%) 17.9 196 1.0 5.3 22.0 4.8 2.9 26.8 Growth Indicators (Compound Annual Growth Net Sales 20.4 Stockholders’ Equity 32. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector. Averaging 42.7 22. and (iv) privately owned.9 22.Chapter 3: Philippines 161 a constant ratio of value added to sales. A study of company performance by ownership type.4 28.3 22. of Companies 73 Sales per Company (P billion) 2.4).2 103 5.1 ROA 8.000 Corporations in the Philippines.4 Fixed Assets 19.5 Retained Earnings 30.4 Total Liabilities 26. various years.3 27.8 No.9 158 13.3 9. The premise is that these variables have a direct bearing on corporate performance and growth.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.0 5. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.0 Net Income 19.1 22 10.2 9.3 42.8 606 0.8 22. corporate control structure.7 2.1 12.3 11. The foreign-owned companies were the Table 3. size. 1988-1997 Indicators Publicly Listed Privately Owned Rate.9 17. privately owned companies constituted the largest group (Table 3.8 percent of the corporate sector’s total sales between 1988 and 1997.6 Total Assets 29.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.8 3.0 31.4 190 5. (iii) Government-owned.5 27.0 Turnover 53 Net Profit Margin 15.5 23 4.0 28. these figures suggest a significant and increasing contribution of the corporate sector to GDP.0 142 22.5 Other Indicators Share of Sales (%) 17. (ii) foreign-owned. .8 14.1 Financial Ratios (%) Leverage 89 ROE 15.8 ForeignOwned 21.3 146 6.5 GovernmentOwned 4.

The compound annual sales growth rate was 21. Privately-owned and Government-owned companies grew at slower rates. . Their ROA and ROE were both more than twice as high as those of government-owned companies. meaning that the remaining 62 percent were relatively small in sales and assets. while there were few of them.75 billion per company for foreign-owned companies. a level high by Western standards but at par with those of other Asian countries. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. 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. Governmentowned companies in the top 1. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. 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. Publicly listed companies had a minor though steadily increasing share in total sales. Vol. However. were among the top 1.1 billion per company in 1997. with an average ROE of 22.9 percent. they generated the highest return on investments.000 list. Bases Conversion Development Authority. The privately-owned companies had a high average leverage ratio of 158 percent. and low return on investment is the norm.2 percent and ROA of 9. registered the largest per company sales at about P9 billion in 1997. Publicly listed companies had the lowest leverage at 89 percent.000 companies in 1997. the highest net profit margin of 15. compared with P2. II second largest at about 27.5 percent. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. but lower than those of foreignowned and publicly listed companies. or 38 percent. exceeding the 17.5 percent average growth rate of the entire corporate sector. selling an average of P4. But by being most efficient in employing assets.162 Corporate Governance and Finance in East Asia. the asset base is large. With an average leverage ratio of 142 percent. followed by publicly listed ones. although small in number.3 percent. foreign-owned companies borrowed more than publicly listed ones. and the second lowest asset turnover. the second best ROE and ROA. These were mostly large public utilities.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. these companies were comparatively large.

3 Other Indicators Share in Sales (%) 32.5). The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.1 124 5.7 2.8 6. of Company 159 Sales per Company (P billion) 2.6 715 0.7 Stockholders’ Equity 34. compared with 32.2 Net Income 21. Table 3.0 166 15.1 Retained Earnings 32.5 Growth and Financial Performance of the Corporate Sector by Control Structure. various years.0 Turnover 67 Net Profit Margin 12.6 26.2 23.3 Total Liabilities 30. a company can be a member of a conglomerate or independent.4 24. Sales and resources of the .1 Source: SEC-BusinessWorld Annual Survey of Top 1.3 Financial Ratios (%) Leverage 98 ROE 15.0 55. 1988-1997 Indicators Group Member Independent 18. Performance by Firm Size By firm size.0 25.000 Corporations in the Philippines. %) Net Sales 20. and small companies. medium.0 22.3 No. depending on assets and sales.3 percent for the conglomerates. and achieved higher returns on invested assets than independent companies (Table 3.8 Growth Indicators (Compound Annual Growth Rate.Chapter 3: Philippines 163 Performance by Control Structure By control structure.7 Total Assets 32. had a lower leverage ratio.2 Fixed Assets 25.8 ROA 8. the corporate sector is divided into large. grew faster. But the conglomerates were larger measured in sales per company.

7 Net Income 1. %) Net Sales 15.6 49.9 32.7 44. 1988-1997 Indicators Large Medium 19.3 Turnover 65 Net Profit Margin 8.5 12. are defined as the largest 100 companies in the top 1.1 81 9.6 Growth and Financial Performance of the Corporate Sector by Firm Size.1 25.1 percent of the total sales of the corporate sector.4 Total Liabilities 18.5 25. various years.5 73 6.9 26.5 128 10. although they comprised only 8.2 29.6).9 89 1. However.1 ROA 5. Sales per company in this group averaged P13. defined in this study as the next 200 largest companies in the top 1.9 Financial Ratios (%) Leverage 158 ROE 13. averaged a far less P3 billion in per company sales.3 Source: SEC-BusinessWorld Annual Survey of Top 1.5 Growth Indicators (Compound Annual Growth Rate.1 4. . which.2 Other Indicators Share in Sales (%) 56. while small companies.3 Fixed Assets 15.6 47.4 billion in 1997.6 Small 19.9 Retained Earnings 13.0 32.000 Corporations in the Philippines.000 list. referring to the remaining companies in the list.000 list. Large companies accounted for 56. averaged only P920 million in per company sales during the same year. Table 3. of Companies 79 Sales per Company (P billion) 7. for this study.0 7. sales of mediumsized companies grew faster than large companies.4 28.0 730 0.8 percent of the total number of companies in the list (Table 3. Medium-sized companies.0 156 16. II Philippine corporate sector are highly concentrated among the large companies. Vol.1 No. Medium-sized companies also performed better in terms of ROE.6 36.2 Stockholders’ Equity 18.5 Total Assets 18.2 25. indicating that they deployed resources more efficiently than large and small companies. averaging 16 percent.164 Corporate Governance and Finance in East Asia.6 31.

specifically those industries least and most affected by the financial crisis. and utilities and services sectors. and equity up to 1996. and utilities and services sectors. and assets was much higher for the real estate and property. at -12. The Asian financial crisis affected large companies most severely. Net income declined from P54. although the largest in number.Chapter 3: Philippines 165 Small companies. Poor returns appear to have been caused by the low profit margin at 6. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. Mediumsized companies’ leverage level was slightly lower. But small companies’ leverage was significantly lower. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. Large.4 percent in 1997 from 11. profits. with their ROE dropping to 3.8 percent.7 billion and P35.8 percent in 1997.7 percent in 1997 for medium-sized companies. from 14.1 percent. assets. Performance by Industry This study also looked at corporate performance by industry.5 percent for medium-sized companies and 8.7 percent a year earlier.2 percent for large ones. and construction. Leverage was the highest for large companies. reflecting to some extent a “bubble” phenomena in the former two sectors. real estate.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. and profitability in 1997 when the crisis started. The growth and financial performance of selected industries. at 156 percent. but suffered its largest decline in net profits in 1997.. compared with 9. net income. The sector showed consistent growth in sales. i. Sales revenue and net income declined from P76. utilities. at 158 percent on average during 1988-1997. as indicated by the negative annual growth.7 percent in 1996 to 8. averaging 10. but lower than that of construction. manufacturing.2 billion in 1997 for this sector.1 billion in 1996 to P4.8 billion in . ROE dropped from 10.8 the previous year.6 percent. The real estate and property sector also suffered significantly in sales. and the construction sectors than for the manufacturing. 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. unlike their counterparts in other Asian countries. ROE dropped to 7. at 128 percent for the period. especially during the period 1994-1996. of net income. For small companies. showed the lowest ROE.e. are shown in Table 3. Growth of sales.7.

and was also much more limited compared with the property sectors in other Asian countries. the sector’s ROE dropped from 15.0 31 0.1 10. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.0 23.7 Indicators Manufacturing Construction 27.3 Fixed Assets 20.4 16.3 20.9 2.7 192 9.4 percent.2 8. respectively.000 Corporations in the Philippines.8 48.8) 17.7 19.7 Net Income (12.2 45.8 Stockholders’ Equity 21.4 19.6 Growth Indicators (Compound Annual Growth Rate. it does not appear to have been excessively exposed to foreign currency-denominated loans.5 12.1 2.2 12.9 billion and P24.6 Financial Ratios (%) Leverage 142 181 ROE 13. As a result.6 Total Liabilities 18.000 companies’ total sales on average during 19881997.0 Turnover 112 24 Net Profit Margin 5.7 percent to 10.6 69 16.3 5.1 24 42. %) Net Sales 16.9 17.3 Retained Earnings 17.7 83 2. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.2 28 0.4 3.7 28.7 billion in 1997.9 23. 1996 to P56.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 Growth and Financial Performance of the Corporate Sector by Industry.9 5. of Company 454 17 Sales per Company (P billion) 1.8 41. various years.6 No.166 Corporate Governance and Finance in East Asia. II Table 3.4 Total Assets 19.7 ROA 5.7 52.0 21. 1988-1997 Utilities Real Estate and and Services Property 39.0 25.2 37.5 Other Indicators Share in Sales (%) 82.7 10.9 2. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.3 55. Vol. .

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

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

Chapter 3: Philippines 169

The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for “suspension of payments” to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors’ properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the country’s facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a “self-regulated” organization. Thus, PSE now

170 Corporate Governance and Finance in East Asia, Vol. II

has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchange’s rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks’ voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks’ voting shares.

Chapter 3: Philippines 171

Regulations on the single borrower limit (SBL) put a ceiling on the maximum amount that a bank can lend to a debtor. SBL rules limit the total liabilities of any borrower of a commercial bank to 15 percent of the bank’s unimpaired capital and surplus, and an additional 15 percent for “adequately secured loans,” to a maximum 30 percent (“unimpaired capital and surplus” refers to the total paid-in capital, surplus, and undivided profits, net of valuation reserves of a bank). SBL limits exclude risk-free loans such as Government-guaranteed loans and loans secured by cash deposits. Total corporate liabilities include all liabilities of the debtors and their majorityowned subsidiaries. The Monetary Board may prescribe the consolidation of the liabilities of subsidiaries with the parent corporation under certain conditions. Central Bank (Bangko Sentral ng Pilipinas [BSP]) regulations do not prohibit loans by the bank to its directors, officers, shareholders, and other related interests, known as DOSRI. However, they are subject to certain prudential requirements under banking laws, as follows: (i) a director or officer of a bank can only borrow or become a guarantor, endorser, or surety for loans from the bank with the written approval of all other directors of the bank (i.e., excluding the director concerned); (ii) the amount of outstanding credit accommodations that a bank extends to its shareholders shall be limited to an amount equal to the sum of their unencumbered deposits and book value of their paid-in capital contributions; and (iii) loans and advances given to officers in the form of fringe benefits shall not form part of liabilities under DOSRI.

3.3 3.3.1

Corporate Ownership and Control Patterns of Corporate Ownership

The historical development of Philippine corporate ownership is rooted in the country’s colonial past, the industrial policies of the Government, and the recent emergence of industrialists and an entrepreneurial class. During the Spanish and American period up to World War II, a small number of families acquired land and owned large businesses. These families built and preserved their businesses over several generations. Many of them became controlling shareholders of family-based corporations and business groups that are major players in the present-day Philippine corporate sector. Ownership is a key element in corporate control and governance. Public listing rules of PSE require that a minimum of 10 to 20 percent of

172 Corporate Governance and Finance in East Asia, Vol. II

outstanding shares, depending on the size of the company, be available for trading in the stock exchange. As companies usually only issue the minimum required number of shares, large blocs of controlling shareholders often dominate corporate decision making in publicly listed companies. Public investors and minority shareholders are not in a position to influence management. Moreover, the presence of large controlling shareholders makes takeovers by other companies difficult. For these reasons, the resolution of conflicts between the interests of controlling shareholders, minority shareholders, public investors, and creditors in Philippine companies depends very much on the effectiveness of internal control systems. Ownership Concentration of Listed Companies This study measures ownership concentration in terms of shareholdings by the top one, five, and 20 shareholders.5 Table 3.8 shows that the top shareholder owned 40.8 percent of the market value of an average nonfinancial company. The shareholding of the top shareholder varied across sectors. It was highest for the property sector at 54.8 percent, followed by holding companies (as a sector) at 53 percent. One shareholder held majority control of an average company in these two sectors. The average shareholding of the largest shareholder was less than 25 percent only in sectors with large market capitalization, such as power and energy, and transportation, and in sectors with high risks, such as oil exploration and mining. These figures suggest that for publicly listed companies, a single shareholder often has substantial or even dominant control. Combined, the holding of the top five shareholders in an average company was about 65.3 percent for the nonfinancial sector and 59.2 percent for the financial sector. The five largest shareholders held majority control over an average Philippine publicly listed company, except in three sectors—transportation; food, beverage, and tobacco; and oil exploration. Ownership by the five largest shareholders was on average most concentrated among holding companies (78.4 percent), and in construction (74 percent), property (69.8 percent), manufacturing and trading (68.4 percent), and communications (67.3 percent).


The study derived ownership data for 194 (169 nonfinancial) companies out of 221 (190 nonfinancial) listed on the Philippine Stock Exchange as of 1997. Shareholdings by the top one, five, and 20 shareholders were estimated for each company and averaged by using the market capitalization of each company as a weight.

Chapter 3: Philippines 173

Table 3.8 Ownership Concentration of Philippine Publicly Listed Companies by Sector, 1997
Sector Financial Institution Banks Financial Services Average Shareholdingb Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food, Beverage, and Tobacco Holding Companies Manufacturing, Distribution, and Trading Hotel, Recreation, and Other Services Property Mining Oil Average Shareholdingb

Top 1 26.9 41.3 27.2 35.4 21.5 23.8 47.7 22.7 53.0 37.4 28.9 54.8 23.4 19.9 40.8

Top 5 59.2 63.2 59.2 67.3 55.4 48.4 74.0 44.1 78.4 68.4 55.3 69.8 56.0 45.1 65.3

Top 20a 76.4 65.8 76.2 76.9 72.1 69.2 86.2 69.7 86.0 42.6 68.0 74.5 51.9 64.3 75.9

Information on the top 20 shareholders is not available for five holding companies, 10 manufacturing companies, and two property companies. b Weighted by market capitalization. Source: PSE databank.

The shareholding of the 20 largest shareholders in an average company was 75.9 percent for the nonfinancial sector and 76.2 percent for the financial sector. In 12 out of 13 sectors, the top 20 shareholders owned more than 50 percent of the voting shares of an average company. In 10 out of 13 sectors, the top 20 shareholders held more than a two-thirds majority control of an average company. Ownership Concentration at Critical Levels of Control PSE listing rules require that a minimum of 10 to 20 percent of outstanding shares of a company be issued to the public, depending on its size. An interesting question is whether in reality Philippine publicly listed companies issue enough shares to be truly widely held or whether they barely meet this minimum requirement. The answer to this can be gleaned from an

five. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. 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. Vol.9 shows that in 44 companies. or 78 percent of the total. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. the top 20 shareholders collectively owned a majority of a company’s shares. a single shareholder held operating control of a company. In four of 11 nonfinancial sectors. In 116 companies. large and family-based shareholders pool the family’s ownership over many . controlling an average of 52. the top five controlling shareholders were classified into eight groups. There are advantages to establishing pure holding companies. In 76 companies. or about 30 percent of the total.10. The largest group is nonfinancial corporations. or 80 percent (only nominally publicly listed) of outstanding shares. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. Table 3. a single shareholder held two-thirds majority control. or 20 shareholders owned more than 50 percent (signifying operating control). 66 percent (signifying strategic control). With such high levels of ownership concentration. and 20 shareholders? In Table 3. In four companies. or 14 percent of the total. The shares of publicly listed companies are thinly traded and illiquid. which are mostly privately owned and controlled by family-based shareholder blocs. or 3 percent of the total. nonfinancial corporations held majority control. a single owner owned more than 80 percent of outstanding shares.2 percent of outstanding shares of publicly listed companies. Who are the top one.174 Corporate Governance and Finance in East Asia. Through these.1 percent of publicly listed companies in the Philippines in 1997. and share prices are sensitive to movements of foreign funds. the top five shareholders owned more than 50 percent of the voting shares. In 21 companies. five. including pure holding companies. holding only an average of 2. or almost 75 percent of the total. or 51 percent of the total. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. II analysis of the number of companies in which the top one. In 111 companies. Individuals did not constitute a significant shareholder group among the top five shareholders. the top five shareholders held more than two-thirds majority control of a company.

and two companies in the property sector.Table 3. and Tobacco Manufacturing. 1997 % of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 — 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 — — 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 — 13 7 — 2 — — — 3 Top 5 40 33 50 28 27 50 — 28 30 Top 20a 60 67 64 20 47 50 43 36 45 Sector Communication Construction Food. a Data for top 20 shareholders were not available for five holding companies. Source: PSE databank. . Distribution. Beverage. 10 manufacturing companies. and Trading Holding Power Transportation Property Total — = not available.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies.

1 8.8 0.1 6.2 10. Beverage.0 0.3 1.7 0.3 0.0 4.0 7.5 0.2 1.0 1.9 6.1 5.6 18.4 29.0 2.5 53.5 4.0 0.6 12.2 3.3 2.7 3.4 2.2 0.3 37.7 0.4 19. Distribution.9 52.0 1.5 13.1 0.4 0.0 1.6 0.9 36.6 0.5 4.0 0.0 45.6 33.0 1.3 0.0 0.6 0.0 1.2 0.6 0.6 1.7 0.1 a Weighted by market capitalization.9 0.4 1.8 21.2 59.5 12.1 9.6 2.3 0.0 0.0 0.0 0.0 0. Recreation.3 26.0 0.4 5.6 2.6 5.0 10.1 7.7 1.0 0. and Trading Hotel.7 0.0 0.5 0.0 0.7 67.3 1.0 1.0 2.2 0.2 0.7 0.0 5. and Other Services Property Mining Oil Average Shareholdinga 33.6 0.2 3.1 0.8 0.2 5.0 0. Source: PSE Databank.3 0.6 0.0 5.8 11.3 5.7 3.8 0.0 5.3 0.2 3.0 1. .7 0.Table 3. and Tobacco Holding Companies Manufacturing.0 0.5 2.3 12.2 0.2 3.4 8.5 26.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.8 66. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.0 1.6 9.3 5.9 0.6 0.1 1.0 5.0 0.

1 percent). As a group.1 percent). with an average of only 7. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. They can also better manage their income taxes because income from affiliated companies passes through a holding company. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). respectively. 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.6 billion or 26. and San Miguel Corporation (SMC) in food and beverages. Holding companies were themselves 66 percent owned by other nonfinancial corporations. The investment funds’ presence in these sectors ranged from 8. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. Petron and MERALCO in power and energy. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. 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. . The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.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. while still allowing the public to own minority shares. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. and insurance companies (0. there was no real market for investment information.Chapter 3: Philippines 177 companies and share in the risks and profits of the group.7 percent of shareholdings). Holding companies as a sector had the largest market capitalization in PSE in 1997.2 percent in 1997. securities brokers (1. financial institutions did not have a significant ownership in nonfinancial corporations. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. accounting for P258.6 percent of market capitalization in 1997.7 percent of market capitalization of the nonfinancial publicly listed companies. Such advantages have contributed to the popularity of holding companies among publicly listed companies. Because of limited ownership by institutional investors. Investment trust funds were the most important institutional investors.3 percent).5 to 12. The 7. commercial banks (1.

a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. using data on the Philippines’ top 1.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. and tracked the financial performance of each company from 1992 to 1997. A common feature of corporate ownership of a business group is the centrality of a commercial bank. 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. Commercial banks hold the largest share. Corporate financing depends on intermediation by banks. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). many companies in family-owned groups are not publicly listed. The Central Bank deregulated interest rates and foreign exchange. so far limiting their involvement to selected products. the study put together a list of prominent business groups.178 Corporate Governance and Finance in East Asia. 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. remain in force to control excessive lending of banks to insiders. including SBL and DOSRI rules.7 6 7 The study used publicly available shareholder information and published reports. including 16 commercial banks. . suggesting that business groups are common in all major markets. 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.11).8 percent of total companies in number. This is significant considering that there were only 31 local commercial banks in the country in 1997. of the financial resources in the country. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. but they comprised only 23. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks.000 companies. For this reason. Vol. about three fourths. Some 20 financial institutions were affiliated with these groups.000 corporations’ sales. Family-based groups have larger companies since their total sales were about 33. All major industries were represented. suggesting that most publicly listed companies are parts of business groups.4 percent of the top 1. To understand the ownership and governance characteristics of family-owned business groups. Prudential regulations. 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. identified the companies belonging to each of these groups.000 Corporations in the Philippines. However. Still. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector.

In 1997. the largest was the Eduardo Cojuangco group. broadcasting (49. Also.6 percent of the total sales of the top 1. To show this. for each of these groups. Foreign-owned companies mainly serve the export markets. for the Lopez group. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities.12). In terms of sales. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. the biggest private company in the Philippines. Gokongwei. it was manufacturing (36. It is also noteworthy that. a substantial proportion of group profits came from its financial subsidiaries. and banking. construction. For the Ayala group. the top 10 family-based business groups had only 119 companies in the top 1. The main constraint may be the availability of family members that could be drawn for top management positions. an average group in the Philippines has fewer member companies. retail merchandising (69.000 companies. the principal owner of SMC.1 percent).8 percent). and Ayala. Commercial banks are often affiliated to a particular business group. the three largest entities were family-based groups.000 corporations in 1997. in most . Significantly. the two were closely related through their affiliations to business groups. and for the Henry Sy group. Cojuangco. ranged according to their sales (Table 3.4 percent of the group’s 1997 profits). In terms of number of companies. as discussed in previous sections. Family-based business groups are most dominant in sectors such as manufacturing. including business groups and independent companies. the largest family-based business group was the Ayala Corporation Group.Chapter 3: Philippines 179 Compared with other Asian countries. the study used the four largest business groups—Ayala. and Henry Sy—as examples. or an average of about 12 per group. which was majority-owned by the Henry Sy group. for the Gokongwei Group. Lopez. with 27 affiliated companies in the top 1. Lopez. These corporate entities accounted for 53.2 percent). with the exception of Banco de Oro.000. 25 out of the 50 top corporate entities were familybased groups. namely. In the meantime. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. the nonfinancial sector was real estate (60. Together. real estate. 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. and more than 20 percent for the Lopez group and Henry Sy group.

Flagship Company.1 2. and packaging Power distribution and mass communications Real estate.4 .4 10.5 6.5 47. 6.3 3. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M.0 5. construction. 16.5 13.2 1. coconut oil.0 26. 15. 9. and Affiliated Bank of Selected Business Groups.Table 3. and tourism Credit card 18.9 2.0 Average Sales Per Company (P billion) 6. food.2 1.0 17.3 15.0 13. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.9 3.3 2. 4. 3. and personal care prods Shipping.8 84.5 46.4 6. beverages. Eduardo Cojuangco Lopez Family Group Ayala Corp. 5.4 48. 13.1 4.5 17. agriculture.6 2. of Affiliated Companies Total Sales (P billion) 123. Beverages. 2. Consunji 4 3 Food and dairy products Construction and mining 10.11 Total and Per Company Sales. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12.5 44. and dairy products Investments. Real estate. 10.6 3. beverages.1 4.6 7. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. telecom.6 3. real estate. Sector Orientation.5 49. and food Food. 8.5 2.3 11. and mining Management. 7.7 98. food. 11. 14.2 16. 17.5 26. power.

7 0. 25.0 0. and various company annual reports.3 7. 38. 27.4 3.1 2. 29. Ramos Gaisano Family Group Felipe Yap Felipe F.7 1.4 5.19.8 1.4 1. 23.7 4. distribution.8 1. 39. 4 238 1.9 1.0 5. 32. and real estate Department store Mining Construction Telecommunication Shipyard and power 4 7 5 2 4 4 3 2 5 7 5 5 2 3 2 3 2 2 2 2 8.9 1. 31. 26.7 0.8 6.9 0.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 24.6 3.0 2. 28.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.1 0.9 6.5 2. 34. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.000 Corporations (1997). and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore.5 8. SEC-BusinessWorld Annual Survey of Top 1. P.7 3.2 4.0 1.2 6. 36. 30.1 1.6 0. 22.3 2. 35.4 3.3 2. 33.9 7.6 2. mining.9 0.6 5.7 0. 37.1 805. . 20.8 1.9 1. 21.1 1. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.2 1.

8. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 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. 11. 19. 15. 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. Uytengsu/General Milling Group David M. 17. 3. 21. 1997 Business Group Size Classa Flagship Company Affiliate Bankb UCPB PCIBank BPI Metrobank/Global Bank PCIBank Banco de Oro Allied Bank Bank of Commerce Asian Bank PDCP Bank Union Bank Consumer Bank (Savings Bank) RCBC Asian Bank Equitable Banking Corp. 14. 16. Alaska Milk Corporation DM Consunji. 1. 18. 10. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . and Affiliated Bank of Selected Business Groups. 5. 12. Flagship Company. Eduardo Cojuangco Lopez Family Group Ayala Corp. 6. 7.Table 3. 2.11 (continuation) Total and Per Company Sales. 4. 13. Sector Orientation. Inc. 20. 9.

medium = P1. 34. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F.48 billion. 33.. 26. unless otherwise indicated. . Fil-Estate Development Inc. 27. Kepphil Shipyard Inc. P. a b Size class is measured in terms of sales: Large = greater than P4. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. Cruz & Co. 23. 31.48 billion. 30.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. SEC-BusinessWorld Annual Survey of Top 1. 28. F. 38. 25. 32. 36.65 billion. Sources: PSE Databank. and various company annual reports. Ramos Gaisano Family Group Felipe Yap Felipe F. Refers to commercial banks. 35. Inc. 22. 37. small = less than P1. PT&T Corp. 29. 39.65 billion to P4.000 Corporations (1997). 24.

16.5 26.0 38. Fujitsu Computer Products Corp. 17. bank.5 15. First Pacific/Metro Pacific Group 21. Inc. 5. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. 22.2 16. 15. agriculture. coconut oil. 14.12 Control Structure of the Top 50 Corporate Entities.8 22.4 19. beverages.2 Business Group Business Group Business Group Government. Inc. 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.2 49.6 18.1 17.5 77. beverages.1 60.5 47.5 17. 20.5 46. food. Philippine National Bank Mercury Drug Corp. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 19. 10.). 11. 9. and personal care products Shipping. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. mass communications.3 15.). banking.8 53. 18. and real estate Banking.6 26. 23. construction. Beverages. telecommunication.0 24. 2.Table 3. power. and packaging Power distribution. 24. 8. food. 12.5 44. of the Phils.8 84. 4. 13. and telecommunications Department store and banking Airlines. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 7.and Foreign Jointly Owned Business Group Business Group Business Group Government-Owned Publicly Listed/Foreign-Owned Foreign-owned Business Group Business Group Business Group Business Group Business Group Foreign-Owned Foreign-Owned Business Group Business Group Foreign-Owned Privately-Owned Publicly Listed/Foreign-Owned Privately-Owned Business Group Corporate Entity 1. and bank Real estate.4 48.0 37. 3. Texas Instruments (Phils. and dairy products Investments. 6. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. and mining Gold and other precious metal refining . food. and food Food.7 98. car manufacturing.

6 1. 42. 35. corn (unmilled). 27.000 Corporations (1997). National Steel Corporation National Food Authority Phil. Inc.. Corp.5 10. Uytengsu/General Milling Group David M.2 7. 43. 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. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. real estate. 14. 33.8 6. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.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. and various company annual reports. 30.A. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. Inc. W. 39.4 8.9 7. 37.6 9.7 13. 40.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. . 26. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.0 5. Philip Morris Philippines.6 12. 46.3 13.7 10. Philips Semiconductors Phils. 9.3 8. Amusement and Gaming Corporation Mitsubishi Motors Phils. 48.290 53.5 8. 28.1 9.5 8.25. 44.9 6. EAC Distributors Inc. 32. 29. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. 49. 47. 41.0 11. PSE Databank. 50.0 13.8 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. 45. 34.8 9.7 10. Inc.0 12. 36.9 7. Consunji Uniden Philippines Laguna.4 10. 31.9 14. Jollibee Foods Citibank N.

and financial disclosure. voluntary dissolution. these were dispersed shareholdings. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. removal of directors. jointly and individually. business groups had only minority ownership. issuance of corporate bonds. Vol. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). such as amendments of the articles of incorporation. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. and declaration of cash dividends. However. accounting and auditing.8 The Board of Directors As the representative of shareholders in a company. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. shareholder voting in general meetings and legal protection of their rights. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. although public investors held a majority of shares. corporate mergers or consolidations. They are likewise liable if they pursue financial interests that conflict with their duty as directors. appointment and compensation of senior executives. II publicly listed commercial banks affiliated to these groups.186 Corporate Governance and Finance in East Asia. 3.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. Of course. Actual control of the banks was still held by the groups. approval of management contracts.3. Shareholders have the right under the Code to file derivative suits against directors and officers and other third parties to redress any wrongdoing committed against the corporation for which the board refuses to sue or to remedy. determination of compensation to board members. 8 The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank. sale or disposition of a substantial portion of corporate assets. issuance of stocks. The Corporation Code holds members of the board of directors liable. the board of directors plays a crucial role in corporate governance. . amendments in the bylaws. investments of corporate funds in other companies or purposes.

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

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

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

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

13 summarizes rights that the shareholders of the responding companies enjoyed.900 shareholders per company did not vote during the last annual general meeting.6 30. representing 3.2 7. 1999.3 56.2 43. Nominees held about 45 percent of the outstanding shares.0 63.Chapter 3: Philippines 191 in a few controlling shareholders and families.0 48. The responding companies had on average 43.8 30.2 69. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.4 percent of shareholders but 58 percent of outstanding shares. and their activism in the corporate sector. The ADB survey provides further evidence on shareholder rights. An average of about 4. appointed either by the board or shareholders during the annual general meetings. the successful hostile takeover by First Pacific Group of PLDT. Yes 100. protection. followed by management and banks. Table 3.7 43. a company that is widely held but has a large shareholder.522 shareholders each. Nevertheless.4 No 0. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.0 51. Table 3.8 56. About 333 shareholders per company voted by proxy.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. The brokers or securities companies were the most important proxy voters.0 36.4 70. representing about 24 percent of outstanding shares.8 92. About 93 percent of the respondents contracted .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.

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

sometimes did not penalize independent auditors for poorly prepared audited financial statements.g. which are closely held by large shareholders and family members. they formed the largest group of corporate entities in the Philippine stock market in 1997. However. arguably. They allow risk pooling and can achieve economies of scale in management. Even for widely held public companies. Controlling shareholders usually select member companies that require large . “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. which are usually controlled by holding companies. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. from a minority-controlled to a majority-owned subsidiary.and medium-sized businesses did not have quality financial statements. because of the highly concentrated ownership of Philippine corporations. accounting for 27 percent of the total stock market capitalization that year. e. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. 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. and publicly listed. marketing. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. and financing. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. the authorities. which are controlled by large shareholders with public investors in a minority position. Publicly available financial information was often of low quality. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). When control rights exceed cash flow rights. Corporate Control by Controlling Shareholders As in many other Asian countries. Pure holding companies can be privately owned. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA).Chapter 3: Philippines 193 Many small..6 billion. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management. 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.

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. Depending on the performance of the company. financing. minority control at 42. Inc. Public investors collectively hold a minority of 41 percent. the parent company plays an active role in management. an active minority share at 44. a family-owned pure holding company. is privately owned.194 Corporate Governance and Finance in East Asia. Ayala Corporation’s majority. Minority-owned companies may also need access to resources of the group. It has a majority control at 71. Ayala Corporation is a publicly listed pure holding company. namely. at 47. as an example (Figure 3.2 percent.6 percent of Globe Telecom. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. Controlling shareholders gain additional leverage in management control over minority-owed companies. In an active minority-owned operating company. . controlling shareholders of the parent company do not participate in management. Ayala Corporation. controlling shareholders of the parent company may eventually increase their shares to a majority position. especially its management. Ayala Land fully owns Makati Development Corporation and holds a minority stake..4 percent of Bank of the Philippine Islands. active minority or passive minority holdings. In cases of minority ownership. The first three companies are publicly listed while the fourth.and minority-controlled operating companies are also holding companies. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. with 59 percent of shares. and a passive minority investment at 15 percent in Honda Cars (Philippines).1 percent of Ayala Land. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. Some holding companies are not pure holding companies. In a passive minority-owned operating company. Honda Cars (Philippines). II equity investment for public listing. They are operating companies but at the same time have majority or minority share ownership in other operating companies. It is majority-owned by Mermac. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. They may have a representative in the board. and customers. Vol.1). of Cebu Holdings (a publicly listed government-owned company).

44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. (47. . (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. (58.Figure 3.96%) Privately-Held Pure Holding Company Public Investors (41. Inc.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. Inc.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.. Inc.

and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Vol. Diversification and Efficiency of Investment by East Asian Corporations.44%] / [25%] = 1.44%] / [58. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. Simeon Djankov.14%] / [1. The situation offers large shareholders tremendous incentive to move resources 10 For details.5%] [39. The control of companies through indirect corporate shareholdings.14%] / [6.3% x 5. Generally.44%] = [42. Benpres Holdings. Rockwell Land. Fan. and 1999c.64% +37.11 The Lopez family’s control rights over MERALCO was 5. See also Stijn Claessens.5% x 14. P.7 times 12 . Simeon Djankov. see the World Bank research papers by Stijn Claessens. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. and Larry H.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group.76%)] [39. Expropriation of Minority Shareholders: Evidence from East Asia.2). P. Joseph P. Lang. MERALCO.98% x 42. Who Owns and Controls East Asian Corporations? 11 Ibid.196 Corporate Governance and Finance in East Asia.64%) + (37. and Larry H. companies in the Lopez Group are large and minority-controlled. 1999b. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank.12 These examples show that even when large shareholder groups are minority shareholders.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. The Separation of Ownership and Control in East Asian Corporations.7 times Ibid. H.5%] / [(88.3% x 1. however. Lang: 1999a. 1998. [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. First Philippine Holdings Corporation. 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.8%] 5. defined as control by large shareholders of an operating company through minority ownership by several companies. is illustrated in the Lopez Group (Figure 3.10 The Ayala family’s control rights over BPI was 1. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. Being in the public utilities sector. a privately owned company. and a minority-controlled holding company.

7% 62. Privately-Held Pure Holding Company 88. .2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez. Inc.64% MinorityControlled 14.Figure 3.76% Operating Company MinorityControlled 24.3% 11.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.

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. However. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. The average company. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. 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.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. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. 3. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. Vol. whether for working capital or capital expenditure. Control by Creditors According to the ADB survey. and (ii) how the legal framework protects creditor interests and rights. Suspension of Payments of Debts Under PD 902-A. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years.198 Corporate Governance and Finance in East Asia. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. the data suggest.

The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse.4 3. Publicly listed companies do not represent a cross section of the Philippine corporate . Inc. The corporation continued to be under rehabilitation receivership as of June 1999. 3. SEC could intervene to avoid asset dissipation. 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. the litigation process. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. a real estate-based business group.. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. could take an indefinite period. including the rehabilitation of the corporation. a company’s assets are of sufficient value to cover all of its debts. SEC and the court required that the creditors of BF Homes. Commercial banks hold about three fourths of the resources of the financial system.Chapter 3: Philippines 199 agreement. wait for 14 years from the time the company petitioned for suspension of payments in 1984. For example. Consequently. under which. There are two modes of suspension of payments under PD 902A. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. Under such circumstances. profitable companies from going public.4. There are no legal or practical limits to the time period of suspension of payments. bank credit is the main source of corporate financing. The first mode is for simple suspension of payments. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. The borrower will propose a rehabilitation plan to SEC. Under this mode. In practice.

and Indonesia ($61.200 Corporate Governance and Finance in East Asia. The period 1993-1997 was one of lower inflation and declining lending rates. The crisis affected the Philippine corporate sector. however. the Republic of Korea (henceforth. Table 3. and convertible securities.g. From the 1970s up to the early 1990s. but not to the same extent as it did in other Asian economies. Korea and Thailand). most listed companies are controlled by their five largest shareholders.. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. However. is far ahead of the flock. companies expanded only at a moderate pace. preferred stocks. Philippine companies were less leveraged. They invested in only a few large companies whose shares were relatively liquid. Foreign funds were wary of the Philippine stock market because of its limited liquidity. II sector. Malaysia. Rising stock prices during the Ramos administration reflected to some extent the business optimism. and less engaged in risky investments. As a result. In part. especially short-term debt.14 shows that the average volume of daily trading in 1997 stood at P2. while interest rates were at high levels and volatile. The stock market was depressed up to the early 1990s. Of the 221 companies listed in the Philippine Stock Exchange in 1997. about the size of Thailand’s. inflation. compared with Malaysia ($186 billion).4 billion (or $59 million using the average exchange rate). compared with other economies. less exposed to foreign debt. this is because. Vol.000 companies. Interest rates. only 84 had sales large enough to be placed in the top 1. the country experienced double-digit inflation.5 billion). Even in the real estate sector. the minimum required to qualify as a public corporation. Equity instruments include common stocks. Equity financing through IPOs was active. was one of the smallest in the region at $47. 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. Most publicly listed companies issue only up to 20 percent of total shares to the public. The market capitalization of the Philippine stock market in August 1997. 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. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. Korea) ($143 billion). Foreign portfolio investments also remained small. The Philippine stock market is not a liquid market. The corporate sector raised a substantial amount of . Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods.7 billion.

3 Market Capitalization (year end.6 1.4 728.0 1.0 2.2 3.248.2 1.2 61.8 1.0 0. P billion) Gross Domestic Product (current prices.8 1.0 0.421.1 0.5 1.3 2.14 Philippine Stock Market Performance.3 — = not available.4 1.5 16.3 158.906.515.8 102.Table 3.2 1.7 41.9 608.251. 1983-1997 Daily Trading Volume (P million) — — — — 129.7 0.2 59.1 0.474.2 57.5 Year 369.6 1.445.9 2.6 261.5 72.7 1.9 114. .9 12.1 0.3 4. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.2 ($ million) — — — — 6.3 0.373.1 524.8 1.545.7 207.0 161. Source: PSE databank.9 2.5 571.077.1 0.5 1.686.386.5 12.8 0.4 Ratio of Market Capitalization to GDP 0.3 314.692.171.2 297.351.2 925.3 59.7 2.5 26.4 9.1 88.2 0.121.0 0. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.9 682.088.1 5.8 799.3 0.9 1.7 391.2 0.

202 Corporate Governance and Finance in East Asia. of which 85 percent was raised from 1993 to the first half of 1997. The largest buyers have been commercial banks. and the dominance of large commercial banks. and high transaction costs. discounting of receivables. However. include bank credits. Under SEC regulations. a strong regulatory system for bank supervision is imperative.. The corporate bond market was stunted. From 1988 to 1997.4. which ultimately influences the pricing of commercial paper issues. The underwriter. the rights issue was a popular way of raising equity capital. moreover. Only the commercial banks. which were the principal source of corporate financing in the Philippines. Because existing shareholders wanted to retain their proportionate control over their companies. However. because business groups often own large commercial banks. corporate bond issuing was even more limited. Negotiated credits. Only a few large companies floated commercial papers because of the limited market. The measures used in the analysis are: . new equity. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. Corporate bonds are another type of debt securities. lack of competition among financial institutions. sells these commercial papers through brokers. asset-backed credits. about 127 companies went public with a total value of offerings of about P134. and inventory financing. leases. Vol. which buy commercial papers either for their own account or for their clients. by virtue of their large stakes in the financial system. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc.6 billion. 3. Capital markets cannot provide the market discipline that corporate investors need. are in a position to provide such discipline. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997.2 Patterns of Corporate Financing The study looked at retained earnings. tight regulations. Debt instruments include negotiated credits and debt securities. which in most cases is an affiliate of the issuing company. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. and debt as sources of corporate financing by using flow of funds analysis. by volatile interest rates and the absence of a secondary market. The picture of the financial system that emerges is thus one of limited capital markets. Debt securities include commercial papers and corporate bonds.

As shown in Table 3.1 0.2 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.000 Corporations in the Philippines. .5 0.8 0.9 0.9 0.8 0. 1988-1997.1 0.5 0.5 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.2 0.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets. it is one minus IDFR. the SFRT was low at Table 3. during this period.4 0.6 0. By definition.4 0.5 0.000 Corporations in the Philippines from 1988 to 1997.3 0.0 0.6 0.4 0. It measures a company’s reliance on borrowings in financing asset growth. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.9 0.1 0.1 Average 1.15 Financing Patterns of the Corporate Sector.4 0.5 0.9 0.2 0.5 2.2 0.3 0.2 0.5 0.4 0.4 1.5 0. the average SFRF was high at 109 percent.1 0.5 0.4 0.7 0.3 0. It measures a company’s capacity to finance asset growth by equity capital. It measures a company’s capacity to finance asset growth by internally generated funds.8 0.3 0.6 0.4 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.3 0.5 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets. On the other hand.0 0.3 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.15. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.1 0.3 0.

Total assets grew by 23 percent that year. implying that internal funds were far from sufficient to finance growth in total assets.3 0. retained earnings declined and few new equity investments flowed into the corporate sector. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. This was mainly caused by the declining contribution from retained earnings. There were significant year-to-year variations.5 Foreign-Owned 1. .3 0. On Table 3.8 0.5 0.and foreign-owned.5 Privately-Owned 0. 1988-1997. Vol. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. Corporate Financing by Ownership Type As shown in Table 3.2 0. Companies financed fixed assets from internal sources in hard times. the SFRF was higher.16. In 1997. 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 1997.7 0.204 Corporate Governance and Finance in East Asia. Retained earnings were the least important.2 (0. privately. In periods of an economic crunch such as in 1989. except for foreignowned companies that had a negative new equity financing ratio.000 Corporations in the Philippines. reflecting the capital flight caused by political instability in the early 1990s.3 0. the level of corporate leverage increased.0) 0. 1991. II only 19 percent. for all three types of companies—publicly listed. internal funds were not a significant source of financing growth in total assets. debts were the most important source of financing.1 a Excludes negative balances. Source: SEC-BusinessWorld Annual Survey of Top 1.16 Corporate Financing Patterns by Ownership Type. As a result. except in 1991. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. In all the years. when it financed 45 percent of it. and 1997.3 0.9 0.6 0. with debt providing 93 percent of the financing requirements.

0 13. publicly listed companies relied more on new equity financing than privately.2 3. especially bank loans.1 15.3 4.7 4.3 12.0 1995 1996 13.8 51.9 3.3 12.4 3.17.1 9.4 100.000 Corporations in the Philippines.3 10.9 12.1 13.3 13.2 12.4 10.1 10.0 9.8 38.0 8.4 41.0 10.5 27.0 12.17 Composition of Assets and Financing of the Publicly Listed Sector.2 51.6 48.0 10.and foreign-owned companies.4 43. 1988-1997.0 1994 19.5 41.8 3. The sector built up its short-term debts. . 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 14.0 9.7 23.9 16. Foreign-owned companies relied more heavily on debt financing.0 9.3 10.6 26.4 2.9 4.0 Source: SEC-BusinessWorld Annual Survey of Top 1. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.7 7.5 16.3 48.7 2.8 26.8 39.3 12.1 7. It presents a composition analysis of assets and financing sources for the period 1992-1996.9 38. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.8 3.0 38.4 100.8 16.2 100.8 0.6 0.0 1993 14.6 37.0 6.2 3.9 100.9 0.7 2.0 53.Chapter 3: Philippines 205 average.5 9.8 100.0 9.4 2.9 24. significantly Table 3.6 48.4 100.2 100.5 12.8 46.8 4. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.9 16.5 0. contributing 90 percent of growth in total assets.9 16.8 17.1 49.2 42.3 11.7 13.8 0.3 51.7 13.4 12.4 100.6 43.0 100.1 50.7 100.

For these two reasons. On average. group companies usually financed their investment in member companies by equity rather than debt.9 0.2 0. 1988-1997. 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.1 0. . The traditional measure of liquidity. their inherent ability to pool risks. Table 3.5 0. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.5 0. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1.000 Corporations in the Philippines.3 0.3 0. II in 1996 and became more vulnerable to the financial crisis in 1997. Group companies financed an average of 45 percent of growth in total assets by debt. the current ratio.45 in 1996. indicating that many publicly listed companies were likely to be in a tight liquidity position. the easier access to external credit.18 Financing Patterns by Control Structure. respectively. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.18. Group companies were generally more profitable than independent companies. and economies of scale in fund raising. The normal standard liquid position is a current ratio of 2 or higher. As shown in Table 3. the average SFRF of business groups was higher compared with that of independent companies. as opposed to 94 and 30 percent.206 Corporate Governance and Finance in East Asia. Vol. Further.13 was at 1.6 Independent Company 0.3 0. for independent companies. compared with an average of 54 percent for independent companies.

20).19 Financing Patterns by Firm Size. equity financed 42 percent of incremental asset growth. There was also increased reliance on debt financing. averaging 61 percent of growth in total assets.Chapter 3: Philippines 207 independent companies.3 0. The corresponding ratio was 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.19).1 0.76 for small companies and 0.55 was substantially higher than the small companies’ 0.47. and 1997 with 131 percent. 1988-1997.8 0. On average.08 and SFRT of 0.3 0.5 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.6 0. compared with 55 percent for large companies and 47 percent for small ones.2 0. Excluding . medium-sized companies used more debts. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. Large companies’ IDFR of 0. With assets growing at a fast pace during this period.5 Medium 3.88 for large companies (Table 3.3 0. Table 3.000 Corporations in the Philippines.50 (Table 3.2 0.2 0. with an average of 3.6 0. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. Large firms consistently increased their reliance on debts from 1994 to 1997.06. Source: SEC-BusinessWorld Annual Survey of Top 1. These years were 1991 with 110 percent.9 0.4 Small 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.5 Excludes negative balances. 1993 with 96 percent.

208 Corporate Governance and Finance in East Asia.20 Financing Patterns by Industry. The sector had the highest leverage among all industries that year. The construction sector was a heavy user of debt financing.5 0. The situation improved beginning 1994. During the crisis year.6 0.4 Construction 0.4 0.04. Excluding 1997 when fixed assets declined. debt financed about 78 percent of asset growth in real estate.1 0.7 0. Up to 1997. Source: SEC-BusinessWorld Annual Survey of Top 1. Since the real estate boom coincided with that of the stock market. increasing to 0.47 two years later.6 0. Incremental equity financing amounted to an average of 44 percent of total asset growth. with an SFRF as low as 0. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.4 0. ranging from 41 to 118 percent. . when debts declined. while SFRT averaged only 0.3 0.4 3.4 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. SFRF for the sector averaged 0.2) 0. the industry generated internal funds. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. In the eight years preceding the crisis. the incremental equity ratios of the industry were high. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.27. The real estate industry financed its growth by substantial equity funds. many of the leading real estate companies successfully went public during that time.29.32.3 0. Table 3.5 (0. Vol. achieving an average SFRF of 3.3 0. While this level is considered prudent.5 Utilities and Real Estate Services and Property 0. II 1991. The effects of the crisis of 1997 were adverse.6 a Excludes negative balances. Equity financed an average of 62 percent of total asset growth.79 and in 1997 at 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994.3 0. the total debt ratio was much higher in 1996 at 0.91. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. the manufacturing industry financed 57 percent of its total asset growth by debt.5 0. 1988-1997.000 Corporations in the Philippines.6 0.58 and SFRT of 0.

ROE = return on equity. creditors bear the consequences. ROE.21 Ownership Concentration.4.004 3. as the dependent variable.287 0.00036 2. and financial leverage are all positively and significantly related to the degree of ownership concentration. Journal of Finance 48: 831-880. Financial Leverage.14 Large shareholders may borrow excessively to undertake risky projects. and leverage. and the Failure of Internal Control Systems. . Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. ownership concentration = the total shareholdings of the top five shareholders. knowing that if an investment turns out to be successful they could capture most of the gain. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and.421 0. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. measured by the percentage of shareholdings of the largest five shareholders. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. Using the PSE database. As shown in Table 3. 1992-1996.769 0.21.Chapter 3: Philippines 209 3. 14 See for example Michael Jensen (1993). ROA.009 5. more profitable. at the same time. was regressed against measures of profitability and of financial leverage. ROA = return on assets. ROE.008 5. alternatively. The Modern Industrial Revolution.130 ROA 0. Source: Author’s estimates based on the PSE databank. Table 3. Exit. Profitability. while if it fails.860 Leverage = the ratio of total assets to total equity.00056 1.230 Leverage 0.00125 2. the degree of ownership concentration.3 Ownership Concentration. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.

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

Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. From 1993 to 1997.1 percent. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. in turn. resulting in stability in the short-term debt to reserves ratio. From 1988 to 1996. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. the Government sought stability and achieved this in 19921997. which. while sales grew by only 20 percent per year. adjustments were focused on the quantity and quality of the banking system’s corporate loans. depended on the quality of the corporate sector’s investments. fueled also by successful IPOs during the stock market boom of 1993-1996. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. Eventually. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. a positive balance of payments from 1992 to 1996.6 billion as of March 1997. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. an average Treasury bill rate of 13. The lessons from debt restructuring became the basis for the Government’s economic policies. however. 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. the Government restructured its debts into longer tenors with a maximum of 25 years. . and a relatively healthy banking system. Closer analysis. In the Philippines. an average inflation rate of 7. During this time. The corporate sector was in a relatively stable financial condition around the time of the crisis.5 percent. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. Total debts were only 52 percent of assets or 108 percent of equity.3 percent. unlike their counterparts in the region. After hovering in the range of 100 to 127 percent. average ROE was 13. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. Profitable operations since 1992 had allowed it to build equity. assets grew at a compound annual rate of about 31 percent. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. a government fiscal surplus from 1994 to 1997. the country and the corporate sector had no access to foreign currency debts from the international financial market.8 percent.

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. precisely. Most of this leverage happened during the boom years in the region. net FDI remained stable at more than $1 billion.300 1. Vol.212 Corporate Governance and Finance in East Asia. Net foreign portfolio investment amounted to $1.22.101 92. or 114 percent of net foreign direct investment (FDI). The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. Debts financed a large part of this expansion. Table 3. growing by about 34 percent per year from 1994 to 1997.073 (406) 121. But portfolio investment amounting to $406 million flew out of the Philippines. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. 1998 = 41.22 Foreign Investment Flows. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.101 billion or 196 percent of net FDI in 1996.609 1.0 1998 739 555 328 69. These patterns in investment and financing are similar to those of other countries in the region.7 Note: Peso-dollar exchange rates used are: 1995 = 25. 1996 = 26.0 1996 3. the other immediate impact of the crisis was that on foreign investment flows. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region.47. It rose to $2. In sum.650 32.22). .06.485 145.5. 1997 = 29. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.718 30.303 23. In 1997.5 billion in 1995.517 1. mitigated the effects of the pullout and liquidation of investments in the aftermath. 1995-1998 Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1. but to a lesser degree.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.4 1997 762 1.749 26.” 3. It financed 26 percent of corporate capital growth. Sources: Bangko Sentral ng Pilipinas and SEC.71.074 2. Data for 1998 cover only January-August.

Loan calls.2 percent in November 1997. they were willing to restructure and renegotiate existing loans by corporate borrowers. Net profit margins were at a 10-year low at 4. The interest rates on Treasury bills. With the increase in borrowings and reduced liquidity.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. in turn. Lending rates were well above the 20 percent level from July 1997 to March 1998. sparking a rise in interest rates on corporate loans. Because of weak internal fund generation. The resources of the financial system that year totaled P3. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. new borrowings financed asset growth. 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. the commercial banking sector’s capital remained strong at 17.3 percent of assets.513 billion. in varying degrees for each sector. Average bank lending rates climbed to their peak of 25. ROE at 6.9 percent. meanwhile. with commercial banks holding P2. albeit at current market interest rates.2 to 28. When the Treasury bill rates eased in March 1998. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. then rose to a high of 22. which held about 75 percent of the assets of the financial system in 1997. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. Companies deferred investments in new fixed assets.7 percent in January 1998. By March 1988. depended on the liquidity and capital position of commercial banks. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. Loans outstanding of commercial banks declined by the first quarter of 1998. By October 1998. lending rates also came down. The real problem of the corporate sector during the crisis was the rise in interest rates. the corporate sector became vulnerable to loan calls and high interest rates.2 percent was barely above inflation rate. Because commercial banks were strongly capitalized. and the wholesale and . Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. and leverage increased to 149 percent compared with 109 percent in 1996. the sectors with the highest outstanding loans had reduced their credit exposures.369 billion. ranged from 11 to 13 percent from 1993 to July 1997.

3. The Central Bank adopted other measures to strengthen the financial system. including (i) a regulatory limit of 20 percent on banks’ loans to the . The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. These figures show that adjustment problems were industry-specific and that the real estate industry. This allowed the Central Bank to convince the banks. However.5. Still. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. was a problem sector. set limits on overbought/oversold foreign exchange positions of banks.3 percent in December 1997. In March 1997. and its experience of low. As for nonperforming loans (NPLs). and the financial system. II retail trade sector. Vol. These peaked at 14. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986. by 12 percent.6 percent in June 1998.5-6 percent.5 percent by September 1998.9 percent of bank loan portfolios. and set up a hedging facility for borrowers with foreign currency-denominated loans. But the Philippine banking system had gone through worse crises in the past. the ratio increased to a high of 11. thereby reducing overall intermediation costs. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. 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.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. single-digit NPL ratios began only since 1989. real estate loans averaged 11. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. The move retained the liquidity position of banks but lowered their cost of reserves. and subsequently went down to 13. as with its counterparts in other Asian countries. the fiscal position. through the Bankers’ Association of the Philippines.214 Corporate Governance and Finance in East Asia.

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

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

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

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

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

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

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

SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. This way. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. In developed capital markets. management. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. Two measures should be adopted to promote shareholder activism. and lending to DOSRI. an active financial analyst community can begin to form. Its priority is to protect prospective fund investors from unscrupulous fund managers. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. and external auditors. 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. The current law should expand class action suits to include management and . SEC appears to be taking a primarily regulatory posture in the operation of investment funds. 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. This investor profile has a “missing middle”—long-term investors who intend to participate in longterm growth of a company and who also trade shares depending on company performance. Investment and venture capital funds meet this description. By supporting the establishment and operation of institutional investors. transparency. 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. Vol. II proper rule. institutional investors lead public investors in providing market signals to companies. If institutional investors are present. foreign ownership of banks. Institutional investors impose market discipline by voting on strategic corporate decisions.222 Corporate Governance and Finance in East Asia. Presently. institutional investors can be a driving force in providing market discipline to management.

the Government could develop the market for future issues of corporate bonds. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. information disclosures. Legal provisions for class action suits should cover self-dealing by directors. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. And by issuing Government Treasury securities in longer tenors. 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. and Credit Information Bureau that can be the starting point of this effort. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. leadership. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. There are existing institutions such as Dun and Bradsreet. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. and the external auditors. their directors and management. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. compensation contracts. SEC should allow minority shareholders to be represented by activist groups. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies.Chapter 3: Philippines 223 auditors. These groups have an incentive to gather technical expertise. entry . guarantees. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. and dividend decisions. Securities market development efforts should coincide with strict regulation of the commercial banking sector. 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 provide quality basic services should also be heightened. and publicly listed companies trade barely the minimum number of shares required for public listing. Current disclosure requirements of SEC are not rigorous enough for public investors. Many large companies remain privately owned. PSE and SEC need to build a liquid and efficient market. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. Lack of liquidity deters institutional investors. Vol. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. PSE should campaign for top-tier companies to go public and work with SEC in encouraging publicly listed companies to expand their share offerings to the public. improve enforcement of the rule of law.and medium-scale companies can become more competitive relative to large companies. Penalties for poor conduct of auditing by independent . The Government should also continue to improve infrastructure. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies.224 Corporate Governance and Finance in East Asia. Audited financial statements contain basic information about a company’s financial position and performance. so that small. II and exit barriers. 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. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. Efforts to reduce graft and corruption. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. and various other forms of protection.

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

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

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

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

1 Introduction In May to July 1997.4 Thailand Piman Limpaphayom1 4. had been plagued with prudential problems for a long time. The author wishes to thank Juzhong Zhuang. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. David Edwards. Republic of Korea (henceforth. the Thai Government conceded and adopted a floating exchange rate regime. the Stock Exchange of Thailand for its help and support in conducting company surveys. Korea). The fixed exchange rate policy. the Thai baht came under pressure from speculative attacks. and Philippines all depreciating significantly. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. the banking system merely validated the financial risks. magnified the impact of these problems on the economy when the crisis hit. The majority of these debts were not properly hedged. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). heralding not only a financial crisis in the country. Faculty of Business. For the period 1994-1996. short-term private debt obligations grew to about 60 percent of total private sector debts. with the currencies of Indonesia. Malaysia.” After mounting an aggressive defense of the currency. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. and Lea Sumulong and Graham Dwyer for their editorial assistance. but also the stalling of East Asia’s “economic miracle. 1 Associate Professor. . both of ADB. In the prelude to the 1997 crisis. Thailand. But it also laid bare weaknesses in both the financial and corporate sectors. with Thai corporations overutilizing short-term foreign currency-denominated loans. The corporate sector also contributed significantly to the crisis. The banking system. As a result. Thai corporations were collectively overexposed to exchange rate risks. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. poorly regulated and sheltered from competition. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. It was inefficient in financial intermediation. Chonburi. Asian University of Science and Technology.

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. as well as its legal and regulatory framework. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. The First and Second Plans (1961-1971) Under the first two plans. its growth and financial performance.2.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. with government policy providing support but avoiding direct interference. This study examines these and other factors that might have weakened corporate sector governance in Thailand. Section 4. Section 4. To protect domestic industries.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. and a family-based corporate ownership structure. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Vol.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. the Government increased tariffs on products that could be produced locally. The country initiated national economic development planning in 1961 when the economy was growing rapidly. The study then considers policy recommendations with emphasis on corporate governance improvement.2 4. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).230 Corporate Governance and Finance in East Asia. lack of transparency and adequate disclosure. Section 4. while new industries were encouraged to reduce the need for imports. The National Economic and Social Development Board was created to plan the country’s economic and social development. Section 4. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. . 4. Import tariffs on machinery and heavy equipment were removed.

including a weakening of the dollar. with the devaluation of the baht in 1984 a major step in this direction. with the agricultural sector the major contributor.5 percent in 1973 and 24. chemicals. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. To close the fiscal gap. Inflation reached 15. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. textiles. The Third. The decline in imports was steady. resulted in increases in the current account deficit. especially foreign aid from the United States. processed steel. The average budget deficit reached an all-time high of $2.6 percent per year. leaving the Government no choice but to resort to overseas borrowings. it proceeded with its development plan for the industrial sector. including luxury goods. Fourth. and reduced current account deficits.15 billion per year or 4. The Government had to shift emphasis to restoration of economic stability. At the same time. Inflation levels were low. Consequently. an improved trade balance. Budget deficits also increased throughout the Fourth Plan. Budget deficits remained a major problem during the Fifth Plan. Average growth for the period was 4 percent per year.4 billion from overseas and increased taxes on numerous items. External factors.4 percent of GDP. lower than anticipated due to a worldwide economic recession. the Government borrowed $6. canned foods. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. The results were increased exports.Chapter 4: Thailand 231 During this period. . the government’s debt burden escalated. however. gross national product grew by about 7 percent per year.3 percent in 1974. Unemployment. however. the industrial sector grew at a faster rate than the agricultural sector. the current account registered a surplus in 1986. helped offset these deficits. As a result. However. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. Thus. and increases in world food and oil prices. averaging 1. capital inflows. became a major problem as domestic investment declined. Industrial sector growth was also rapid and many industries (tires. the value of the baht remained stable. The focus shifted to export promotion. remaining high until 1981. and automobile assembly) emerged.

China—went to export-oriented manufacturing industries. compared with the 14. The manufacturing sector became a dominant force in the economy. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. Inflation was 4. Average annual growth in real GDP was 8 percent. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. the bulk of domestic investments went to speculative ventures such as real estate. from only $31 billion in 1992.2 percent per year.7 and 11. Europe. respectively. with private foreign debt reaching $92 billion by the end of 1996.4 percent targets.5 percent. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. averaging 10. On top of its predominantly “borrowed” nature.2 and 13. Private sector investment grew at an average annual rate of 7 percent. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. Vol. Most of the FDIs—originating mainly from Japan. the property sector began to collapse in 1996.5 to 13. combined with its liberal financial policies.8 percent. From 1989. and Hong Kong.6 percent. property development.8 percent. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. The country’s high ratings in the international capital market. Thailand became a debtor’s market. lower than the target of 8. invited a deluge of capital seeking profitable investments. The country also attracted a large amount of foreign direct investments (FDIs). while exports expanded considerably. reaching an annual inflow of $2 billion in 1991.232 Corporate Governance and Finance in East Asia. and the stock market. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. better than the 5. compared with the 8. an oversupply of housing emerged. . Singapore. Growth of exports and imports averaged 14. rather than to productive activities.6 percent target of the Seventh Plan. United States. Growth rates during 1987-1991 ranged from 9. By 1995. The exchange rate was steady at around B25 to the dollar. increasing its share in total export value from 42 to 76 percent.2 percent target. compounded by a slump in property sales.

In May 1974. many companies considered the Act too restrictive and a hindrance to growth. SET officially became “the Stock Exchange of Thailand” in 1991. the Government passed the Public Limited Company Act. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. In 1972. Under the 1962 Commercial Banking Act. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. However. 4. which raised the debt service ratio. the Government amended the “Announcement of the Executive Council No. a former Chief Economist from the US Securities and Exchange Commission. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. on account of an overvalued baht that weakened export competitiveness. the corporate sector’s main source of funding was the banks. Foreign banks were barred from competing directly with domestic banks.8 percent in 1995 to 1. In his report.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. Sidney M.” which later became the master plan for the development of the Thai capital market. 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.Chapter 4: Thailand 233 Toward the end of the Plan period. Robbins. which was amended in 1979 and 1985. And because the Government considered the banking system vital to the development of the economy. The deficits caused the Government to rely on even more external borrowing. a policy that held throughout the first six economic development plans. In 1969. the signs of an economy about to falter were there.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. its policy had always been to protect domestic banks. the Bank of Thailand and . with growth shrinking from 23. In 1978. the capital markets didn’t play a significant role until 1975. Before the capital market emerged. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. placing all publicly listed companies under regulation. prepared a comprehensive report entitled “A Capital Market in Thailand. Exports went into a tailspin.3 percent in 1996.2. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975.

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

3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act.6 23.9 1. Source: Department of Commercial Registration.Chapter 4: Thailand 235 fast-growing neighbors. and Communication Financing. Hunting. in that order.2. and Restaurants and Hotel Transport.3 83. The majority of the companies are in manufacturing. and Water Construction Wholesale and Retail Trade.1 30. Storage.0 21. about 661 companies with total registered capital of B2. Financial deregulation and liberalization were key to realizing that vision.1). the country became recognized as an economic development model for other emerging economies. 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. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.394.1 Public Companies Registered.0 110.9 16.6 1. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. .2 Type of Business Agriculture.0 19.9 261.5 791. the financial sector is the largest. and Business Service Community.4 trillion in registered capital and B791 billion in paid-up capital.101.1 78. The result was a corresponding growth and development in Thailand’s capital markets. Insurance.5 111. In terms of capital.1 trillion and paid-up capital of B1. however. and Fishing Mining and Quarrying Manufacturing Electricity. Worldwide.9 34.0 Paid-up Capital (B billion) 1.2 11. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. finance. 4. with B1. and wholesale/ retail trade and restaurant/hotel sectors.6 2.3 trillion have been registered with the authority (Table 4. Forestry. Real Estate. Social and Personal Service Total Note: The data for 2000 is as of October 2000. Thailand.5 50. Ministry of Commerce.6 350. Gas.291.

7 billion in 1996. After the passage of the SEA of 1992.5 39.6 — = not available.7 7. the value of public offerings rose steadily.9 1998 1999 15. 1992-1999 (B billion) Type of Securities Equity Debt Instrument Domestic Offering Offshore Offering Hybrid Instrument Domestic Offering Offshore Offering Total Funds Raised 1992 1993 1.4 96.7 9. meanwhile. The signing of Article VIII with the IMF.3 31.1 599.9 37. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.3 22.5 1.2 5.236 Corporate Governance and Finance in East Asia.6 174. from only B20.4 277.8 billion. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.0 20.1 54.8 1995 64. These peaked at B89. 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. reached .0 0.3 194.3). reaching a precrisis peak in 1996 (Table 4.4 34.6 8. Vol.5 1. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. The stock market also became an invaluable source of funds for corporations.8 151. respectively.3 1996 1997 65.2). The 1997 crisis battered the primary market for securities.1 286.1 — — — 6. Market capitalization. The number of listed companies and securities steadily increased until 1996 (Table 4.7 136.1 2.6 7.3 6.2 40.2 25. The development of the corporate sector closely followed the development of capital markets.5 — — 56. Domestic and offshore debt issues reached B54. II B261 billion. Source: Key Capital Market Statistics.2 Public Offerings of Securities. moreover. Securities and Exchange Commission of Thailand.5 billion and B1 billion the previous year.8 201. Table 4.2 12.8 — 26. the capital market became instrumental in the rapid growth and development of the corporate sector.6 39.7 5. the year before the crisis struck. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.0 1994 82. allowed Thai financial institutions and corporations to obtain funds overseas.7 27.9 31.4 51.7 billion and B27.

gross profit margin rose until 1991 before falling in 1992. Foreigners accounted for an increasing proportion of SET’s turnover value. then stalled in 1990. as measured by return on assets (ROA). however. however.3 percent in 1989 to 3.133 1. ROA dipped from 10.325 3.610 1. their share rising from 17 percent in 1993 to 43 percent in 1997.201 2. From 10. Side by side with this surge of financing for corporate growth. resulting in their inability to fulfill debt obligations. not all public companies are listed on the SET. corporate profitability had been declining.1 by 1996.683 1. the averages for all three profitability ratios took a downswing all the way until 1996.3 Statistical Highlights of the Stock Exchange of Thailand.4). By the early 1990s.Chapter 4: Thailand 237 Table 4. The key financial ratios of all companies listed on SET bear this out (Table 4. Throughout the 1990s. the companies could not generate enough net returns from their assets and equity.4 percent to 5. the average times interest earned (TIE) was down to 5. Corporate profitability.6 trillion. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . return on equity (ROE).114 1. The financial leverage of all companies declined until 1994. But instead of shifting to a low gear.268 2. and gross profit margin. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. in the end. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3.8 percent.360 1.560 1.281 832 373 356 482 Due to listing requirements and other reasons.301 3. its high point in 1995 at B3. Source: Securities and Exchange Commission of Thailand.5 at its peak in 1987.565 2. pulled down by active public offering activities.4 percent in 1996.303 930 855 1. had been on the rise throughout the 1980s. While the decline in gross profit margin was not as sharp.535 1. was the ominous deterioration in the key financial ratios of publicly listed companies. Meanwhile. The upward trends for ROE and ROA continued through 1989. ROE similarly fell from 21.193 2. The trend reversed in 1995.

8 5.4 119. They were generally more efficient in managing their assets and .3 10.8 151.5 15. Hotels and travel showed the highest ROE of 15 percent while textiles.8 51. Severely affected by global competition throughout the decade.5 51. the textiles.4 7.1 9. and footwear industries also experienced losses.9 8.0 29.3 8.6 125.2 64.6 12. US.4 26.7 12. which was particularly significant in the two years preceding the crisis.1 120.1 242.8 5. and footwear had the lowest at 11 percent.4 139.8 25.1 16.2 27. Among the crisis-hit countries.7 4.2 10.238 Corporate Governance and Finance in East Asia.7 15.6 41. which fell from 16 percent in 1991 to just under 6 percent in 1996. was also distinct in the region. Overall.7 59.9 51.7 27.7 5.8 8.4 12. resulting in higher collateral values for borrowers.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.0 7.7 27. these companies opted for debt. clothing.8 14. II Table 4.7 12.5 50.7 12.7 5. Thailand’s ROE.5 52.4 12.4 Key Financial Ratios of Publicly Listed Companies.9 66.7 34.2 10.4 18.7 54.7 21.4 24.0 145.2 49.1 114.7 80.1 16.0 63. was felt across industries.8 54.5 30.9 14.2 215.2 35. practice of heavy borrowing. Despite the availability of the equity market. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.2 10.2 161.8 88.9 7.6 138.1 44.7 20.9 140.5 38. 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 (%) (%) (%) 3.7 5.4 44.3 91.4 9.4 51.0 125.4 34. The downtrend in corporate profitability.9 39.9 77.6 27.4 5. Vol.6 7.4 47.8 11. 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 7.0 3.1 60.6 168.3 4.6 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.5 9. Korea and Thailand had the highest debt-to-equity ratios.7 35.9 27.4 3.4 7. clothing.4 28.3 12.4 4.2 6.7 12.0 139.5).1 52.6 36.0 117.5 63.2 27.9 144. A major reason for this was the rapid rise in asset prices.

6 31.6 12.2 12.1 29. 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 6.1 6.5 87.6 10. In sum. For instance.1 Small Medium Large 5.6 61.8 26. by the 1990s.3 43.8 62.3 88.5 6. capital despite the higher gross margins of small companies. the overall activities of listed companies.3 176.8 10.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 20. could lead to a high turnover in the board. measured by total asset turnover. 4. .6 6.7 6. it was thought.0 20.3 49. the law disallowed cumulative voting.Chapter 4: Thailand 239 Table 4.4 Legal and Regulatory Framework Before 1992.3 49. US. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. During the 1990s.5 7.3 15.2 18.3 52.6 30. Cumulative voting.2 10. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.8 6.2 121.1 13.4 52. They also tended to use more financial leverage than small companies as their total DERs show.4 116.2 134. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.6 7.3 164. although the performance of listed companies in the late 1980s was strong. also deteriorated.7 10.8 47.3 135. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.7 14. total asset turnover declined after 1989. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.8 6.2.1 25.3 23.0 48.5 Average Key Financial Ratios by Company Size.1 5.6 5. However.4 8.5 94. weaknesses became evident. Although stable in the 1980s. which would be disruptive to company management.0 83.8 142.9 13.6 30.3 25.

a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. Cumulative voting was made optional. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. the exit of these provisions appears to have contributed to the 1997 financial crisis. that creditors had generally little influence on the management of corporations. relaxed the contentious provisions of the 1978 Public Limited Company Act. 4.5. As the succeeding sections point out. Fortysix companies responded. but not all questions were answered. and external monitoring and control of corporations were also weak. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. and the punishment for management misconduct was also lightened considerably. for instance. The protection of minority shareholders was inadequate under the Public Company Act of 1992. This will be discussed in Section 4. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. . The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. As it turned out. The Public Company Act of 1992. An Asian Development Bank (ADB) survey conducted for this study shows. played an important role in bringing about the financial crisis. adopted to promote the development of publicly listed companies. The law prohibited the largest shareholders. The provision discouraged original family owners from registering their companies. II Another issue was the proportion of shareholding by top shareholders.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. coupled with weak corporate governance. Vol.240 Corporate Governance and Finance in East Asia. concentrated ownership. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. as a group. However.

China firms have the highest single shareholder ownership concentration at 35.9 3.9 11.0 53.1 5.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.9 54. 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.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.1 11.0 3.1 5. 56. Indonesian.1 4.4 26.6 4.4 5.3 7.2 11. .8 32.China have the least concentrated ownership.Chapter 4: Thailand 241 4. there were only slight variations in the pattern.4 6. Ownership Concentration Between 1990 and 1998. these companies obtained funding solely from banks or from their own retained earnings. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. Across industries.3 28.9 26. Ownership was most concentrated in the packaging.1 3.3 11.4 percent of outstanding shares.4 6.4 26.7 6. Table 4.1 12.6 57.5 Average for 1990-1998 period.5 9.0 7. respectively.2 56. one would expect the public. Source: Comprehensive Listed Company Information Database.4 10.3.0 56. 33.9 55. Most large Thai corporations listed on SET started out as family businesses. with the largest shareholder on average controlling 10.1 percent of control rights.7 7.6 68.0 3.2 4.2 4.0 7. on average. and Hong Kong.7 11.9 3.3 percent and 18.7 12.4 4. and 28. the top five shareholders of each of publicly listed Thai companies held.9 6.1 5.3 5.8 11. But with their increased reliance on new varieties of equity and debt instruments. with the top three shareholders accounting for almost 50 percent (Table 4.0 5. In contrast.4 26.3 percent.9 52.3 16.2 4. Stock Exchange of Thailand.8 5. In the past. and minority shareholders to stake their claim in the control and regulation of these companies.7 percent.9 percent of shares of a company.3 7. creditors.9 52.5 28. this was not the case. Thai.6 27.6 28.9 4.9 52.1 7.6). Unfortunately.

001 0.533)*** Debt-to-Assets (0.072) (0. owning 26. II agribusiness. results show a significant positive relationship between ownership concentration and financial leverage.001*** 0.080 6.242 Corporate Governance and Finance in East Asia. Vol. US. founding families maintain effective control of entire groups.800 0.7).7 Statistical Relationships between Corporate Profitability.034*** 0. with a top-five ownership concentration of at least 60 percent. including those that are publicly listed . Based on a regression analysis. year. Leverage.058* ROE (0. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. Through these holding companies.8). 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. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. as measured by debt-to-equity and debt-to-asset ratios.031 3.029 3.116) Debt-to-Equity (1.169*** 0. *** at the 1 percent level.003 0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. and ownership types.022*** 0. there is no statistically significant relationship between ownership concentration (measured by percentage of shares owned by the top five shareholders) and profitability of Thai publicly listed companies (Table 4. and building and furnishing industries.7 percent of outstanding shares on average (Table 4. Ownership Concentration. * Denotes significance at the 10 percent level.005** 0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.647 Note: The regression included dummy variables for industry. Table 4. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. ** at the 5 percent level.037 0.001) 0.090 0. On the other hand. Company size is significantly related to ROE and leverage.115 9.

3 20. averaging about 18. a company listed in the real estate sector of SET. the company.2 1.4 20. Typically.5 26.6 28.6 1.9 18. Established in 1980 with a registered capital of B300 million.9 7.5 1.6 percent of outstanding shares.7 Bank 2.2 5.2 1.8 28.5 Government Other 0.1 1.9 15.6 25.5 percent.8 0. Individual family members also hold a significant amount of outstanding shares.5 2.0 19.0 3.8 1.5 Individuals 13. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. in SET.Chapter 4: Thailand 243 Table 4.5 0.6 1.1 4.3 1.0 18.9 6.3 27. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.6 1.9 19.5 NBFIsa 6.7 5.7 — 1.4 22.0 17. Stock Exchange of Thailand. unlike in Japan where crossshareholding is common. The top 10 shareholders include a holding company owned by the Tejapaibul family. The ADB survey indicated that listed companies held shares in an average of 11 companies.4 1.2 7. In addition. owned by the Chirathivat family. In 1994.6 5. the affiliate firms rarely hold shares of their parent companies. Although holding companies set up affiliate firms.4 1. operates five of the most successful shopping malls in Thailand. individual members of the Chirathivat family aggregately hold 25. This practice is illustrated by Central Pattana.7 1.3 1.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.4 1.3 27.3 percent of outstanding shares.5 0.3 27. These individuals usually hold important management positions in concerned companies. . including finance and investment companies. one of the founding members.7 0.5 1. The largest shareholder is Central Holdings Company.5 0.3 — = not available. the company increased its registered capital and became a public company listed in SET.3 1.5 5.8 23. with 29. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28. a NBFIs denotes nonbank financial institutions. a joint venture among three families.3 0.2 18.9 0. Source: Comprehensive Listed Company Information Database.1 0.1 1.

5 percent of total outstanding shares. only one tenth of listed companies have commercial banks on their top-five shareholder list. roles. The Government holds.. Across industries. the Government owns the majority of the shares. . has the Ministry of Finance as its only large shareholder with 92. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. 4. the predominance of individual family members and holding companies in the top shareholder list remains valid. and responsibilities of directors of public companies. they account for 80 percent of total outstanding shares. they exercise limited influence in operations because of the restricted size of their shareholdings. Another example is Bangchak Petroleum Plc. In such cases. Thai Airways International Plc.3. both conducted in 1999. Nonbank financial institutions hold an aggregate 5. the top 10 shareholders consist predominantly of members of founding families and their holding companies. 1. duties.5 percent of total outstanding shares of listed companies. on average. Only a handful of companies have the Government among their large shareholders. On average. However. Vol.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. By owning 62 percent of voting shares. commercial banks account for only 1. qualification. Moreover. the Government’s role in public companies is expected to decline. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company.1 percent of total outstanding shares of listed companies.9 percent of outstanding shares. Together. Except in the hotel and travel service sector. the Petroleum Authority of Thailand. with the envisioned privatization master plan. II another of the company’s founding members. In effect.244 Corporate Governance and Finance in East Asia. these shareholders are able to control the company. For example. There was a trend of rising government shareholdings throughout the period 1990 to 1998. 3 Discussions in this section are based on results of company surveys by SET and ADB. and a state bank. Although the list of top shareholders of publicly listed companies includes financial institutions. where the top three shareholders are the Ministry of Finance.

an executive board consists of senior management and some main board members. Generally. Many companies have a formal policy on corporate governance and business ethics. but not in 22 others. If found in violation of these provisions. Unless stipulated in public companies’ articles of association. Meanwhile. In their business conduct. while 30 percent of respondent companies held board meetings monthly. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. Although 28 percent of the chairpersons came from the ranks of independent outside directors. directors may be imprisoned or fined. 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. directors could be compelled to compensate the company for damages arising from their misconduct. 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. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. . Three companies indicated that the CEO and the chair were close relatives. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. In five other companies. The ADB survey indicated. Some companies (36 percent) had five to six main board members holding seats in their executive boards. and to comply with the laws and articles of association. 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. selection was based on relationships with controlling shareholders. meanwhile. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. while 15 percent of respondents went beyond the requirement.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. In addition. directors shall be elected at the annual general shareholders’ meetings (AGSMs). A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter.

In 25 companies. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. 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. while 19 companies observed only some of them. Where different. Companies already with audit committees did not have independent outside directors as audit committee members. not an independent assignment. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. the remuneration packages had to be approved during AGSMs. the auditor is not .246 Corporate Governance and Finance in East Asia. These committees were mainly responsible for determining compensation for senior and regular staff. 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. Three companies allowed their management to determine the chair’s compensation package. Chair. Audit Committees and Accounting Standards Since January 1999. All respondents confirmed the use of external auditors. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. Vol. Half of the companies in the SET survey had a separate remuneration committee. II Compensation of Directors. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. however. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. Also. the work of this committee was often considered part of the executive board’s responsibilities. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. In one company. However. with 41 firms admitting the use of services of international auditing firms.

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

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

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

Such efforts would serve to strengthen external discipline on controlling owners. of shareholders: (i) all shareholders must receive tender offers. with a total tender offer value of B42. Vol. only a limited number of successful mergers of public companies have taken place. whether directly or indirectly. Recently. before the extent to which the bankruptcy framework has been strengthened becomes clear. In 1996. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. In this case. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value.9). It will take years. The second category is the tender offer. its main role is to ensure transparency and fairness. there were 41 cases of tender offers. there are two categories of merger and acquisition activities with associated regulatory measures. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. There are detailed requirements regarding such notification. The market for corporate control has not been active in Thailand. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. Since the introduction of the Public Limited Company Act of 1978.3 billion.3 billion (Table 4. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. Although merger and acquisi- . In 1994 and 1995. According to the SEA of 1992. and failed to provide managers with strong incentives to perform efficiently. however. SEC was later made responsible for regulating corporate takeovers. SEC has no authority to either approve or reject tender offers. if the purchase of shares implies a change in the directors or business activities. The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. with a significantly lower total tender offer value of B8. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. there were only six tender offers. 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.250 Corporate Governance and Finance in East Asia.

The number of domestic institutional investors rose after the mutual fund industry was established in 1991.3 11. While the Thai mutual fund industry compares well to those in other developing countries in the region.4 23.9 3. employees are even less willing to accept common shares as a form of compensation or benefit. . but the average shareholding is smaller than 1 percent of total outstanding shares.9 Merger and Acquisition Activities.1 75.3 60.5 6.2 6.7 Purchase Value Number of % of Tender Offer Value Companies 84. Eleven of the 46 responding companies in the ADB survey offer ESOPs.1 19. Twenty-nine firms indicated that employees held shares of their companies. Since 1994. Employee Participation in Corporate Governance There has been little.Chapter 4: Thailand 251 Table 4.1 84. Even when companies offer ESOPs.7 11.3 6.0 B billion 4.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. tion activities increased after 1997. Provident funds for government workers and workers in public enterprises have been established only recently. they have mostly been concerned with short-term gains. Pension funds are perhaps even weaker in Thailand. not with a view to becoming involved in actual management. employees regard the plans as monetary incentives.8 81.0 55.1 58.2 8. But instead of opting for an active role in the market for corporate control. but employees have never been represented in the board of directors since their shareholdings are minimal.2 6.6 17. trading by mutual funds in SET represented less than 10 percent of total trading. Because of the current crisis. Few companies offer employee stock option plans (ESOPs). 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. Source: Securities and Exchange Commission of Thailand. it remains small. most of these were forced mergers or related to rescue packages.2 7. employee participation in corporate governance in Thailand. if any.

0 8.5 6.390.8 941.564.3 546.5 4.912.4 4.1 6. In 1996. Vol.037.9 2.4 1.3 1.8 3.5 5.2 2. 15 of which were domestic banks.906.4 4.6 1. and Bank of Thailand.193.663. the banking sector was highly concentrated. Table 4.1 5. total assets of commercial banks amounted to B5.300.1 3.0 424.325.3 5.10) shows that Thailand is a highly bank-dependent economy.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.669.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4. the next four largest banks accounted for 63 percent.4. The country’s largest bank. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.133.6 6.4 519.372. . II 4.1 Domestic Debt Securities Outstanding 215. there were 29 commercial banks.360.0 3. The bond market played only a marginal role in corporate financing.10 Size and Composition of the Thai Financial Sector. The Banking System Until recently.775.430.171.252 Corporate Governance and Finance in East Asia..979. Competition from foreign banks was limited as they were not allowed to engage in full branch operations. Thai Bond Dealing Centre.0 339.119.485.5 trillion.5 4. The share of domestic banks in the banking system’s total assets was 80 percent.230. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.4 3. accounted for 28 percent of the banking sector’s total assets. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2. although its role increased in the wake of the crisis.1 3.477.2 262.825.1 7. Bangkok Bank Ltd.161.6 2.0 SET Market Capitalization 1.5 Outstanding Loans from Commercial Banks 2.559.268.

3 trillion. self-regulatory organization under the . Many company founders did not want to release even a small portion of corporate ownership and refused to go public. The Equity Market During the first few years of its operations. The lack of supply of quality shares was a big problem for SET at that time. In contrast. and almost all capital account transactions were deregulated. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. reaching 355. In the following years. SET is organized into 32 major industries. also made it unattractive to raise capital from the equity market. After that.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. Banking activity peaked in the mid-1990s. and property have accounted for the bulk of trading volumes. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. finance. was set up by 74 members with an initial capital of B500 million. In 1993. Because borrowers carried the exchange rate risk. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. The number of listed companies also quadrupled between 1981 and 1993. the stock market entered its first boom period in 1986. Easy access to commercial bank loans by family business groups.2 trillion. an over-the-counter market. owning 70 percent of the country’s second largest bank. the Bangkok Stock Dealing Center (BSDC). Benefiting from rapid economic and industrial growth. and 20 new foreign banks. Turnover value reached B2. Licenses were granted to 15 Thai banks. the SET index declined. SET immediately recovered due to the strength of the Thai economy. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. due to their close ties. In 1995. the market rose steadily and reached a record high in the fourth quarter of 1993. banking. BIBF banks also enjoyed tax incentives on their operations and profits. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. SET was not very active.8 in 1998. The Government removed controls on capital and dividend repatriation in 1991. BSDC is a nonprofit. Through the years. Some 347 companies were listed in the same year with a total market capitalization of B3. Despite the worldwide market crash in 1987. 12 existing foreign banks.

also acts as a clearinghouse. It separated the primary and secondary markets to promote more flexible and effective supervision of both. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. 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. Vol. The listing application should be submitted concurrently to SEC and SET. lottery drawing must be used to ensure fairness. to assist in the public offering process. each holding no more than 0. Only one security was listed in BSDC in 1995 and two more in 1996.8 billion in 1996. but dropped the following year to B122 million.254 Corporate Governance and Finance in East Asia. securities can be traded in the secondary markets. The company should then appoint a financial adviser. . In July 1990. If approved by SEC and the SET Board of Governors. In 1996. Before 1993. with each facing different listing requirements. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. Turnover value was B1. and pro forma balance sheet and income statements.5 percent and collectively owning at least 30 percent of paidup capital. the two classifications were merged. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. II jurisdiction of SEC. financial projections. turnover value was negligible and the BSDC Index remained flat throughout 19961998. so now only listed companies are traded in SET. After initial public offerings. the BSDC was dissolved in 1999. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. The allocation procedure is nondiscretionary. In 1998. and (ii) a minimum of 300 shareholders. Listed companies were those that had (i) paid-up capital of at least B20 million. however. there were two kinds of companies in SET—“listed” and “authorized” companies. According to the SEA of 1992. securities deposit center. If the issue is oversubscribed. Company applicants must have an established history of operating under substantially the same management. stock trading can commence within five days. which consist of SET and BSDC. SET. and securities registrar. among other functions approved by SEC. SET established new requirements for initial public offerings. Consequently. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. The primary market is supervised by SEC. approved by SET. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital.

compared to 110 percent in the US and 74 percent in Japan in the same year. in 1994.9 billion. Upon its founding in 1942. The budget surpluses of the 1990s eliminated the need for new bond issuance. 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. A turning point of the corporate debt market was the enactment of the SEA of 1992. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. To gain some perspective of the size of the bond market in Thailand. However. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. it represented only 9 percent of GDP. Investors had limited knowledge of debt instruments. The proportion of domestic convertible debt instruments increased until 1995.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. 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. 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. Four years after the passage of the SEA. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4.11). The bond market in Thailand started in 1933. the first bond rating agency in Thailand. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. was also instrumental to the growth of the corporate debt market. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. Beginning 1961. while secured debt instruments accounted for just above 10 percent. the Bank of Thailand assumed responsibility for regulating the bond market. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. In 1996. The recent financial crisis. it accounted for a small share of the entire financial sector. . however. the Government issued more bonds to finance industrial development projects and perennial deficits. The Thai Rating Information Services. which encouraged limited companies and public companies to issue debt instruments. the size of the corporate debt market rose to B132. and the Government did not issue new bonds during 1990-1997.

II Table 4.3 3.0 60.3 50.2 43. . The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.7 — — — — — — — 77.0 27. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.3 46.5 — — — 3.1 — — — 29.8 55.1 141.7 821.9 5.7 95.5 37.3 — — 3.11 Offerings of Debt Securities. Vol.3 — 14.1 315.3 29. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts. turnover value had reached B51.7 5.3 13.5 5.6 — 0.2 28. However.3 8.7 7.4 — — — 1.9 37. Total offshore debt offerings peaked in the run-up to the financial crisis.7 — — 40.4 57.8 191. 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 — — — — — — 400.2 45.9 329.8 2.5 — — 32.0 7.3 140.7 — — — — — 4.4 49.1 10.8 31.6 19.2 39. By 1995.2 57.3 22.9 40.5 43.0 26.7 132.5 billion.3 6. a surge attributed to capital inflows encouraged by high returns on Thai bonds.0 0.7 90.5 10.2 2.9 37.1 6.0 — 26.7 538.1 61.4 — 9.2 89.1 121.8 47.6 billion.1 — — 6.0 281.1 41.0 5.5 138. total offshore debt offerings had plunged by 68 percent to a mere B28.1 289.7 28. then declined substantially in 1996 and 1997.1 12.9 30.0 33.2 — — 50.1 21.7 0.4 110. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.6 — — 0.9 20.5 — 39.3 46. The following year.7 0. the year the crisis unraveled and the baht was floated.5 — 0.4 billion.9 0.0 17.0 — 5.1 8.5 — — — — 1.1 55.4 — 26.0 86.5 55. this had climbed to B200.256 Corporate Governance and Finance in East Asia.4 7.8 167. by the end of 1997.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.7 5.0 — 5.1 107. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.1 59.0 333.

In any case.4. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. judging by their relatively low levels of retained earnings. There was also little change in the trend in retained earnings within the seven-year period. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. The average for all industries was only 22 percent. while for the property development industry. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996.1 billion in 1998. Equity financing remains an important part of listed companies’ long-term financing. In 1997. In the same year. From 1990 to 1996. these comprised 31 percent.2 billion as a result of the default of debentures due to the Asian crisis. cash balances. Across industries. and marketable securities holdings. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. these accounted for 33 percent of total liabilities. The proportion of accounts receivable also declined steadily. In addition. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. For the construction industry.12).Chapter 4: Thailand 257 compared with investment in equities. turnover value plummeted to B106. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. 4. a trend most apparent in the leap between 1991 and 1992. Construction and property development industries tended to have high proportions of long-term loans and debentures. short-term loans accounted for more than 40 percent of total liabilities. At lower than 5 percent of total liabilities. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. significant variations can be noted. with equity levels remaining high despite an increase in debt. steadily easing up between 1990 and 1996. Longterm loans accounted for about 20 percent of total liabilities. Turnover fell further to B72. they also had a relatively small proportion of equity and . Retained earnings accounted for about 30 percent of total equity financing. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. Companies in construction and property development seemed unable to generate internal funds.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side.

8 34.4 8. The level of total liabilities for the group characterized by high ownership concentration .0 100.0 51.3 25.8 8.9 2.2 34.4 21.8 21.2 17.6 36.9 40. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.9 14.3 34.6 0.7 36.2 22.3 21. were highly leveraged.2 17.0 10.0 100.5 1.2 42.9 10.8 9.7 9.3 49.2 12.9 14. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.258 Corporate Governance and Finance in East Asia.9 0.3 38.1 13.6 11.7 0.0 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.8 37.9 14.6 50.5 1.0 48.2 2.5 37.3 18.8 19.9 6.5 43.13).2 35.8 46.0 10.9 20.12 Common-Size Statements for Companies Listed in SET.6 13.1 17.5 9.6 15.9 6.6 12. compared with the 44 percent general average.7 50.7 7.4 7.4 17.2 1.9 17.7 1.5 11.6 8. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.0 12.0 100.0 100.0 6.0 100.3 14.6 38.9 18.9 38.9 16.5 0.3 14.2 2. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2. Vol.7 16.3 18. US.0 100.9 3.2 16.6 6.9 14.0 100.8 20.1 50.9 17.0 100.5 9.0 2.0 100.2 17.3 17.2 15.2 3. II Table 4.6 2.8 1.0 7.0 100.4 14.4 43.2 45.7 17.9 14.0 1.7 15.7 18.0 15.4 49.4 6.8 25.0 100.3 2.0 100.6 22.1 5.3 48.7 16.5 14.3 1.9 15.6 0.9 12.1 2.9 43.8 14.2 1.8 9.8 35. Printing and publishing companies had lower financial leverage than companies in other industries.8 7.1 18.2 1.3 34.3 12.2 43.2 43.1 49.6 0.4 48.7 52.4 17.8 3.6 18.3 1.6 10.2 17.2 2.0 13.3 6.7 14.4 2.6 100.1 36.9 49.0 100.5 1.6 14.6 0.9 50.0 100.6 21.8 37.6 100.8 6.4 49.8 17.3 50.2 2.6 51.8 10.0 14. medium.1 7.2 16.

2 45.2 0.1 53.2 8.2 14.0 6.1 18.7 12.2 22.3 16.6 2.0 Low 1. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.4 13.9 2.1 49.4 3.6 47. was 53 percent of total assets compared with 49.5 percent for low ownership concentration companies.4 50.7 17.9 100.4 18.5 18.9 21.8 37.4 1.0 41.0 Medium 2.8 13.3 1.4 37.0 14.7 percent for medium ownership concentration companies and 49.3 100.0 6.5 11.9 7.3 35.6 100.4 49.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.7 19.0 19.0 7. For the high ownership concentration group. 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 2.3 1. US.3 8.6 22.9 50.1 44.6 0.9 0.5 21.4 7.9 16.Chapter 4: Thailand 259 Table 4.0 100.5 13.1 36.6 9.2 11.5 100.9 36.13 Common-Size Statements of Public Companies by Ownership Concentration.0 16. .8 13.8 12. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.0 100.4 35.6 14.6 15.

9 7.2 49.7 5.9 14.1 in 1996. The ratio of total debt to total assets increased from 50.1 16.2 35.4 139. bond issues overtook loans from commercial banks as the second preference. Short-term debt accounted for most of the increase.7 11. was the headlong deterioration of firms’ ability to meet their interest payment obligations.14). II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.5 52.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.0 28.7 in 1994 to 5.4 44. Table 4.8 65.1 23.9 140. Generally.8 percent in 1990 to 52.4 12. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. As a result. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. and rights issues.6 7.4 5.0 50.6 41.4 7. After the crisis. thus rendering them more vulnerable.0 145. Public companies relied more on short-term debt financing in the period before the financial crisis.7 percent in 1996. these firms more easily increased their leverage.8 65.1 44.7 34. While further detailed investigations are necessary.6 125.14 Financial Ratios of All Listed Firms.8 5. Vol. bond issues.5 38. 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 4.7 66. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.1 144.7 12. the choice of financing is determined by the company’s liquidity considerations.7 12. however.8 151.1 52. however.4 51.8 51. Such deterioration of financial positions during the period was a common feature of listed companies.9 51.6 138.1 64.15.2 68.1 31.0 25.7 34.1 31. minimization of transaction and interest costs. especially from 1994 to 1996.3 61. The TIE ratio declined from its peak of 7.260 Corporate Governance and Finance in East Asia. and maintenance of the existing ownership structure. .3 31. More important.7 28. 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 8.9 63. US. followed by bank loans.1 16.

unhedged foreign exchange liabilities. This decline was accompanied. debt-creating capital inflows rose to 65 percent in 1990.8 66.4 63. private debt accounted for 84. 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.16).1 High 6.7 percent from 1991 to 1996. peaking in 1994 at 84 percent. Their average annual growth rate declined from 28.15 Financial Ratios of Listed Companies by Ownership Concentration.0 64. US.6 11.5 4. Nonbank private debt increased from 27.5 126.5 percent of external debt in 1996 (Table 4. From only 34 percent in 1986. however.8 percent in 1986 to 52 percent in 1995.8 28.4 13. The proportion of external debt as a percentage of GDP consequently increased from 42.4 27. 4.2 percent in 1986 to 251.5 percent between 1985 and 1990 to 8.8 29. such as direct equity and portfolio investment.2 49.1 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. The composition and term-structure of this debt.8 14. 1990-1996 Degree of Ownership Concentration Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) Low 6. the proportion of short-term debt increased from 15.5 34.9 percent in 1997. Additionally.4 percent to 46 percent during the same period.5 148. The proportion of nondebt-creating capital flows.8 Medium 7.5.2 124. and a preponderance of short-term debt liabilities. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. is even more telling.8 49. .3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.Chapter 4: Thailand 261 Table 4.6 30.4 52. continued to slide from 1985 to 1997.3 42. From 45 percent of total net capital movements in 1985. on the other hand.

1 34.8 108.5 12.5 1.3 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.6 1.9 35.7 13.2 2.3 3.9 1.2 2.3 16.0 4.8 31.3 0.1 Source: Bank of Thailand.1 23.3 20.3 0.9 43.2 0.3 105.9 3.7 1.3 0.4 2.6 52.7 2.3 10.8 0.3 0.8 10.1 0.6 Total 18.7 109.2 15.5 14.9 10.3 37.9 11.9 5.9 6.1 0.0 13.5 4.8 13.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.2 14.3 0.9 6.2 10.2 32.5 16.8 12.5 4.9 13.0 3.1 12.9 0.6 7.9 3.3 0.1 22.16 External Debt.1 64.5 12.3 7.4 15.9 29.0 11.7 10.0 6.1 0.1 30.4 3.4 5.9 7.2 0.2 0.3 3.7 24.7 20.0 8. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.9 1.0 11.7 23.3 — — — — — — — 6.4 10.7 0.3 2.0 0.6 18.9 31.2 2.1 95.0 21.6 — 0.3 12.4 — — — — — — — 1.9 10.8 3.4 18.1 0.3 0.9 4.8 3.1 5.1 2.5 19. .9 100.Table 4.

360. 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. closures. from its peak in 1995. Similarly. outstanding credit also declined throughout the second half of 1998. the index declined to 1. On average. based on the three-month past due definition. Meanwhile. Even before the crisis. If lending rates remained high.6 in December 1996. Aside from the problem of NPLs. and poor business confidence on the other. Foreign investors retreated from the market. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. With easy access to foreign funds. . the number of newly registered companies dropped to a 10-year low in 1998. and (iii) bankruptcies. Due in part to liquidity problems on the one hand. At the end of 1994. The effects of the crisis were felt across all industry sectors. suggesting that serious investors have not returned to the market. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. according to the Bank of Thailand. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. trading activity at SET had been on the downturn. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. leaving domestic investors with large capital losses. reaching 45 percent of total outstanding credit in December. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. exposing the companies to disaster when the baht started tumbling on 2 July 1997. After that. It hit a 10-year low in the second quarter of 1998. the SET Index stood at 1. banks would be recording more of such NPLs. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. Most of these foreign debts were not properly hedged. the liquidity problems faced by the corporate sector are likely to continue for some time.281 in December 1995 and to 831.6 billion from the 1996 level of B201 billion. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. The value of public offerings sank in 1997 to B56. Trading volume has since been thin.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. and drastic decline in the number and capital of newly registered companies.17).

1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.410 5. As part of the assistance package.6 in 1997.264 Corporate Governance and Finance in East Asia.066 19.17 Number of Newly Registered and Bankrupted/Closed Companies. But when assistance from other sources did not materialize. the Government was left with no choice.409 6.095 14.695 3. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.312 25.904 20.792 7.5. 4. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.096 22.288 35.334 4. II Table 4.797 4. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. Vol.902 3.052 36.105 4.112 9.410 37. It also explains the higher dividend yield ratio.915 37.677 Bankrupted/Closed 2. A steady price decline over the past few years has dragged down the ratio of market price to book value.201 24.925 12.777 11.933 25.2 Responses to the Crisis Initially. Ministry of Commerce.2 billion for balance of payments support and buildup of the country’s reserves. .134 31. The IMF financial package was a credit facility of $17.407 28.224 4.080 9.307 4.218 3.5 at the end of 1994 to 12 in 1996 and further to 6. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures. Thailand.977 Source: Department of Commercial Registration. The price-to-earnings (P/E) ratio deteriorated from 19.

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

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

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

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

accounting for B1. Another 77. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy.147 cases (B1. the court had more than 80 cases for disposition. personal consumption. By October 2000.764 debt restructuring cases involving B1. In response. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court.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. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. contributing to the unprecedented rise in the corporate sector’s bad debt.068 cases involving B475 billion are undergoing restructuring. will be settled by the courts. The first bankruptcy court in Thailand opened on 18 June 1999. Considerable progress has been achieved on this front. as well as those that did not cooperate with CDRAC’s restructuring process. However.1 trillion of outstanding credit. methods. Within three months. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. where bankruptcy procedures are swift and effective. CDRAC’s target debtors comprised 10. although since then. Commercial banks initiated 74 percent of these cases.8 trillion had been completed. In addition.1 trillion in outstanding credit. This point is crucial because compared with .6 trillion) have agreed to cooperate with CDRAC’s restructuring process. with the majority of the debtors coming from the commerce. 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. As of November 2000.6 trillion. 322. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. and procedures for debt restructuring. In particular. accounting for B1. the number of cases has abated. Cases for which negotiations were unsuccessful. only 7.767 cases involving outstanding credit of B2. Some 82 percent of these cases have been successfully restructured. the Government introduced debt restructuring-related measures to help resolve bad debts. and manufacturing sectors.

despite the weakness of their disciplinary powers. 4. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. Financial information from listed companies will also soon be required to conform to International Accounting Standards. and even Indonesia. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. Such improvements in disclosure standards are part of the efforts of SET and SEC. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. II Malaysia.6 4. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. It required listed companies to establish their own audit committees by the end of 1999. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Conclusions.1 Summary. The . The study covers the period 1985 to 1996. 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 1997.6.270 Corporate Governance and Finance in East Asia. the Government protected certain corporate sectors through tariffs and regulation. Vol. Philippines. In the next three decades. Examination of corporate ownership. and promoted key industries through incentives. For this reason. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. and performance during this period helps understand the causes of the crisis. behavior. 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. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. to push companies to harmonize their accounting with international standards. 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.

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

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

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

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

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

Further. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. which. This may not be possible without reforms in the banking sector itself.276 Corporate Governance and Finance in East Asia. A well-developed domestic debt market will provide corporations with an alternative to bank financing. especially in the area of connected lending. 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. for instance. while a strong domestic debt market will also offer protection from foreign exchange risk. Accounting standards have also been under review. Vol. in turn. The same goes for improvements in the bankruptcy system. . a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. there is a need to increase market disciplinary power through market competition. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. Capital Market Development and Regulation Another important issue concerns the development of capital markets. However. the power of the capital market to discipline inefficient management is almost nonexistent. 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. it will be difficult to improve corporate governance in Thailand. In the stock market. In an environment of highly concentrated ownership. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. II responsibility among companies. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. aimed at ensuring that banks finance only creditworthy projects. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. Without a strong and efficient capital market. will lead to the emergence of a reference yield curve.

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