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

1992-1999 Table 1. 1996-1998 2.14 Banking Sector Outstanding Loans.6 GrowthandFinancialPerformanceofState-Owned Companies.21 Nonperforming Loans by Type of Bank.13 Presence of Board Committees in Listed Companies Table 1.2 KeyMacroeconomicIndicators Table 2.19 DER and ROE of Publicly Listed Companies by Sector. 1992-1999 Table 1. 1996-1999 Table 1.3 Subsidiaries of the 30 Largest Chaebols Table 2. 1992-1997 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1. 1990-1998 Table 1. 1996-1998 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies.2 Foreign Capital Flows.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1990-1997 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies.15 V alue of Stocks Issued and Stock Market Capitalization.1 Growth of the Banking Sector.5 Financial Performance of Publicly Listed Companies by List of Tables 1. 1988-1996 Table 1. 1986-1996 Table 1.18 GDP Growth by Sector. 1993-1999 Table 1.4 Development of the Stock Market. 1997 Table 1. 1992-1998 Table 2. Indonesia Table 1. 1992-1995 Table 1.1 Listed Firms with Positive Economic V alueAdded.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .20 ROE of the Banking Sector. 1992-1997 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates.7 Growth Performance of the Top 300 Conglomerates. 1993-1997 Table 1.4 Growth Performance of Publicly Listed Companies by Sector.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.12 CharacteristicsoftheBoardofDirectors Table 1. 1992-1997 Table 1. Republic of Korea Table 2. 1992-1997 Table 1.

25 Table 2.26 Table 2.7 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.18 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 . 1995-1997 Ownership Composition of Listed Companies.14 Table 2. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 1997 Ownership Composition of Listed Firms in Selected Countries.12 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.16 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols.11 Table 2. 1997 Ownership Concentration ofAll Listed Firms.10 Table 2.vii Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.29 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.9 Table 2.24 Table 2. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio.5 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols.6 Table 2.17 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.27 Table 2.23 Table 2.30 Private Capital Flows to Korea. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.13 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.19 Table 2.22 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.8 Table 2.21 Table 2.28 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.20 Table 2.15 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.

1986-1998 Nonperforming Loans of General Banks.18 Financing Patterns by Control Structure.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. 1988-1997 Table 3. andAffiliated Banks of Selected Business Groups. 1988-1997 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1997 Table 3.SectorOrientation. 1992-1996 Table 3. 1990-1998 131 137 138 158 159 160 161 163 164 166 173 175 176 180 184 191 201 203 204 205 206 207 208 209 212 235 236 3. 1988-1997 Table 3.2 Public Offerings of Securities.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.Profitability andFinancial . 1988-1997 Table 3.000 Companies.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.21 OwnershipConcentration. 1983-1997 Table 3. 1988-1997 Table 3. 1988-1997 Table 3. Thailand Table 4.11 TotalandPerCompanySales. 1990-1999 Table 3. 1997 Table 3. 1985-1997 Number of Firms with Dishonored Checks.31 Table 2.19 Financing Patterns by Firm Size. Flagship Company. 1995-1998 4.1 Public Companies Registered. 1989-1997 Table 3.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry. 1997 Table 3.22 Foreign Investment Flows.1 GDP Growth of SoutheastAsian Countries. 1997 Table 3.15 Financing Patterns of the Corporate Sector. 1997 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1992-1999 . Leverage Table 3.16 CorporateFinancing PatternsbyOwnershipType.2 Growth and Financial Performance of the Top 1. 1989-1997 Table 3. 1978-2000 Table 4.12 Control Structure of the Top 50 Corporate Entities.3 TheCorporateSectorandGrossDomesticProduct.viii Table 2. 1989-1997 Table 3.20 Financing Patterns by Industry.32 Table 2. 1989-1997 Table 3.14 Philippine Stock Market Performance.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.1989-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.33 Net Profit Margins of Chaebols. The Philippines Table 3.17 Composition ofAssets and Financing of the Publicly Listed Sector.

1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.17 StatisticalHighlightsoftheStockExchangeofThailand.9 Table 4.12 Table 4. 1992-1999 Common-Size Statements for Companies Listed in SET. 1990-1996 Financial Ratios of All Listed Firms. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. Leverage.3 Table 4. 1992-1999 Offerings of Debt Securities.16 Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies.2 Figure 3. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.7 Table 4.10 Table 4. 1990-1996 External Debt.13 Table 4. 1985-1996 Average Key Financial Ratios by Company Size.11 Table 4. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1990-1998 Merger and Acquisition Activities.ix Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.6 Table 4.15 Table 4.4 Table 4. Ownership Concentration.1 Figure 1.14 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies. 1993-1999 Size and Composition of the Thai Financial Sector.1 Figure 3.5 Table 4.8 Table 4.


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

Arvind Panagariya ChiefEconomist


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


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

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

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

1 Indonesia
Saud Husnan1



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

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

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

in the course of the fight for nationhood from 1942 to 1950. Section 1. textiles. and its response. Subsequently. Section 1. However. a gradual shift in public investment away from manufacturing took place.2. while Chinese and indigenous entrepreneurs ran some large businesses in trading. how it was affected by the crisis. Up until the mid-1960s.2 1.and large-scale companies were dominated by state-run industrial concerns. medium.4 analyzes corporate financing patterns. The industries that emerged were highly import-dependent and reliant on tariff protection. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968.1 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.2 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. . substantial volumes of private investment entered the scene. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. 1. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). Not all items in the questionnaires were answered by the respondents. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. In the early 1970s. and tobacco industries.5 examines the corporate sector during the financial crisis in terms of its role. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. It also examines the statistical relationship between corporate performance and corporate governance characteristics.

many founding owners of companies were reluctant to go public and dilute their corporate ownership. the Indonesian industrial sector was quite diverse.2 The Capital Market The Government reactivated the stock exchange in 1977. 1.2. the number of firms quoted in the stock market was only 24. exports of nonoil products (particularly textiles and footwear. But until the end of 1988. produced consumer goods. and related products) had shares in total exports that were rapidly increasing. 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). potentially subjects companies to greater regulatory scrutiny. In the 1980s. the value of manufactured exports overtook the value of oil and gas exports for the first time. A number of underwriters emerged. and employed the bulk of the industrial labor force. the Government shifted its industrial policy toward the promotion of labor-intensive exports. even when new shareholders do not threaten the control exercised by the original owners. Second. 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. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. mostly nonbank financial institutions and stockbrokers.4 Corporate Governance and Finance in East Asia. First. Third. But these proved counterproductive because they limited the potential for capital gains to prospective investors. the dilution of corporate ownership. During this period. Last. a distinct industrial elite started to emerge. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. wood. The equity market remained largely unappealing due to a number of factors. These were families with strong links to the political elite of the New Order. Generally speaking. Partly as a result of various government policies. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. there were also many rapidly growing large-scale companies and business groups or conglomerates. While most of the companies were small. Vol. . By 1987. In 1992. which dominated their respective sectoral outputs and markets.

. from 24 in 1988 to more than 300 in 1997. began to face competition. with a total value of more than Rp8 trillion. which were previously constrained to 4 percent per day. companies could no longer enjoy low-interest credit from state banks. six SOCs had issued equities in the market. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. state-owned banks were still among the biggest. In 1988. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). The initial banking sector reform was introduced in 1983. the banking sector has undergone many reforms. the controlling shareholder of these SOCs is still the State. The Government also allowed foreign investors to buy up to 49 percent of listed shares. Partly as a result of these reforms. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. Since 1977.5 trillion. which up to then was channeling oil revenues to priority sectors. Conglomerates carried out 210 out of 257 IPOs. These included the opening of the banking industry to new entrants. with a total value of Rp16. and increased access of domestic banks to international financial markets. The dominance of state banks started to erode. private domestic banks dominated the sector in terms of number and total assets. Interest rate regulations on state banks and credit ceilings in general were removed. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. But in terms of assets per bank.3 The Banking Sector Despite the development of the stock market. Table 1.Chapter 1: Indonesia 5 At the end of 1988. the capital market played an increasing role in raising long-term funds needed by the corporate sector. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. Consequently.2. Through the years. However. the banking sector has been and still is the major source of credit for the corporate sector. However. However. the number of private domestic banks increased. 1.1 shows that from 1994 to 1998. to date. Thus. reduced restrictions on foreign exchange transactions. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. more significant reforms were introduced. The banking sector. During this period. the number of listed companies in the stock exchange increased substantially.

2 161 214. Bank Danamon (ranked 7th).8 166 248.8 391. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). 1993 100.9 248. banks could earn profits even when they did not gather and process information about risk.9 291.5 7 7 7 5 15.5 165 308.8 10 37.8 10 19. the 10 largest were all affiliated with major business groups.9 27 113.6 34 14.1 240 1995 122. Vol.9 31 9. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).3 27 51. II Table 1.8 29 6.4 34 12.5 27 88.9 304.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks. Both BCA and BUN have shareholders linked to the former President Suharto.0 234 1994 104.5 27 66.9 39 18. and Bank International Indonesia (ranked 9th). But the banking system proved incapable of performing its intermediation function.7 351.3 201. 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. BCA.6 240 1996 1997 1998 1999 141.3 30 7.6 Corporate Governance and Finance in East Asia. Of these.6 7 12.9 762.1 10 47. Because regulation was weak.8 27 200.2 10 14.3 10 17. while BUN has been closed down by the Government.6 164 144 130 92 387.6 7 7. The other banks among the top 10 were state banks.4 10 35.5 7 9. In terms of assets.4 789.9 10 11.7 27 37.1 Growth of the Banking Sector.8 31 10.5 528. Among private domestic banks. . 1993-1999 Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks Source: Bank Indonesia.8 27 147. Bank Danamon.

when the financial crisis hit Indonesia.2. In effect. initially from Japan and the Republic of Korea.88 4.74 5.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).00 2. But FDIs were only one form of foreign capital inflows to Indonesia. In 1994.2 Foreign Capital Flows.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. as shown in Table 1. From the mid-1980s until July 1997. Source: IFS CD-ROM. September 2000. foreign investment also had a strong presence in the services and infrastructure sectors. and footwear. In the 1990s. .88) — — — — — — 8. November 2000.48 1. Between 1990 and 1996. FDI flows were strong. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). Indonesia received capital inflows averaging about 4 percent of GDP. except in certain strategic sectors.59 4. there was a phenomenal growth in direct borrowings by Indonesian corporations. 1.40) (0.50 (0.78 2. IMF. they still amounted to a large sum for the economy to absorb. Table 1. textiles. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. Until the onset of the crisis.15) — = not available.81 3. the Government allowed foreign investors to own 100 percent of an Indonesian company.10 5.87 7. Net FDI flows increased to $5.59 billion in 1996.09 1. Most FDIs came in through joint ventures with business groups having strong political connections.11 3. foreign creditors were eager to provide financing to Indonesia. 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. especially through bank loans. Increasingly. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. Successive policy deregulation facilitated FDIs in various light manufacturing industries.01) (0.63) (1.09) 1. such as metal goods.01 (2.09) (0.2.33 (13.

plus 4 percent for the depreciation of the rupiah. participation in the Indonesian stock market was exclusive to domestic investors.2. Between 1989 and 1992. the average borrowing rate for dollar loans was 9 percent. Due to data constraints. the analysis focuses only on publicly listed companies. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. state-owned companies (SOCs). and conglomerates. The Government relaxed this restriction in 1988. with the onset of the Asian crisis. The following section looks at the growth and financial performance of the corporate sector. The external corporate debt owed to foreign commercial banks was $67 billion. Private borrowers preferred foreign loans since these were relatively cheaper.8 Corporate Governance and Finance in East Asia. In September 1997. In the 1990s. the average foreign ownership of listed companies was 21 percent. Vol. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. Consequently. 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. This increased to 30 percent by the end of 1993. of which two thirds were rupiah-denominated. especially the short-term ones. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. but declined to an average of 25 percent during 19951997.5 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. 1. total corporate debt reached nearly $118 billion. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country.4 trillion in 1997. Domestic corporate debt was about $50 billion equivalent. . This is lower than the average borrowing rate of 18 percent for loans in domestic currency. From 1987 to 1996. 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. 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. foreign banks became a significant source of financing for the corporate sector. By the end of 1997. In November 1998. II Up until the late 1980s. increasing the total trading value from Rp8 trillion in 1992 to Rp120.

Average return on equity (ROE) of listed firms was 11. publicly listed companies as a group contributed less than 10 percent to GDP.4 1997 7. but turned negative in 1997.7 — = not available. b Asset turnover is defined as sales over assets.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.4 1993 45.0 12.7 — 250.7 percent in 1997. 248 firms. but dropped to 1.6 24.5 3. The growth of listed companies was sustained by continuing investments. 226 firms.0 12.2 7. total sales of listed companies grew at an annual average rate of 31 percent.0 3.6 48. During 1992-1997.7 3. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines. 1993.3 6. Note: The number of firms is not identical for each year. averaging 3.2 1995 37. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. 174 firms. 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 — 3.6 3.9 310. the average DER increased to 310 percent from 230 percent the . and 1992.4 1996 18.0 12.1 0.8 6.0 6. but declined to 0.1 220.5 34. but fell to 24.6 1994 50. 250 firms.3 shows the growth and financial performance of Indonesian publicly listed companies.9 37.0 1.0 33. Source: JSX Monthly (several publications). Return on assets (ROA) was also relatively stable during 1992-1996. 1995. 246 firms. 1994. while total assets grew at 43 percent. a Value added was assumed to be 30 percent of total sales. 1996.5 240.2 30.8 220.3 Growth and Financial Performance of Publicly Listed Companies.0 11. When the crisis battered Indonesia in 1997. Asset turnover was above 30 percent until 1996.4 percent.0 64.1 4. Table 1.3 3.4 38. ranging from 220 to 250 percent between 1992 and 1996.5 37.8 percent between 1992 and 1996.8 230. In 1997. Despite such rapid growth.1 percent in 1997 when the crisis began to buffet Indonesia.4 31.5 34. there were 204 firms. although the contribution increased over time.0 10.6 percent in 1997.

However. investment. consumer goods. infrastructure. the mining sector had the highest ROE. helped in part by the relatively strong demand for consumer goods. In terms of sales and asset levels in 1997. and building construction. the property sector was severely affected by the crisis. Before the crisis. For instance. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. the banks eagerly provided credit to property development companies. Four sectors (basic industry and chemicals. From 1995. indicating its reliance on equity to support growth. Meanwhile. meanwhile. and services. averaging 21. But the sector’s ROE fluctuated a lot. due mainly to the domination of the International Nickel Company of Canada. still posting a positive but lower ROE.7 percent during 1992-1996.73 percent in 1992 to 1.2 in 1997. the companies in the sector did not operate with a high leverage. with ROE falling to -11. in terms of growth of sales and assets. only two sectors (mining and finance) showed a consistently increasing trend from 1992. Vol. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. ROA of all sectors dropped in 1997. finance. although asset turnover was slow. and property. The consumer goods sector ranked second in terms of ROE.4). averaging 17. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. real estate. During those years. the mining sector ranked first.64 percent in 1997. it appeared that the performance of listed companies was quite satisfactory prior to the crisis.3 percent between 1992 and 1996. Overall. The same applied to the trade sector. Also. which operated in nickel and copper mining in 1992 and 1993.10 Corporate Governance and Finance in East Asia. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. and trade) even posted . Table 1. This sector was less affected by the crisis. When interest rates increased. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. The finance. basic industry and chemicals. The finance sector’s contribution to GDP. and trade. In terms of share of value added to GDP. the dominant sector was the finance sector. mining. miscellaneous industry. and services. the mining sector had the lowest DER. ROE fell drastically because the sector had one of the highest DERs. when the property sector was booming during 1993-1997. miscellaneous industry. increased from 0. followed by agriculture (Table 1. real estate.5 presents the financial performance of listed companies by sector. trade. investment. II previous year. property. property.

8 50.2 0.0 43.4 31.0 0.1 0.0 (20.6 (0.9 54. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.1 1.4) 8.2 14.0 18.7 112.7 34.0 0.7 0.4 64.5 23. and Bldg. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.6 51.9 59.6 28.4 1. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.9 31.1 35.7 133.1 0.3 1.8 24.6 15. Industry Consumer Goods Industry Prop.5 1.3 31.3 0.3) 39.5) 6.2 41.5 9.8 62.7 54.8 1. Constn. Industry Consumer Goods Industry Prop.5 53.1 0.5 0.1 0.2 0.8 28.3 340.4 1.4 77.6 1994 (75.4 1.6 133.6 0.7 1995 51. Investment.6 0. Investment.0 0.1 1.0 22.7) (113.3 (203.7 (82.1 67.1 42.0 31.7 — 36.1 71.0 0. Real Estate.9 0.2 13.9 14. Infrastructure Finance Trade.0 68.2 41.6 26..9 (7.5 1.3 92.9 123.7 28.1 28.4 30.1 32. Industry Consumer Goods Industry Prop.3 0.1 0. and Bldg. Industry Consumer Goods Industry Prop.3) 53.1 23.4 43.9 8.6 85.4) 6.6 1.6) 25.6 24.5) 13. Constn.6 22. and Services — = not available. Constn.1 0.6 135. Investment. Real Estate.3 17.5 45.8 27.0 (28.6 83.6 0.3 31.2) 0.7 21.5 1.4 170.5 68.9 .4 1993 155.9 36.8) (12.1 0.3 51.5 0.5 13.0 1.2 5.8 29.1 0.4 38.7 40.1 1.0 0.6 0. Investment.8 66.7) 26.4 30.7 0.1 16. Infrastructure Finance Trade. Source: JSX Monthly (several publications).9 54.1 1.0 64.0 (192.9 25.1 (11.4 0.5 92. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.9 53.3 0.5) 49.1 0.5 (8.8 0.2 35.9 1.7 43. Real Estate.0 0.5 28.4 21.0) 46.4 103.Table 1.3 0. and Bldg.8) 0. Constn.0 1996 1997 58.5 61. Infrastructure Finance Trade.7 — — 11.1 — 39.6 (41.3 0.1 0.9 64.9 0.7) 17.1 1.7) (27.5 95.8 1.7 62.8 (76.7 90. Infrastructure Finance Trade.6) 119.5 (11.7 24.8 51.8 32..4 Growth Performance of Publicly Listed Companies by Sector.4 44.1 (41.. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.0 16.6) 19. and Bldg.2 59.. Real Estate.4 (149.2 11.7 17.0 24.

1 11. Industry Consumer Goods Industry Prop.0 110. and Bldg.0 1997 230.0 140.0 120.1 4.0 150.1 4.0 630.5 11.4 20.6 23.0 3.1 4.0 100. Constn.7 26. Infrastructure Finance Trade. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.8 382.1 (5. Industry Consumer Goods Industry Prop.0 80.8 11.6 13.0 160.0 46.4 46.7 1.0 80.8 11.Table 1. Investment.0 15.0 110.2 30.7 5.2 7. Industry Consumer Goods Industry Prop..0 39.0 86.6 74.2) 15.8) 8.0 700.0 80.2 8.7 8.9 40.1 8.8 16.1 13.0 650.7 8.0 100.0 120.2 23.2 7.0 100.8 479. and Services Source: JSX Monthly (several publications).3 18. Infrastructure Finance Trade.0 70.0) 7.9 7.8 8.4 4.4 46.6) 18.0 190.7 71. Investment.7 9.0 14.1 9. Real Estate.7 46.2 15.3 7.5 4.0 150.0 66. 1992 20.8 44.8 67.9 29.6 8.7 4.9 87.4 17.0 120. Investment..8 168.0 650.4 35.0 560.6 8. Constn.9 14.4 6. and Bldg.1 7.3) 5.0 110.4 79..1 10.2 6.1 6.5 56.7 (3.4 13.2 111.0 160.0 100.1 1.5 1995 80.8 20.9 10. Infrastructure Finance Trade.0 190.5 4.6 (11.0 180.3 64.1 10.6 14.3 17.7 1.1 65. and Bldg.3 0.3 33.7 61.0 60.2 39.2 (4.9 17.4 13.1 10.9 38. Real Estate.5 43.3 7.1 1994 80.1 3.0 170.0 130.1 1996 100.3 5.0 220.0 110. Real Estate.2 3.0 19.4 71. Constn.5 19.4 35.0 69.1 9.9 38.0 210.7 12.4 1.9 4.4 5.7 13.6 (2.0 150.0 180.4 6.4 .0 12.0 8.0 9.0 8. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.5 5.2 13.9 42..3 1.5 17. Investment.7 5.0 120.0 3.0 180.3 73.1 (3. Constn.1 89.0 140.0 50. Infrastructure Finance Trade.0 380.5 Financial Performance of Publicly Listed Companies by Sector. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.0 680.2 11.0 190.0 17.7 10.5 7.0 11.3 13.6 1.7 12.2 53.6 13.5 13. Real Estate.7 4.6 19.0 70. Industry Consumer Goods Industry Prop.4) (1.0 110.1 2. and Bldg.2 3.0 110.7 12.8 9.3 17.6) 36.7 10.7 10.8 3.7 4.3 38.0 90.5 14.0 110.2 1993 130.2) 7.8 5.0 70.8 25. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.1 63.9 41.0 160.6 18.8 81.0 (0.

the ratio decreased from 8. averaging 24 and 31 percent. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. Trade had the highest ROA of 39. registering an average annual rate of 10 percent. SOCs’ sales growth fluctuated during 1990-1996.Chapter 1: Indonesia 13 negative ROA. Similarly.1 percent in 1992 to 28. between 1993 and 1995. SOCs diversified into many businesses. The DER was slightly higher than for listed companies. Asset turnover rates were lower relative to those of publicly listed companies. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. increasing from 21.7 percent. Taken together. Just like private companies.6 to 8. However.7 to 7 percent for publicly listed companies. ROA had been at high levels from 1992 to 1995. the subsidiaries and affiliates number 459 with total assets of Rp343. there were 58 SOCs with subsidiaries and affiliates. respectively. the Department of Finance supervised 30 SOCs. but dropped dramatically to 4. State-Owned Companies At the end of 1995. there were 165 state-owned companies (SOCs)3 in Indonesia. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). . which collectively had the largest assets. For instance. and finance company (four companies). Assuming a fixed ratio of value added to sales.8 percent between 1992 and 1995 (Table 1. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.4 percent the following year. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. This was relatively high compared to the 3. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. This was due to large sales by the National Oil Company (Pertamina). Six SOCs were listed in the Jakarta Stock Exchange. and basic industry and chemicals sectors had relatively stable ROA before the crisis. SOCs’ ROE ranged from 6.1 percent in 1993. By 1995. banks (seven companies).3 percent in 1995. These growth rates were low compared to those for listed companies during the same period. The finance and miscellaneous industry. indicating SOCs’ declining contribution to GDP.3 trillion. insurance (11 companies).7 percent in 1990 to 6 percent in 1996. growth of net profits and assets was erratic.6). SOCs actively operated in various sectors4 under the supervision of “technical” departments. much lower than that of companies listed in the stock exchange.

a Value added was assumed to be 30 percent of total sales.8 11. Table 1.4 13. Source: Indonesian Data Business Center.0 8.1 19. Source: Indonesian Data Business Center.6 Growth and Financial Performance of State-Owned Companies. b Asset turnover is defined as sales over assets.6 1995 25. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.5 3.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.6) 260.2 23.4 percent in 1994. mostly private companies.1 32.14 Corporate Governance and Finance in East Asia. 1992 — 7.8 21.7). Assuming a constant ratio of value added to sales.7 13.4 13. a Value added was assumed to be 30 percent of total sales.1) 5.4 7.6 28.3 250. but dropped to 11.8 percent in 1990 to 13.4 1993 16. SOCs’ asset turnover rates showed a downward trend from 32. these conglomerates owned 9.2 18.1 6.2 — 370.0 7.0 6.0 17. II companies consistently declined over time.4 16.6 percent in 1994.6 28.1 trillion in 1990 to Rp234 trillion in 1997.7 1994 (9.2 percent in 1997 (Table 1.0 24. Table 1.1 12. In 1997. the contribution of conglomerates to GDP increased from 12.7 Growth Performance of the Top 300 Conglomerates.0 8.0 28. Vol.4 13.4 percent in 1992 to 28.7 (2.3 30.3 12. Their total sales increased from Rp90. 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 12.1 30.5 percent in 1995.2 — = not available.766 business units. .7 16.1 310.8 12. but climbed to 30.

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

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

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

Vol.8 68.1 4.2 1. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.6 3. On average.8 1.1 13.0 67.0 1. the founder usually continues to own the majority of shares through a . consumer goods.7 3. When a company goes public.2 11.9 2.9 percent of total outstanding shares.5 Average 48. The pattern of ownership concentration changed little over this period.5 16.5 72. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. for instance.4 2.0 0.9 0.6 percent.6 3.6 68. mining.1 1. respectively.9 Source: The Indonesian Capital Market Directory. This is because a few companies in the transportation sector issued high proportions of shares to the public. Table 1. issued 93. Rig Tenders Indonesia (shipping services) issued 51. 13.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.18 Corporate Governance and Finance in East Asia. Meanwhile.8 68. and basic industry and chemicals sectors than in others.5 percent. and 0.0 2. When a company makes a rights issue.6 13. II Publicly Listed Companies Table 1. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.0 0.9 2.2 67. 3.7 1996 48.6.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture. Zebra Nusantara (taxi services).4 percent.0 4. 2.1 0.8.7 1994 48.5 12.9. This preserves the pro rata share of existing shareholders. the controlling shareholders usually act as standby buyers.5 1997 48.8 Ownership Concentration of Publicly Listed Companies.3 1995 47.9 14. The percentage owned by each of the five largest shareholders was 48. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48. the five largest shareholders owned 68.6. Table 1.6 4. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table).

the top family controls 16.5 1.9 3.3 2. on the one hand.3 0. is strong. (1999).3 36.2 10. on the other.6 9.4 44. and corruption. In fact.7 1.2 0. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in . These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.2 46.6 0. as well as the existence of corruption.5 4.1 1.0 5.1 2.3 0.1 percent) of Indonesian publicly listed companies were in family hands.. and only 0.3 14. two thirds (67.7 13.7 9. (1999) also found.2 This is confirmed in Claessens et al. and the efficiency of the judicial system. Industry Consumer Goods Industry Prop.6 percent of total market capitalization while the top 15 families control 61. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).9 0.9 44.1 0.9 1. Infrastructure. In terms of capitalization. and Transportation Finance Trade. Indonesia has the largest number of companies controlled by a single family.4 4.1 11. Real Estate.9 Ownership Concentration of Publicly Listed Companies by Sector. 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.3 48. that the correlation between the share of the largest 15 families in total market capitalization. and Services Average Source: The Indonesian Capital Market Directory.6 2.1 2.4 11.4 54. Table 1.7 percent of the market. Constn.1 0.1 1. Claessens et al.2 15. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. Util.4 6.7 6.6 percent were widely held.8 14.6 1.9 44.5 58. which shows that in 1996. in a cross-country study.6 8.9 50..1 13.7 4. the rule of law.4 1.1 1.1 1.2 2.1 2. Investment. and Bldg.

In 1993. But these benefits are few and often dubious compared to the high costs of concentration. In Indonesia. During 1988-1996. accounting for 64 percent of total conglomerate sales in 1988-1996. . with all its regulations. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. and Padang. conglomerates established before 1969 dominated in terms of sales. Indian. Among the top 300 conglomerates. political affiliation. 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.5 Conglomerates Table 1.42 percent in December. Indigenous businesspeople include the Javanese. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. From 193 in 1988. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. the onset of the crisis negated this development. This may indicate that the New Order Government. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. was able to create a favorable environment for business development. However. their number increased to 5 In 1997. the proportion of foreign ownership declined from 27. ethnicity. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates.55 percent in August to 25. Coordination is easier because informal communication channels exist.20 Corporate Governance and Finance in East Asia. Sundanese. numbering 162 in 1988 and 170 in 1996. and family origin. or other ethnic groups. the Government allowed foreign investors to buy up to 100 percent of listed shares. the legal system is less likely to evolve in a manner that protects minority shareholders. However. Vol. In September 1997. but later declined and steadied at around 25 percent. foreign ownership increased to 21 percent. most were established during the New Order Government. resulting instead in a decline in the proportion of foreign investor ownership.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. II the small number of families and the tight links between companies and the Government. it rose to 30 percent. The nonindigenous businesspeople are usually Chinese. Batak.

In 1996. Meanwhile.4 31.1 42.6 12.2 33. 1988-1996 Item Number of Groups Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily Sales (Rp trillion) Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily 1988 1989 1990 1991 1992 1993 1994 1995 1996 13 125 162 86 193 21 260 40 176 124 13 125 162 83 196 21 259 41 175 125 13 123 164 80 196 24 260 41 171 129 13 120 167 76 199 25 260 40 174 126 13 118 169 76 198 26 262 38 172 128 12 122 166 71 201 28 263 37 171 129 12 122 166 69 205 26 262 38 172 128 11 120 169 71 204 25 260 40 177 123 10 120 170 68 204 28 259 41 175 125 9.2 29.5 22. sales of the Bakrie group before it went public in 1990 were only Rp369.9 13.9 trillion.9 137.6 77.3 101.9 77.7 106.4 37. Conglomeration Indonesia 1997.4 16. the number of mixed groups declined from 86 in 1988 to 68 in 1996.4 19.4 68.4 52.4 48.7 95.2 159.4 59.9 billion.3 134.4 18.3 120.2 48.4 57.8 12.1 87.8 25.8 30.10 Anatomy of the Top 300 Indonesian Conglomerates.4 32.7 49.9 14. 204 in 1996.0 58.2 12.1 46.3 20.0 31.8 57.0 28.1 33.6 trillion in 1988 to Rp137.4 81.1 58.4 31.9 73.8 68.2 30. its sales reached Rp1.9 35.4 22.3 43.8 Source: Indonesian Business Data Centre.2 76.0 15. due to their “go public” activities.0 58.5 120.1 21.4 15.7 24.6 34.4 59.9 42.0 116.8 38.1 52.4 86.6 54.9 47.7 64.7 40.0 18.8 28.1 41.5 106.1 179.Chapter 1: Indonesia 21 Table 1.6 114.1 25.1 103.8 49.6 17.8 36.3 80.2 23.4 69. more than five times its 1988 level.1 46. Their total sales also increased from Rp38.5 21.4 trillion in 1996.7 89.6 95.0 44.1 percent of total . For instance.3 36. While they supplied 20.7 28.

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

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

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

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


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

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

1992 1993 1994 1995 1996 1997 1998 1999 68.6 48.3 111.6 292. remain the major financing instrument for the corporate sector.9 153. Bank loans.9 150. bank credit surged from Rp122. Data from Bank Indonesia show that from 1994 to 1997. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.7 122.14. when the Government reactivated the stock exchange.7 112.9 378.2 6. Private national banks and state-owned banks were the biggest domestic creditors. companies considered alternatives to bank loans.4 1. private national banks overtook state banks as the dominant credit source.4 86.32 Corporate Governance and Finance in East Asia.3 9. however.0 93.8 193.0 3. and others offered by nonbank financial institutions or finance companies. Table 1.3 188. the share of private national banks in outstanding total loans increased to 44. new instruments have been introduced to the corporate sector.5 42. From 34.1 Equities In 1977.3 60. because of the restrictions discussed below.3 14.9 234.5 108. equities became available to the corporate sector.14 Banking Sector Outstanding Loans.4 percent in 1992. including bonds.2 27.6 3.6 4.4 225.0 168. II 1.6 6.4 56.5 80. Since then.4.6 percent in 1997. .4 24. Bank Credit As shown in Table 1. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).5 7.2 5. Vol. However.9 trillion in 1992 to Rp487. stocks.0 6. jointly providing almost 90 percent of loans until 1997.0 487.7 18.1 220.1 Corporate Financing Financial Market Instruments Prior to 1977. this market was not well developed.3 66.6 150.2 71. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.4 trillion in 1998.7 50.

thus increasing the role of the capital market in raising long-term funds. Prior to 1995. offering services such as leasing.9 406. It gradually increased again starting in 1991.7 9. allowed to accept deposit accounts from the public. finance companies were increasingly used as channels for the inflow of foreign loans.. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. factoring.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. the stock market has gained a bigger role in corporate sector financing (Table 1. .7 percent in 1997.2 16. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.0 70. and consumer credit.Chapter 1: Indonesia 33 Some companies went public.. when foreign investors were not yet allowed to purchase listed shares. i.6 91. the Government issued regulations to supervise and promote prudential practices in finance companies.1 17.6 859.5 333. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. The ratio reached 8. During the 1990s. Overall. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. and net open position). credit cards.0 206.6 123. 1992 1993 11.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares. legal lending limit. 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 1996.1 18.5 1995 35.0 15. however.7 15. In 1995.15).9 1999 76.4 1996 1997 1998 50.6 310. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. shooting up to 18.e.6 301.7 14. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. capital adequacy ratio.8 48. In 1988.1 10.1 1994 26.g.15 Value of Stocks Issued and Stock Market Capitalization. They were not.4 207. Table 1.

0 — = not available. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.5 — 26.3 14.6 12. respectively. averaging 26.8 17.2 26. Vol. PACAP Research Center.1) 23.5 21. In the second half of the 1980s.3 (0.1) 23. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings). In terms of composition.0 3. which are unsecured negotiable promissory notes with a maximum maturity of 270 days.4 13.34 Corporate Governance and Finance in East Asia.3 16. . Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. they were not rated by a rating agency.5 (0.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.2 Patterns of Corporate Financing Table 1. While banks had some exposure to these instruments.5 percent and 36.16 Financing Patterns of Publicly Listed Nonfinancial Companies.4 8.5 11.0 1986-1996 17. short-term borrowings were greater than long-term debts.4.9 16.0 100. at 81 percent of total borrowings.7 22. II Commercial Papers Commercial papers.8 7.3 37.6 23. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. have been popular in Indonesia since 1990.8 percent. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments). Thus in November 1995.0 1991-1996 16. Table 1. 1996. 1.4 23.0 39.6 100.6 8. otherwise it would be classified as a loss in the banks’ books.6 100. This is in contrast to the lower share of borrowings during the same period.

in the context of Indonesia and some other countries.9 trillion. rising from Rp54.6 trillion and Rp1. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Indosat and Telekom. These liabilities grew significantly because corporate expansion was largely financed by debt.4. Corporate debts grew over time. that ownership concentration may be associated with heightened risk-taking by companies. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. . Most corporate charters require commissioners to approve debt issues or sign debt agreements.Chapter 1: Indonesia 35 In the 1990s. For instance. with longterm debts increasing rapidly. respectively. 1.2 trillion (mostly foreign exchange losses). 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. was due largely to a rapid rise in long-term debts. reaching Rp229. the pattern changed. They also do not want to dilute corporate control and are more likely to finance growth with debt.4 trillion in 1993 to Rp112. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. Of the various financing sources. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.17 compares the DER of listed firms by degree of ownership concentration. also suffered from foreign exchange losses but managed to post profits of Rp0. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. Table 1. Bank loans also surged when the banking sector was liberalized in 1988. corporate debts accounted for 39.3 Corporate Financing and Ownership Concentration It has been suggested. The results indicate that firms with higher ownership concentration tend to have a higher DER. Hence.1 trillion. while Semen Cibinong’s losses reached Rp2. the corporate sector’s high leverage. which was masked by the rapid growth in investments. Indofood registered losses of almost Rp1. which managed to post significant profits due to low exposure to dollar-denominated loans.9 trillion in 1996. Two telecommunications companies.3 percent during 1991-1996.2 trillion. This amount doubled in 1997. All companies in the cement industry suffered from foreign exchange losses. except Semen Gresik (an SOC). Many companies suffered big losses in 1997 due to their high exposure to dollar loans.

0 386.0 1. and high ownership concentration among families with political affiliation. the private sector borrowed heavily in unhedged dollars. In addition.358. 1. This section highlights those that were seen to have contributed significantly to the crisis in Indonesia: inadequacy of the regulatory framework under the financial liberalization.5. Controlling parties rely on external financing to maintain their equity share and. As a result. decisions on debt are made with the implicit endorsement of owners. aided .56 significant at the 10 percent level.5 1. The test of the difference between the two means found the t-value of 1. Vol. II However.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders.36 Corporate Governance and Finance in East Asia. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.17 DER of Listed Companies by Degree of Ownership Concentration (percent) Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699. to maintain control of the company. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. Between 1987 and 1996. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. since commissioners represent the controlling party. Source: Author’s estimates.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. the borrowings swelled. heavy reliance of companies on bank credits to finance investments. ultimately. The availability of bank credit brought by the rapid rise in the number of banks and the free capital flow system led to a credit boom.0 351. Table 1.

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

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

2 8. Only 86 companies reported profits.5) (18. Table 1.8) (11.18 shows that growth in most sectors significantly fell in 1997.1 6. except utilities.4) (0.24 trillion for the first six months of 1998.370 percent. Real Estate. Gas. and 128 companies reported a total loss of Rp46.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. and building construction.4) 2.0) 1999 2.9 3.52 trillion.0) (15.7 1998 (0. as shown in Table 1.4 5. Hotels. Sectors with lower ROE generally had higher DER. much higher than the 307 percent registered in December 1997. Livestock.8 7. and Business Services Other Services GDP 1996 3. The average DER was found to be 1. BPS). The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.19.8) (13.7) (2.6 12.6 8.6) (0. when all sectors.1) 1. posted negative growth rates.8 8. Most sectors showed significant increases in leverage.0 2.18 GDP Growth by Sector. DER and ROE were calculated per sector.4 7.5.1 5.7 6. Forestry. The construction sector was the worst hit. followed by the finance and trade sectors.1 (1. and Water Supply Construction Trade.8 0.1) (26. 1996-1999 (percent) Sector Agriculture.2 (1. followed by property.3 11.Chapter 1: Indonesia 39 1.7) 2.58 trillion (meaning their losses were greater than the paid-up capital). This continued in 1998.4 7.0 3.7) (8.6 4. 53 companies reported negative equity of Rp6.6 (36. and Restaurants Transport and Communications Financial. and Fisheries Mining and Quarrying Manufacturing Electricity.6) (3. real estate.0 5.8 1997 1.6 13. indicating a rapid rise in .3 12.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. The consumer goods industry reported the lowest ROE. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.

7) 6. Impact on the Banking Sector Table 1. the NPL ratio had reached more than 60 percent. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.4 5.0 12.0 193. a Actual data for 1st semester only.2) (264.4) 18.0 177.0 1998 186. Mostly suffering from a liquidity squeeze.0 307.19 DER and ROE of Publicly Listed Companies by Sector.0 1. as shown in Table 1. from only 8.0 a ROE 1996 1997 1998a 14.4) 8.1) 7.9 12.0 108.0 158.0 177. Financial and banking analysts estimate that by September 1998.0 635.1 30.0 163.0) 10. Second.0 697.8 percent in 1996. First.2 (4. foreign exchange losses came about with the use of unhedged foreign debt.0 97. II Table 1. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.0 2.625.0 191.2 13.7 percent in July 1998.1 (3.0 65.8) 36.395.8 17.0 105.4 (6. but annualized to approximate full year values. the NPL ratio rose to 25. .0 219. losses in operation were due to declines in sales and increases in the cost of imported inputs.8 (373. As the rupiah weakened and interest rates increased.6) 15.0 92.0 229.0 2. and would have kept on increasing if interest rates had not declined. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. This figure further increased to 47.0 864.20 reveals that the banking sector’s ROE decreased significantly in 1997.0 205.370.6) (115. Source: JSX Monthly. private banks posted negative ROEs in the same year.5 8.5 percent in April 1998.1 (5.7 1.3 7.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 1. Third.0 108.1 (92.0 631.0 72.0 1.0 1997 234. Vol.1 1.0 111.6 (11.2 23.0) (78.271. The huge losses suffered by most companies were caused by three factors. small foreign banks enjoyed the highest profits.21.1 (124. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.097.40 Corporate Governance and Finance in East Asia. several publications.

Chapter 1: Indonesia 41 Table 1.6 — 13.12 15.2 10.09 (11.5 222.0 — 4. Source: Infobank. however.0 622.91 21.3 361.2 1.81 13. 230/1998.86 11.21 Nonperforming Loans by Type of Bank.89 27.5 128.1 30.06 20.7 106.2 — 8.68 1996 1997 8.43 10.3 22.1 47.8 14.84 27.8 187.09 11.70 1995 7.6 — 4.1 13.3 Private National Banks — 179. July No. Source: The National Banking Association.1 274.5 2.20 ROE of the Banking Sector.07 13.6 — 1.34 16.44 15.8 3.69 14.9 — 11.2 8.28 5.1 1.67 8.9 11.2 47.9 297.8 8. private national banks overtook State-owned banks when their NPL ratio jumped to 57.7 — = not available.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 331.9 Regional Foreign and Development Joint Venture Banks Banks — 9.72 16.8 11.2 — 19. In July 1998. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.25 22.2 37.30 5.5 57.24 15.7 4.07 1994 14.2 48. put pressure on the banking sector.24 (4.5 31.47 20.1 198.4 7. State-owned banks initially had the highest NPL ratio.9 percent.2 8.45 — 1993 15. 1992 7.15 20.7 — 1. 227/1998 and October No.50 9.5 34.0 129.0 — 32.37 19.3 445.7 29. 1996-1998 (Rp trillion) State-Owned Banks — 140.45 21. .20) Table 1.38) 11. The high and increasing NPLs.73 30.6 6.39 13. coupled with negative spreads (deposit rate was higher than the credit rate).

the scheme failed. Thus. assembling the legal and policy framework to facilitate corporate restructuring.000 eligible firms had signed up for the scheme.5. companies were not servicing their debts. The scheme encourages negotiation between creditors and debtors. In November. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. While the process of restructuring was in progress. only a . The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. a number of prominent companies. about 80 percent of which was private. Aside from being described as overly complicated. have been subject to restructuring deals under the initiative.2 billion debt. 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.000/$1) in debt from domestic commercial banks. By end-November. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). the corporate sector had more than Rp600 trillion ($75 billion at Rp8. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps.7 billion of foreign exchange debt. Unfortunately. a more comprehensive scheme to tackle domestic and foreign corporate debt. Astra International (automotive). and Ciputra (property business). the committee launched the Jakarta Initiative. particularly in terms of debt resolution. II 1. Corporate debt accounted for 46.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. In addition.6 billion) of Indonesia’s total external debt in March 1998.7 percent ($64. such as Garuda (a national flag carrier). On 9 September 1998. Vol.42 Corporate Governance and Finance in East Asia. Since September 1998. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. the Government and private sector formed a committee to help corporates deal with the crisis. by mid-September 1998. IBRA was formed to offer Mexican-style resolution for private sector foreign debt.4 trillion of domestic debt and $6. few companies were in a position to resume interest payments. However. In June 1998. none of the 2. 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.

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

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

improvement of rules and prudential regulations. the Government established IBRA to supervise problem banks. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. The importance of this legislation may need to be emphasized. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. and Bapindo) will be merged into one bank named Bank Mandiri. To overcome these problems. merged. Bank Indonesia has announced a recapitalization program for potentially viable private banks. depositors will be fully protected by the Government. BBD. BEII. In October 1998. Some 175 groups that originated from family businesses controlled . Liquidity support given to troubled banks should be repaid in four years. The merger process will be finished within two years. However. providing Bank Indonesia with substantially enhanced autonomy. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. A new central banking law. and follow-up action on bank restructuring.6 1.1 Summary. The four state banks (BDN.6. the Government required banks to be audited by international external auditors. Other Regulatory Reforms To push corporate restructuring further.Chapter 1: Indonesia 45 In 1997. or sold (after transferring NPLs to the AMU). it is doubtful whether pure holding companies are able to enter into swaps. It has also drafted regulations to remove obstacles for converting debt to equity. To obtain a clearer picture of the banking sector. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. was enacted in 1999. In particular. Conclusions. 1. Banks deemed ineligible for recapitalization will be closed. The Bank Indonesia 21st package includes recapitalization.

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

The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. and registered a net loss of Rp39. were the most adversely affected.1 percent in 1998.370 percent in 1998. the highly leveraged companies.24 trillion in the first half of 1998. Impact of the Financial Crisis Prior to the crisis. Bank Indonesia extended emergency loans to many banks. Sales of conglomerates as well as those of publicly listed companies were increasing. At the height of the crisis. As the rupiah weakened and interest rates increased. although at a declining rate. the consumer goods industry was the worst hit. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. facilitate debt restructuring. the high domestic interest rates that prevailed from 1998. On the other hand.Chapter 1: Indonesia 47 without diluting their control. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year.1 percent in 1997 to -124. the corporate sector was in quite good shape in terms of growth and profitability. particularly those with large short-term foreign loans. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. DER increased to 307 percent in 1997 and further surged to 1. To restructure the corporate sector. followed by the property sector. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. financed by issuing nearly $80 billion worth of bank restructuring bonds. and strengthen prudential regulations and supervision of the financial sector. When the crisis hit Indonesia. corporate-initiated debt restructuring . The Government and the private sector responded with measures to mitigate the negative effects. The financial crisis led to the closure of several dozen banks. Meanwhile.21 trillion in 1996. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). The Government introduced reforms to improve bankruptcy procedures. NPLs rose and capital adequacy ratios fell. Total profits of publicly listed companies dropped to Rp3.1 trillion in 1997 from Rp13. and the rapid decline in equity due to losses. ROE dropped from 1.

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

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

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

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

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

Vol. T. and individual companies.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. accountability of controlling shareholders and boards of directors.1 1996 561 163 29. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. Koller. This study collects and analyzes data on the Korean economy. especially chaebols. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. capital market discipline. and improvement of bankruptcy procedures. which distributed and collected the questionnaire.1 1997 518 104 20. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. Government reform goals for the corporate sector include enhancement of corporate transparency. Many firms left some questions unanswered. .4 1993 513 174 33. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. Weaknesses in the overall corporate governance system in Korea had many ramifications. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. The EVAs are the same as the economic profit as explained in T.1 1998 490 164 33. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. June 1999. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. and J Murrin (1995). 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. the corporate sector.1 1995 560 163 29. 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 Listed Firms with Positive Economic Value Added.54 Corporate Governance and Finance in East Asia. Copeland. II Table 2.9 1994 531 165 31. Source: Korea Stock Exchange.

Section 2. Section 2. clothing. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. In the period 19481961.2.6 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. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. and employees and their role in shaping corporate governance practices.4 contains analyses of corporate financing and its relationship to performance. corporate control by the Government. This chapter is composed of six sections. reviewing government policies responsible for the development of the modern corporate sector. The evolution of the modern Korean economy can be divided into four periods. From 1948 to 1961. the board of directors system. Major economic indicators for some of these periods are shown in Table 2. creditors. . It then presents recommendations for further reform in corporate governance and financing. and other necessities domestically.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. and Yim (1998).2. 2. Yang. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn.2 presents an overview of the corporate sector. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. The Government tried to produce food. It reviews such elements as shareholders’ rights. Section 2.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis.2 2. Section 2. It traces the country’s economic development. which account for a substantial portion of the Korean economy. Section 2.

7 30.4 24.0 27.8 15. lack of strong drive.1 — = not available.4 (1.4 29.5) (1.56 Corporate Governance and Finance in East Asia.1 9. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.9) 1. d Refers to 1997.855.8 (724.7c 11.2 6.8 12.265.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.9) (7. In the Plan. IMF. This goal required very high savings and investment rates. Economic Statistics Yearbook.102.0) 492.2 757.8 24. However.2 314. Source: Bank of Korea.5) 8.5 38.949. and implementing new budget and tax measures.4 10.4 1990-1997 7.1 15. e For maturities of one year or more. International Financial Statistics. The Government tried .2 1980-1989 8. modernizing the industrial structure. high unemployment and inflation. and large current account deficits. Export Drive: 1962-1971 Between 1962 and 1971.3 8. b Refers to 1979. 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. the Government called for an unprecedented average annual economic growth rate of 7.2 Key Macroeconomic Indicators Annual Average (percent.0 41.2 30.9b 15.753.447.8 (8.0) (297.2 31.1 29.2 452. Vol. a Refers to 1971.6 11.7 14.332. the Government was not successful in solving the problems of slow growth. II Table 2.2 1.1d 9.1 35.2 32.1a 21.5 250. largely because of political instability. c Refers to 1989. and inconsistent economic policies.9 — — 21.4 29.9 794. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).7 37. 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.

channeling funds from curb markets into the banking sector. The well-educated. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. During the first five-year plan period.3 percent average between 1954 and 1959.3 percent to 60. In 1971. This change raised the import liberalization rate from 9.5 percent. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. boosting internal investment resources. The interest rate reform enabled banks to allocate large funds to the industrial sector and reduced the high inflationary pressure that had built up in the economy. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. resulting in high real interest rates. abundant. which laid a solid foundation for a steady growth path. But the liberalization trend turned out to be short lived as current account deficits continued. the Government tried to provide exporting firms with a free trade environment. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported.2 billion in 1972. 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. However. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. up from 30 percent in the late 1950s. Bank deposits increased rapidly. 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.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. the import liberalization rate was 55 percent. while the average tariff rate was 39 percent. The average growth rate of the economy from 1960 to 1964 was 5. Exports increased sharply from $41 million in 1961 to $2. Also. . In 1964. and cheap labor force was well utilized by the export-led growth strategy. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). The exchange rate system was a kind of crawling peg until 1974. a modest improvement over the 4.4 percent. but tariff rates were raised to 40 percent in the 1960s. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. due to continuous current account deficits. During this period. the growth of gross domestic product (GDP) raised domestic savings.

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

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

Meanwhile.60 Corporate Governance and Finance in East Asia.9 percent. 46. 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). 47. and acceded to the World Trade Organization (WTO) in 1994. total sales.2 percent. the import liberalization ratio reached 98. Korea began participating in many multilateral trade negotiations during the Uruguay Round.2. 4. 13. II world interest rates.1 percent and average tariff rates 8. which gradually widened. total debts. further increasing its pace of import liberalization. giving up its foreign exchange controls related to the current account.1 percent. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. . and low oil prices. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. 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 committed itself to further liberalization of the goods and capital markets. whose business activities are controlled by an identical person. 45. Industrial and trade policies were modified to be consistent with WTO.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies.3 percent. but it chose to liberalize gradually. with the 30 largest in the total economy in 1997 standing as follows: value-added. Vol. Korea adopted a market average exchange rate system. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. 2. The official rate fluctuated within a band. and total workforce. while continuous and large current account surpluses saved Korea from the foreign debt problem.” A large-scale business group is called a chaebol. The low value of the dollar led to a low won and high yen. In 1993. total assets. In 1990. and declaring that it would follow Article XI of GATT. The Government tried to adjust economic policies and regulations to meet global standards. the importance of chaebols was increasing.9 percent. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. The most important element characterizing chaebols is the concentration of ownership. In 1988.9 percent.

it was more effective to deal with a small number of companies to secure tangible outcomes. One reason for this controlling power is inter-company shareholding among subsidiaries.Chapter 2: Korea 61 War II. chaebols that maintained a close relationship with the political authorities were able to grow fast. This galvanized the fast growth of chaebols. and they are aided and supported by one another. 1993-1996 Year 1993 1994 1995 1996 No.8 22. In the mid-1970s. Since the 1960s. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. From the standpoint of the Government. Important managerial decisions are made primarily by owners. Chaebols have a history of substantial concentration of ownership. However. financial assistance. the ownership and management of a chaebol’s subsidiaries are not separate. Table 2. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital.5 20. and tax breaks to key industries to promote exports and industrial upgrading. Table 2. This policy contributed greatly to the expansion of chaebols. Chaebols are also excessively diversified. of Subsidiaries per Chaebol 20. reaching 669 in 1996.1 20.3 Subsidiaries of the 30 Largest Chaebols.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. the number of subsidiaries declined drastically due to corporate restructuring. In this sense. The Government provided subsidies. of Subsidiaries 604 616 623 669 Average No. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. Since the Government controlled most business activities. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. .3 Source: The Fair Trade Commission.when the Government put a great deal of emphasis on development of the HCIs. after the financial crisis.

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

however. continued until 1989. The policy to expand the size of the stock market.798 Market Capitalization as a Ratio to GDP (%) 8.1 Market Capitalization (W billion) 6.020 151.4 40.2 44. several important policy measures were implemented to promote the development of the stock market. First.9 918.0 49.Chapter 2: Korea 63 During the 1980s and 1990s. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. a country fund.570 95.4. The aggregate Table 2. 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). was established to invest in domestic shares beginning in September 1985. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused.9 833.476 79. . of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.989 137.4 Development of the Stock Market.7 934.1 16. In this regard.. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.6 747. 1985-1998 No. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues. Second. As shown in Table 2.151 117. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. especially those paying small or no dividends.0 965.1 30.5 406. Third. The Korea Fund. 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.0 79. the stock market grew rapidly during the 1980s.4 654. Also that year.370 70.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. Inc.217 141. Because of government policies and the booming economy. the Government announced the gradual opening of the capital market to foreign investors in January 1981.9 34. Beginning 1990.

534) 1. and stayed at the 30-40 percent level up to 1996.800 (7.59 percent in 1998 and to more than 50 percent in the early months of 1999.001 4.546 (2. However. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.5 Private Capital Flows to Korea.571 2.347 3. 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) (2.287 (340) 73. 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 1986-1989.942) 42.785 (1.714 1.239 19.338 4.296) (6.149 13.352 471 3. trade credits.433) (9. Table 2. The aggregate market value of listed shares bottomed at 16.858 4. The growth in the number of listed firms also slowed in the 1990s.017) 1. and 1993.852) (2.255 2.553 8.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.642 21. . The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.382 Permit basis.183 12.2 percent by 1989.875 21.742 (3.339) (9. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.817 16.326 1.658) (3.924 (1.453 (2.944) 8.650 (1. but increased sharply to 79.150 5. II market value of all listed firms represented only 8 percent of GDP in 1985. but rose again to 34.500 7. Bank of Korea.440 1.085 2. currency and deposits.450 24.141 4.126 (1. Other investments include loans.413) 56.953 10.008) (3. Source: Balance of Payments.86 percent of GDP in 1997.123 3.868 (518) (418) 63 1.455) 13.264) (3. Vol.583 25 10.910) 2.414) 5.870) (1. and other liabilities.542) (1. Table 2. due to declining stock prices.64 Corporate Governance and Finance in East Asia.737 (333) (297) (607) (2) 218 2.694) 2. The relative size of the stock market diminished to 44 percent in 1990.

However. weak incentives for attracting FDI.Chapter 2: Korea 65 Complicated government regulations. increasing to 76 percent in 1997. and sales of the aggregate sector during this period were very high (Table 2. In addition to FDI.9 billion. but dropped in 1996 and were negative by 1997.7 billion and loans $42.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. Japan’s was consistently higher. excluding FDI. Net private capital inflow. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. Of this. and high production costs were the main reasons for low FDI in Korea. but between 1988 and 1993.2.China. Korea had substantial current account surpluses and experienced net private capital outflow. (ii) listed firms. the growth rates of equity and sales dropped sharply in 1996 and 1997. Return on equity (ROE) and return on assets (ROA) showed similar patterns. The growth rates of total assets. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Taipei. Between 1986 and 1989. Table 2. The same categories will be analyzed in later sections. portfolio investments amounted to $73. This would lay the foundation for evaluating the effect of corporate governance on performance.China and the US. Profit rates of Korean firms were relatively low compared to those of Taipei. following the sharp depreciation of the won. The contribution of the corporate sector to GDP was 73. and US. 2. Corporate sector net proft margins increased from 1993 to 1995. equity. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector.6 percent in 1997.2 percent in 1987.5).6). other net private capital inflows amounted to $130 billion during 1985-1998. and (iii) chaebols. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. The ratio is generally in the same range for Japan and Korea. The dismal performance of the Korean corporate sector compared to the . This indicates that a substantial proportion of debt was denominated in dollars.

5 (0.9 5.3) 5.7 4.0 4.1 2.9 3. Table 2.3 — 3.0 13.4 2.0 0.5 1.4 19.1 2.9 13.3 312.2 1.0 (0.3 21.6 (4.2 19.3 6.8) 297.0 305.3 14.7 3.6 4.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.9 4.6 9.6 1.4 2.9 16.3 3.9 2.0 8.4 1.4 4.6 2.9 18.7 3.6 424.7 4.9 2.5 0.7 15.8 21.2 13.8 22.1 6.4 1.9 5.0 13.1 — — — = not available.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.2) (0.9) DER = debt-to-equity ratio.8 3.2 1.1 2. Net profit margin = ratio of net income to sales.7 15.5 4.6 13.4 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).7 2. ROA = return on assets (ratio of net income to total assets). Financial Statement Analysis Yearbook.3 21.2 9.7 1.5 1.4 10.5 1.Table 2.9 3.0 3.5 4.7 4.6 318.9 16.4 1.9 8.9 18.8 2. .6 3.7 325.8 8. 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 23.8 1.9 5.5 2. ROE = return on equity (ratio of net income to stockholders’ equity).2 13.3 1.3 17.3 308.4 — 6.2 18.2 1.3 11.1 5.0 7.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.5 7.9 2. Source: Bank of Korea.1 8.0 10.8 1. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).0 6. Financial Statement Analysis Yearbook.5 3. Source: Bank of Korea.6 1.3 335.

This preference of Korean firms has its roots in the structure of corporate governance. 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. with equity in wholesale and retail trade even contracting. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. gas.6). construction. Profit rates of most industries are also quite low. . Net profit margins. Small listed firms were hardest hit by the financial crisis. In most years. sales of listed firms grew 18. trade. In 1997. with the wholesale and retail trade sector and the construction sector having the highest figures. Again. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits.4 percent.9). Growth rates of total assets are generally high. the exception being the electricity.5 percent while the aggregate sector recorded only 13. and transport sectors recorded negative profit rates in 1997. However. a year ahead of the other industries. Performance followed similar patterns across different industries (Table 2. The other financial ratios follow the general pattern of the aggregate corporate sector. followed by mediumsized firms and large ones. The growth performance of large firms for the 1988-1997 period was better than that of medium. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997.and small-scale firms (Table 2. the average ROE was lowest for large firms.10). and steam supply industry. A comparison of performance by firm size reveals some interesting results. However. ROEs. This may be related to its having the lowest DER. this may be an indication of the bias toward large firms in terms of access to credit. but higher than that of small firms. both ROA and ROE were lower for the listed firms compared to the latter. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. while their average net profit margin was lower than that of medium firms. The manufacturing. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. All sectors experienced a sharp decline in equity and sales growth in 1997. It is notable that the construction sector’s profit rate began its decline in 1995.8).

2 20.0 37.9 31.1) (3.2 0.4 1.7) 2.8 1.7 514.9 10.4 2.4 5.8) 0.4 9.4 14.2 16.4 2.6) 3.8 0.0 16.4 12.2 241.5 3.5 28.2 0.8 23.2) 22.8 0.3 288.0) 1.5 (1.7 (3.2 0.6 16.4 1.0 21.3 10.8 302.2 6.8 12.6 7.0 245.6) (6.9 (0.1 0.4 3.0 (0.4 458.9 340.2 20.9 9.3 18.3 8.3 8.8 3.0 1.1 27.1 296.4 15.9 13.0 15.9 25.8 17.2 15.9 16.8 10.2 36.6 0.7 317.1 (0.5 1.2) 6.2 12.0 2.1 17.5 1.5 286.1 290.8 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 13.3 11.0 3.9 3.4 17.4 5.4 474.8 14.9 (0.9 19.7 17.1 1.2 18. Renting.1 28.0 22.5 30.8 2.3 11.7 294.7 16.5 6.5 338.4 .8 345.9 2.0 (4.4 0.8 24.2 6.5) 0.6 1.0 1.8 24.3 8.3 14.5 306.4 10.3 285.1 0.8 7.0 19.0 1.8 34.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.6 12.4 0.1 10.5 13.0 2.0 24.8 562.0) 0.0 1.0 16.5 1.8 13.8 12.8 22.2 5.0 22.0 1.1 16.9 5.5 473.1 2.6 14.4 348.9 16.0 1.9 16.3 13.6 375.1 7.5 27.6 11.9 10.3 15.4 740.8 16.3 25.9 538.6 17.6 12.8 2.6 14.2 16.4 4.0 18.8 32.6 3.1 (0.7 30.7 (0.6 1.2) (0.8 461.0 22.9 1.0 2.1 1.1 21.5 569.2 5.1 2.4 10.4 2.4 350.1 1.0 7.2 2.7 228.3 14.0 24.1) 3.9 2.6 2.8 616.3 15.7 5.3 8.8 526.7 1.6 14.4 291.6 0.0) 0.8 16.5 483.0 9.1 1.9 0.5 4.5 1.9 (0.4 2.1 396.8 3.0 23.0 12.1) 0.5 432.3 15.7 21.3 10.5 16.6 3.3 15.2 423.6 6.5 239.8 2.0 18.9 14.1 0.5 5.8 Real Estate.9 428.3 31.7 520.5 1.2) 15.3 1.7 9.5 19.0 2.5 6.2 5.2 25.0) 4.7 10.4 10.9 29.5 1.5 (5.5 23.6 655.8 1.0 1.1 20.0 5.3 2.2 (1.6 15.5 (0.8 16.3 2.0 15.5 270.3) (1.Table 2.4) 0.0 (0.6 5.4 10.7 7.7 22.5 14.6 318.9) 1.1 22.6 24.6 17.4 (0.7 4.2 7.3 1.8 35.8 22.0 254.8 14.2 315.7 0.4 5.4 2.5 5.0 5.2 24.8 10.

0) 1.0 5.6 20.2 — — — — — 2.2 3.6 1.6 (2.6 6.2) 0.7 0.2 18.0 2.1) (0.5 344.3 125.3 740.1 3.9 4.6 9.9 6.9 9.4 0.6 512.8 6.1 (0.1) (0.0 7.1 323.5 12.9 9.6 16.0 98.5) 22.6 9.5 30.3 17.1) 5.8 3.0 (1.4 — — — — — 448.8 0.2 18.0 14.7 116.2 7.1 21.8 4.1 17.4 7.1 6.3 18.4 2.3 (2.3 2.7 0.9 456.8 529.4 12. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.4 3.0 106.2 10.9 17.3 0. Financial Statement Analysis Yearbooks. Source: Calculated using data from Bank of Korea.8 11.6 19.4 7.4 (0.7 16.0) 1.3 1. a New equity does not include capital surplus.6 4.5 13.7) (4.9) (8.4 13.9 1.8 12.6 19.3 112.9 10.5 307.8 8.7 2.5 612.7 187.4 3.0 89.6 1.1 (2.1 15.3 23.4 3.9 (11.4 6.1 2.5 462.8 14.9 18.7 2.1 1.4 14.062.5 8.0 1.6 0.5 (2.8 14.5 117.5 539.1 14.3 18.3) 15.1 16.8 0.5 14.6 2.9 12.4 15.1 15.7 19.8) (12.9 10.5 47.2 122.4 169.4 (2.1 12.1 8.3 8.3) (1.2 15.6 8.8 (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 8.2 10.1 11.4 0.7) 0. Gas.0 21. b NPM denotes net profit margin.3 8.2 90.4 10.7 — — — — — 14.4 6.4 1.2 1.8 15.7 11.2 698.5 11.0 2.5 26.9 4.0 14.9 12.2) 13.3 0.9 17.4 11.7 12.7 7.5 14.5 0.6 21.3 4.4 341.4 12.3 34.0 13.8 6.7 — = not available.8 9.1 15. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.5 16.9 Electricity.4 0.2 10.0 Transport.6 12.2 2.6 8.9 (10.5 14.5 14.5 15.6 6.6 3.7 15.3) 11.3 19.3) 4.8 12.3 1.6 14.6 4.3 543.4 633.3 4.2) 9.3 524.8) 1.0 1.Table 2.4 367.6 18.3 — — — — — 10.4 9. Storage.5 11.2 18.1 11.0 5.5 482.4 1.2 14.7 7.6 — — — — — 17.4 21.4 1.7 11.8 7.1) 1.9 321.5 2.5 15.2 143.0 (15.7 20.6 — — — — — 0.6 172.6 (2.6 34.7 14.1 (11.9 3.9 18.7 11.3 9.0 1.9 8.5 4.4) (1. .9 332.2 11.6 15.4 16.7 510.0) (0.6 8.1 4.6 12.6 6.4 30.0 921.8 3.3 12.3 4.9 7.4 2.3 3.8 111.2 14.6 9.

7 percent) of the corporate sector.3 20.2 9.9 percent). It should also be noted that when the financial crisis struck in 1997.4 22.4 0.4 1.6 3. the 30 largest chaebols accounted for 13. In 1997. Kis-Fas.4 1.9 2.3 15. Between 1993 and 1997. of which four were listed.5 5.9 2.4 2. but the number of designated groups has been fixed at 30 since 1993.2 6.7) 0.9 6. 1998. had 46 member companies. of which 16 were publicly listed (Table 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.4 1.8 24. The top five chaebols registered the highest growth rates.1 1.4) 1.70 Corporate Governance and Finance in East Asia.6 1.5 ROE 3.5 19.6 22. followed by the top 6-10 (Table 2.9 21.7 1.11). of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. The smallest group had 16 members in 1995.0 3.2 0.6 and 2.1 6.6 2.3 0. The criteria for selection of largest chaebols have changed a few times.0 18.5 ROA 0.1 percent of the economy’s total value added (excluding the financial sector).12).7 (5.0 0. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. the top 11-30 chaebols experienced a decline of .1 1. The number of Hyundai member companies rose to 57 in 1997. the largest chaebol.8 5. In 1995. and net profits (46. it is the chaebols’ large firms that are listed.6 23. and close to half of total assets (46.8 0.1) 4. Chaebols have been the most important actors and engines of growth in the Korean economy.9 0. Vol.7 Net Profit Margin 0. II Table 2.9 26.9 11.2 2. Generally.12).3 percent).9 percent).8 6. Hyundai Group.5 19.3 2.3 4.3 (0.6 0.2 9.9 Growth and Financial Performance of Listed Companies.9 Source: Constructed using data from Korea Investors Service.9 1.6 (1. debts (47.5 0. Performance of Chaebols This section uses available data on the top 30 chaebols.7 1. 1985-1997 (percent. sales (45.

2) (1.2 2.3 Medium 14.0 19.5 1.6 0.6 (0.1 11.4 6.7 1.9 5.7 (0.3 (0.7 2.4 16.6 2.4 3.9 0.8 0.4 3.1) 5.1 8.9 6.4 5.6 6.9) (6.7 (1.3 15.8 1.0 4.8 0.0 16.9 25. Kis-Fas.9 (0.6 2.5 (1.5 5.3 9.9 1.0 (4. 1998.2 Small 13.8 7. Others are medium firms.0 6.9 0.2 13.9 2.8 6.4 1.5 2.Table 2.0 1.3 6.5 5.6 3.2 0.0 10.7 2.6 13.8) 6.2 (0.9 22.9 0.5 25.6 1.0 17.4) 1.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.2) 0.5 17. .9 6.2 7.3 3.0 1.9 14.3) 5.8) 1.0) 0.1 2.8 10.7 4.4 Medium Small Large Medium Small ROA Growth Performance Large 17.9 2.6 5.8 17.0 1.5) 1.6 (1.1 0.3 (0.1 2.0 15.5) 1.2 2.6 3.6 0.3 11.2) (1. 1988-1997 (percent) ROE Large 9.7 3.6 7.7 18.6 1.8 (5. Source: Korea Investors Service.4 11.5 0.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.2 13.10 Growth and Financial Performance of Listed Companies by Size.1 1.8 6.2 1.7 (1.4 1.6 9.2 10.3 1.4 2.6) 0.6 8.2 3.9 1.5 3.8 0.8 3.0 1.2 12.0) 1.9 2.6 2.6 1.3 15.8 16.8 0.3) 0.9 3.

597 351.398 — 2.651 38.287 10.11 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 43.117 4.376 35. .180 2.967 7.574 3.427 9.951 3.445 4.433 3.158 7.457 14.766 3. Source: Fair Trade Commission.873 2.935 2.677 3.774 7. 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.246 11.756 5.910 3.147 5.995 2.309 14.129 2.Table 2.370 6.303 3.458 6.346 3.690 3.761 31.090 6.313 14.798 — No.853 1997 53. 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.177 — 6.364 5.956 3.131 3.158 1.486 6.599 — 2.395 31.924 2.423 5.990 2.475 2.927 16.640 4.455 22.743 40.929 12.996 1.501 13.

9 18.3 15.0 19.12 Growth and Financial Performance of the 30 Largest Chaebols.5 2.7 10.2 11.2 (2.6 19.0 0.0 17.4 30.8 27.7 0.6 25.7 13.6 4.2) (0.4 26.Table 2.3 16.4) (0.7 15.0 6.1 19.2) (2.3 0.1 (1.1) (0.5) (0.1) (0.2 0.5 20.3 19.2 (16.6 (0.1 (3.4 0.3 1.0) 3.3 1.8 Assets 12.9 1.9 3.7 15.1) 0.4 38.1) (1.8 0.1) 0.5 (0.3 27.4 12.3 11.2) 1.2 0.3 3.4 (2.7 1.9 17.3) 0.5) (0.9 3.9 20.0 2.2 3.0 31.0 2.6 Financial Performance Net Profit Margin 1.6 18.0 1.1 10.5 19.2 0.7 10.0) 12.9 20.0 0.6 1.2 20.4) (14. 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 12.2 (2.0) ROA 1.7 4.1 (2.2 1.5) (0.5 32.7) ROE 5.2 (5.3 9.3 14.3 0. .9 24.1 27.8 18.5 5.1 2.4) 1.7) Source: Bank of Korea.0 2.5 27.

weak corporate control. The better showing of the top five chaebols was a direct result of their dominance in human resources. and access to credit.7 percent growth in total assets. . more important. Vol. his/her relatives.3. except for 1995.” in Korea’s legal and regulatory framework. However. The absence of a well-developed equity market and the provision of subsidized credit.765 percent (Table 2. Only the top five chaebols registered a positive net profit margin in 1997. In general.5 Founding families are mostly still the largest shareholders and. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. 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. There has been a wide range in DER among chaebols. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997.74 Corporate Governance and Finance in East Asia.” This “identical person. and government intervention interacted through a set of laws and regulations to bring about the existing structure. Ownership patterns. loopholes and inconsistent policies spawned strategic behavior and agency problems. the average DER of the 30 largest chaebols reached 519 percent. in this instance. technology. internal and external control mechanisms.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. and the companies that are under the control of the largest shareholder.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. The Commercial Code stipulates the basic governance framework and applies to all corporations. 2. resulted in the chaebols’ excessive leverage. 2. from 190 to 3. a pyramidal structure of corporate ownership is prevalent. coupled with weak corporate governance. chaebols had a higher average DER than the corporate sector as a whole.13). the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. and vulnerable balance sheets. Their worst year was 1997 when ROE hit -15. 5 While “ownership concentration” can be defined and measured differently in different contexts. and led to a high concentration of ownership. includes the largest shareholder. By the end of 1997.95 percent. II 2 percent in their sales and a very low 4. it refers to the degree of concentration and shareholdings in the hands of an “identical person.

Sammi 27. Byucksan 1996 1. Doosan 13. Hansol 17.855. Halla 13. Daelim 14.2 2. Hanwha 10.441. Hanbo 15.5 337. Jinro Debt-to-Equity Ratio 376.1 385.0 436.7 354.4 622.7 621.244. Daelim 16.6 409. LG 4. Doosan 15. Sunkyung 6.6 936.5 343.9 751. Hanwha 10. Lotte 11.4 556. Hyundai 2. Kukdong Construction 29.2 346. Halla 17.6 .5 383.8 312.1 477. Samsung 3. Ssangyong 7.6 2.4 192.3 572.7 620. Daewoo 5. Kumho 12.1 3.0 486. LG 4.2 423. Hanil 28.7 688. Tongyang 22. Dongbu 24. Hyundai 2. Jinro 20.1 278.7 267.2 471.065. Newcore 30.3 328.Table 2.2 924.8 336. Dongkuk Steel 19. Ssangyong 7. Sunkyung 6. Daewoo 5. Haitai 26.5 3. Hanjin 8. Hanjin 8.1 674. Kolon 21.9 321.0 370. Samsung 3. Hyosung 18. Dongah Construction 16.2 292.1 190. Hansol 23.8 313. 1995-1997 (percent) Chaebols 1995 1. Kia 9. Lotte 11. Hyosung 18.4 205.3 297.0 506. Kumho 12.6 516.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.3 315. Dongah 14. Kia 9.5 2.4 175.5 464. Dongkuk Steel 19. Kohap 25.7 416.0 218.764.2 328.

5 386.1 375.0 419.501.3 676. SK 6. Dongbu 23. Doosan 15.9 490.5 323.225. Samsung 3.8 307.0 505.8 658.3 347.5) 404. Haitai 25.6 416.13 (Cont’d) Chaebols 20. Hyosung 17.Table 2. Keopyong 29. Newcore 26. Kumho 10. Dongah 11.4) 513.1 359. Hanjin 7. Daesang 27.784. Hanwha 9.7 1.1 472. LG 5.498. Jinro 23. Haitai 25. Hansol 16.3 399. Tongyang 24.5 (1.6 478.7 370.9 578.8 399.0 907. Newcore 28.6 590.6 424. bBank of Korea.0 305.8 338.214.9 465.9 1. Kolon 19. Dongkuk Steel 20. Kolon 21. Daelim 14. Shinho 1997 1.1 433.8 347.8 647. Hanil 28.3 1.5 (893.600.8 590. Financial Statement Analysis Yearbook.8 468. Anam 22. Miwon 30. Kamgwon Industrial 30.1 438. Keopyong 29. .5 519. Ssangyong 8.9 472. Dongbu 21.5 576. Kohab 18. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.5 261. Hyundai 2.9 216. Kohab 22. Daewoo 4. Halla 13.6 335.4 1.7 944. Lotte 12. Shinho 26.6 Sources: aFair Trade Commission. Anam 27.5 1. Tongyang 24.

Among listed nonfinancial companies. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. large ownership can also bring about the entrenchment effect.14). the Government. i. The percentage of shares owned by “other corporations. fluctuated widely during the period.” followed by banks.” foreigners. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. However. with a given range of managerial shareholdings (for instance. including banks and other financial firms.e.6 percent by 1997. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. the entrenchment effect outweighs the incentive effect. Composition of Ownership Among listed companies. including investment trust companies. The holdings of financial institutions. and state-owned companies and securities companies declined. The reduction can be . Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. The pattern of distribution changed little through 1992-1997.7 percent by 1997. the extent of ownership by these individuals declined gradually after 1988. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. that is. the percentage of holdings by individuals slipped to 60. the year the stock market was in a frenzy due to buying sprees. resorting to extensive use of pyramiding to maintain control. The next important group was “other corporations. the incentive effect once again dominates. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. and insurance companies increased during the period. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. From 69. and then steadily declined after 1993. Thus. 10 to 30 percent).1 percent. managerial entrenchment becomes more likely. However. individuals were also the largest shareholder group.. but their shares declined to 21.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. while those owned by banks. Beyond that range. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. the ownership structure can bring about an incentive effect. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. Theoretically.

6 9.5 7. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.7 9.2 7. c Data from Korea Stock Exchange.2 5.5 12. d Constructed from data files of the Korea Listed Companies Association.6 9. .2 1993 511 2. merchant banks.7 4.2 9.1 18.0 8.7 6.7 7.9 5.4 Insurance Firms Other Corporations Foreigners Individuals 39.5 18.4 13.9 19.7 14.9 1.7 8.7 18.9 4.1 1.6 13.6 16.4 1997 551 1.5 Note: Ownership is based on number of shares. investment trust companies.6 8. etc.0 4.4 5.1 21.6 2.6 1991 505 0.9 36.3 26.1 21.5 1989 498 0.5 4.0 7.1 68.7 1990 531 0.8 17.0 5.3 1996 570 2.3 2.14 Ownership Composition of Listed Companies.3 5.2 5.6 19.8 2.3 18. b “Banks.3 39.0 5.2 8.1 3.5 6.1 2.1 8.8 5.2 B.4 18.6 20.5 1.5 60.5 1.9 1.7 9.8 2.1 4.7 3.0 60.0 27. Listed Nonfinancial Companiesd 1988 406 0.8 1995 548 2.6 Year No.1 11.0 9.0 28.3 1.2 9. etc. of Firms The Statea Banks.3 18.2 8.8 4.b A.4 34.2 17.1 60.5 7.3 1.7 59.2 3.9 37.2 2.3 17.1 10.9 17. a The State covers the Government and state-owned companies.8 59.8 59.8 5.3 8.4 13.8 17.5 6.6 36.0 59.6 22.2 18. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.3 1994 521 1.4 6.4 5.9 26. mutual savings.8 69.3 5.5 62.9 2.Table 2.5 1992 508 2.2 1.” includes commercial banks.2 4.1 17. and finance companies.1 18.9 2.9 15.5 16.4 14.1 8.6 12.6 16.3 17.6 16.

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

2 64.4 2.2 0.8 5.5 0.8 1.9 1.3 38.5 0.3 7.3 13.7 2. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.1 10.9 19.6 — — 2.4 1.0 9.3 9.0 2.5 85.8 Individuals 83.0 0.6 18.4 7.0 10.2 2.15 Ownership Composition of Listed Nonfinancial Firms by Industry.5 17.0 9.7 20.5 — 0.5 3.2 17.6 1.1 1.4 0.9 0.9 23. Elecl Mach.5 7.Table 2.1 19.7 63. Paper.0 8.4 8.3 0.4 62.9 16.1 0. 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 .9 59.9 42.2 7.9 10.3 0.3 0.9 52.2 9.3 11.1 0.4 8. and Printing Chemicals.1 4.8 8.3 1.2 0. Gas.4 14.3 1.3 2.2 9.3 2.3 57.4 1.1 8.2 1.5 6.8 3.5 19.7 22.9 15.2 22.8 6.3 6.7 20.6 8.5 4.7 17.7 14.6 5.0 — 0.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.3 62.2 54.4 56.8 7.8 7.6 11.2 9. and Printing Pulp.8 7.8 7.2 0. Rubber..7 2.1 8.1 27.9 4.1 7.0 9.3 10.4 5.5 0.7 64.7 1.4 — 0.7 29.1 65.2 0.9 60.1 0.7 6.9 8. and App. Paper.5 0.1 88.5 12.2 — 0. Etc.5 — 1.2 1. Motor Vehicles Electricity.0 20.9 66.9 1.7 22.1 0.7 14.4 Banks.8 7.9 55.2 — — 0.4 8.0 1.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.0 — 39. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.6 3.5 — — 0.3 4.8 3.7 2.0 7.0 9.7 59.4 56.8 73.6 24.

4 9. and Printing Pulp.8 0. and finance companies.6 1. Motor Vehicles Electricity.1 2.8 12.5 1.2 1.6 20. .6 2.0 60.0 43.6 7.1 9.7 23.8 57.9 57.2 4.1 4.4 43.0 5.5 3.4 — 1.4 0.0 3.8 11.6 75.3 31.2 4.7 4.4 2.0 1.6 14. a The State covers the government and state-owned companies.2 0.3 6.3 65.0 4.1 — 0. etc.4 1. and App. mutual savings.5 3.4 45.3 8.8 5.2 3.7 2.3 7.2 7.9 78.5 12.8 6.0 6.6 18.9 2.9 6.4 6.5 3.5 0.4 68.4 1. Elecl Mach.9 18.2 0.2 13.6 5.4 76.3 57.1 54.” includes commercial banks.3 6.9 20.1 25.1 2.4 3.1 1.9 7.6 0. Rubber.8 54.9 5.5 4.3 0.7 2. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.6 59.8 5.6 0.0 11.1 3.8 2.5 59.6 — = not available.7 2.3 60. and Printing Chemicals.9 2. investment trust companies. Note: Ownership is based on number of shares.2 1.5 3.9 1. Paper.9 1.7 5.0 7.6 3.4 58.4 58.6 60.5 — 2.2 5.8 2. merchant banks.7 1. Paper.6 2.78 81.8 4.2 5.6 6.5 6.6 6. b “Banks.3 1.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.0 6.5 7.9 2.1 9.1 1.4 2.4 4.3 2.3 1.7 6.8 27.1 — 1.5 5.9 0.7 17.2 4.1 3.5 63.9 7.6 2.9 5.9 2.1 18.2 8.4 20.9 69.9 20.2 4.5 4.7 19.8 0.8 2.9 1.7 2. Gas.8 3.2 23.2 6.2 49.9 6.1 6. Source: Constructed from data files of the Korea Listed Companies Association.4 4.0 8.3 15.4 16.4 2.4 1. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.

5 62.0 6.3 Banks. merchant banks. . Others are medium firms.7 1.9 2.8 4.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.5 8.4 5. etc.6 16. 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.8 60.0 1.7 8. 1997 (percent) The State 1.4 61. etc.5 6.4 5.9 5. Source: Constructed from data files of the Korea Listed Companies Association. The State covers the government and state-owned companies.8 6.8 4.8 1. Securities Firms Insurance Firms 2.0 Other Corporations 16.5 Individuals 60.1 6.8 3.16 Ownership Composition of Listed Nonfinancial Firms by Size.4 21.1 Banks.4 17.1 2.Table 2.” includes commercial banks.7 Control Type No.7 0. c “Banks.7 4.5 19. 1997 (percent) The Stateb Foreigners 4.8 2.4 1.4 2.2 1. investment trust companies.4 Firm Sizea No. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.4 2. mutual savings.7 6.9 4.4 61.7 Foreigners 4.5 4. etc.3 6.5 16.5 18.5 2.1 8. and finance companies.4 4.c Securities Firms Insurance Firms Other Corporations Individuals 58. b Table 2.6 60.

the majority shareholder group in all listed companies consists of the corporate. Foreign holdings of Korean shares were 9. and the companies under the control of the largest shareholder. But these may .6 39.6 Foreigners 9. corporations held 70 percent of the controlling blocks of shares. At the moment.1 financial institutions’ establishment of corporate pension fund accounts. rather than the individual.19).7 16.18 Ownership Composition of Listed Firms in Selected Countries. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. In 1997. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. including those of the largest shareholder. only closed-end investment companies and traditional investment trust companies are allowed. for example. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.Chapter 2: Korea 83 Table 2.3 54. This has had profound implications for corporate governance and the market for corporate control in Korea. his/her family members.4 26. investors (Table 2.6 Individuals 23. minority shareholders.3 6. Generally. while family members accounted for only 30 percent. 1997 (percent) Country Japan Korea Taipei.3 47.China United Kingdom United States Source: Stock Exchange of Korea.1 8. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996.8 56.5 20. Among nonfinancial listed firms. defined as those holding less than 1 percent of shares.8 9. Institutional Investors 42. 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.8 10.20).5 45.

6 2.0 22.9 33.3 30.1 4.2 Minority Shareholders Subtotal 71.6 5.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.0 1.1 37.0 4.3 18.9 7.9 32.0 69.8 Individual Subtotal Other Shareholders Corporation 3.1 21.4 3.1 23.9 Individual 2.1 32.Table 2.0 66.8 73.9 6.6 26.1 15. Source: Stock Exchange of Korea.7 6.7 44.7 Note: The majority shareholder includes the largest shareholder.2 2.4 7.7 18.1 5.8 72.0 25.2 26.6 73.2 2. his/her family members.4 5.7 7.7 16.8 8.1 28.6 46.0 2.19 Ownership Concentration of All Listed Firms.1 5.9 2.3 2.3 Subtotal 5.6 22.5 43. and the companies under the control of the largest shareholder.0 29. Minority shareholders are those holding less than 1 percent of shares. . Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.9 3.1 14. 1992-1997 (percent) Majority Shareholders Corporation 15.

minority shareholders.8 57.22).6 58. .1 50. 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. In telecommunications.5 12.20 Ownership Concentration of Listed Nonfinancial Firms.0 58. which held less than 1 percent of a company’s outstanding shares as of 1997.9 25.5 60. collectively owned less than 50 percent of an average firm.5 13.6 11.3 62.8 25. It was highest in medium-sized firms before 1993 and. thereafter. Besides.6 57.5 23.8 12.9 29. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.4 Source: Constructed from data files of the Korea Listed Companies Association.21]).3 25. and mining categories.Chapter 2: Korea 85 Table 2.4 23.8 28. 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. the Government has retained a large number of shares.0 22. ownership was relatively diffused due to government regulation.9 48. Majority ownership is also high in the chemicals.7 18.9 27. The percentage of shares held by minority owners (with less than 1 percent of outstanding shares) was highest for large firms at more than 55 percent (Table 2. The practice of hidden shares seems to have been less prevalent in recent years. the majority owner held more than 20 percent of an average firm.8 54. Meanwhile.9 Other Shareholders 18. hiding shares offers no additional tax or other benefits.9 12.2 15.8 Majority Shareholders 27. In such cases. rubber and plastics. In most industries. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average. in the small firms. Ownership concentration tended to be lower in large compared to medium and small listed firms.0 20. Across industry.4 28.

0 51.7 21. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.1 43.0 54.3 26. Rubber.2 20.5 19.5 44. .2 19.5 16.8 24.7 27.8 41.8 29.0 39.5 52.2 37.5 41.4 53.4 11.Table 2.9 10.8 31.7 24.9 Minority Shareholders Majority Shareholders Other Shareholders 12.5 47.9 26.5 20.0 30. Motor Vehicles Electricity.9 44.. Elecl Mach.6 19. and Printing Pulp.2 23. Gas.8 44.1 49.0 21. and Printing Chemicals.3 39.3 19.21 Ownership Concentration of Listed Nonfinancial Firms by Industry. 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 36.7 36.8 25.8 21. Paper. Paper.7 29.5 21.2 22.6 38.8 55.8 51.7 26.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.6 34.2 26.2 34. and App.1 17.6 53.4 16.6 25.2 48.2 46.1 19. 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.5 23.7 17.6 50.

2 21.Table 2.9 53.8 52.2 Source: Korea Listed Companies Association.2 21.6 24.1 15.0 66.2 Majority Shareholders 26.5 26.2 11.5 Other Shareholders 19.6 31.5 10.9 22. of Firms 66 81 72 76 80 67 78 102 134 115 148 197 219 212 210 217 216 216 215 215 165 213 220 217 218 217 227 230 231 221 Minority Shareholders 53.6 59.3 27.7 28.5 19.4 29.2 18.8 62.2 52.2 50.4 51.4 30. .3 25.5 51.1 20.2 12.7 57.5 19.6 27.6 15.7 16.5 33.8 50.7 17.5 28.9 28.6 65.8 27.6 11.8 28.2 21.5 12.9 56.6 55.7 31.3 21.5 49.8 56.9 23.1 27.3 55.9 60.8 11.6 62.8 52.4 47.1 16.9 26.1 58. 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.9 12.7 15.9 16.2 55.7 14.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.7 57.2 26.4 21.3 19.5 12.0 24.0 26.2 32.7 22.2 56.1 48.4 30.5 21.5 27.8 17.0 55.9 55.0 59.9 21.9 17.3 26.4 30.

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

34 percent were foreign companies. Thus. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place.5 percent. or about four firms each. In many instances. or about five subsidiaries each. there are instances of direct cross-shareholding in Korean firms. If we define the internal shareholdings of a . not individuals. 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. and about 11 percent were domestic financial institutions.5 corporations and two individuals. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. together owning an average of 38. and 319 foreign subsidiaries. although they are likely to be insignificant. In the case of the 30 largest chaebols. In Table 2. for example. 59 parent companies collectively had investments in 759 firms.5 percent as of 1997. Among chaebol affiliated firms. The fact that corporations. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study.5 percent of shares. Among the 81 listed firms in the ADB survey. the average shareholding of the controlling owners and their families was 8. Partial results are shown in Table 2. 59 were parent firms with one or more subsidiaries. For the same year. together owning an average of 37.Chapter 2: Korea 89 guarantees from other members of the group at no cost. standalone setups. For the whole sample. Twenty-two of the 81 respondents were independent. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. 53 percent were domestic nonfinancial firms. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally.14.4 corporations. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. the top five shareholders consisted of 2. together having a total of 292 domestic subsidiaries. or an average of 13 firms per company. The extent of pyramiding can be seen in some of the previous tables. Until recently. Among the subsidiaries or firms receiving investments. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. Of the 81 respondents.9 percent of shares. 62 percent (16 out of 26) had a corporation as the largest shareholder. the top 30 chaebols’ shareholding by subsidiaries was 34. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. Thus.23.

4 1.1 3.5 2.5 38. 1999 Five Largest Shareholders No.8 31.0 1.5 1.6 3.5 2.7 39.8 8.7 37.7 5.7 19.5 4.0 2.4 42.8 38.3 12.4 18.2 25.9 21.5 24. a Number of shareholders.23 Ownership Concentration in the Survey Sample of 81 Listed Firms. .6 16.5 2.5 18.8 18.0 3.0 21. 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 20.4 25.0 3.4 21.0 13. A few companies reported less than five largest shareholders.0 17.9 34.6 34.3 26.Table 2.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.5 31. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.8 37.4 38.6 3.9 29.0 1.6 3.2 37.7 0.4 11.1 1.9 5.1 22.5 4.4 2.5 2.

7 1992 46. 15 October 1998. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. the controlling families owned 8.8 33. edited by K. Based on these studies.1 1997 43. 79-95.2 12. “Japanese Zaibatsu and Korean Chaebols. Table 2.6 33. Ungki Lim.0 8. As of 1997. 1997. Lee.2 33. pp. . Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. it appears that the chaebol families have had a strong desire to expand their business bases.5 percent.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. 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.” In Korean Managerial Dynamics. Hattori (1989) identified three patterns based on data in the early 1980s.” Paper presented at the Annual Conference of Financial Management Association. 6 7 Hattori. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. The family and member companies’ shareholdings have been declining over time. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. 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. Tamio. Jae Woo.2 15. Lee. 1989. 1987 56.7 9. 1998. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. H. the ownership patterns can be described as follows.7 31.24 Internal Shareholdings of the 30 Largest Chaebols. C. Chung and H.4 13.5 34. 34. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.4 10.4 1993 43.4 1990 45.5 percent and member companies. Table 2.2 1994 42.24 shows the average internal shareholdings in the 30 largest chaebols. Chicago. New York: Praeger.5 Judging from the historical record.8 40.

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

At this early stage. The Government is also considering whether to allow consolidated taxation for pure holding companies. Initially. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. However. These amendments prohibited holding companies and direct cross-shareholding. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. This was the reason why chaebols chose to employ pyramidal structures. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. 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). The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. The prohibition of holding companies was also abolished in 1999. Existing guarantees had to be resolved by March 2000. A third disallows multiple layering of holding companies.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. following the amendment of the law. . the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. bankruptcy reorganization. Until the end of 1998. Also. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. It remains to be seen whether they will adopt the holding company structure in the future. thus hurting the shareholders of stronger firms. This limit was also applicable to banks and insurance companies. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. One condition requires that the DER of the holding company should not exceed 100 percent. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. They hindered early exits (liquidation. 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. only operating holding companies were allowed to be established.

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

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

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

1 percent of outstanding shares of a listed company. These results are in accordance with the new listing rules introduced in 1998. are required to have a majority of outside directors. In 78 percent of the responding firms. a blue-ribbon committee. In March 1999. having no controlling shareholders. he or she held 6. 88 percent had plans to hold elections in the near future. and a nominating committee. This is because most banks. Where the two were separate. Directors were also chosen on the basis of their relationship with the controlling .9 percent on average. who would comprise at least 50 percent of the boards. although some banks recently have established board committees. the Korean Code recommends that large listed firms should have at least three independent directors. the Corporate Governance Reform Committee. 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. the chairperson of the board was also the CEO and on average held 10. Among others. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice.2 percent and the CEO 14. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). this committee adopted the Code of Best Practice in Corporate Governance. which had extended financial support in their recent recapitalization efforts. In September of the same year. The average board had 8. Among the firms with no outside directors. they had a parent/child relationship in 20 percent of the cases. an audit committee. Where the chairperson was not the CEO. inside directors owned 16.4 directors. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange.1 percent and outside directors 1.5 percent of the shares. Meanwhile. On average.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies.

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

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

and accounting standards. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. but in practice is fixed and understood as part of a fixed salary. it was common for all senior executives to be elected as directors at the shareholders meeting. (ii) establishment of accounting standards for financial institutions. 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. This action was in response to calls by international investors and. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. and . disclosure. Transparency and Disclosure Accounting Standards The Financial Supervisory Commission (FSC) was established in April 1998 to take charge of supervising the financial markets and institutions. 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. However.100 Corporate Governance and Finance in East Asia. Vol. in particular. The term of appointment of executives did not have any real meaning because they had to leave the company if and when the controlling shareholder demanded. from IMF and the World Bank. 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. Senior managers were even often called directors although they were not official members of the board. Korean firms have rarely used shares for executive compensation. Penalties for fraudulent financial reports were increased. The bonus is supposed to be linked to company performance. II Senior Executives In the past. The commission has played an active role in introducing new rules on corporate governance.

Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. Under the Commercial Code. but 49 percent confessed that they have not followed international standards at all. 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 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. Thus. In practice. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. Those that never adopted international standards show their willingness to do so once the Government introduces international 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. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current year’s financial statements. Consolidated reporting was introduced before the outbreak of the crisis. they also have the power and duty to monitor the activities of executive directors. the internal auditor is considered to be a subordinate of the . In the ADB survey. however. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. 41 percent of the companies believed that they have followed some international accounting standards. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Notwithstanding a regulation limiting the votes of the largest shareholder to a maximum of 3 percent of the outstanding voting rights in selecting an internal auditor. Only 10 percent of the respondents have followed all international accounting standards. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities.

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

No companies have so far introduced voting by mail. However.53 percent of the total shareholdings.” The survey shows that the Korea Securities Depository holds 69. charter amendments. The securities companies and banks are the second and third.” Companies can increase the number . About one fifth of the listed firms issued nonvoting preferred shares. or 10. Approval of mergers and major divestitures. corporations cannot issue common shares without voting rights.77 percent of the shares.Chapter 2: Korea 103 2. voting by the Depository can influence the outcome of votes because an “ordinary resolution” of the general shareholders meeting requires a majority of the votes attending and one quarter of total votes outstanding.3. in general.79 percent of the shareholders. or telephone. This shows that a relatively larger number of shareholders send in their proxies. The management is the most important proxy. the Depository is instrumental in getting resolutions passed.21 percent of total shares issued.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. attended the last annual general meeting. These voters represented only 5.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. Internet. the Depository is subject to “shadow voting. small shareholders do not attend the annual meeting and that. The Depository represented 20 percent of the shares attending the meetings. Thus. respectively.93 percent of the shareholders but 26. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. Under the Commercial Code. and dismissal of directors and internal auditors require a “special resolution. The above results indicate that. amendments of the articles of incorporation require a “special resolution. representing 62. One common share should have one vote. 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. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. A total of 326 shareholders per firm. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. However. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). for some firms.

104 Corporate Governance and Finance in East Asia. Changes in the authorized capital require an amendment of the articles of incorporation. It also attended the shareholders meeting of several companies to present the views of outside shareholders. Only two out of 62 respondents to this question have had cases in which proposals were rejected. Proposals put forward by management are rarely rejected at the general meetings. Various measures have since been taken to improve investor protection. and for access to unpublished accounting books and records. Shareholder Protection Before the economic crisis. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. 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.5 percent. Vol. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. However. but these can be waived by an amendment of the articles of incorporation. As an example. an institutional investor based in the US. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. 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 company also agreed to the right of the fund . the Tiger Fund. demand changes in business policy. and major investment projects (only five firms answered this question). the requirement was lowered from 1 to 0. II of votes required for a resolution to amend the articles. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. the board of directors decides on issues of shares within the limit of the authorized capital. 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. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. or block charter amendments considered harmful to minority shareholders. from 3 to 1. In February 1998 and again in March. Due to the changes in rules for investor protection.0 percent. laws and regulations were generally very loose in protecting the rights of minority shareholders. Shareholders have preemptive rights. For recommendations for dismissal of directors and internal auditors. In four out of 62 respondents. mergers and acquisition plans.01 percent.

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

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

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

Under a contract signed between the creditors and the debtor. Role of Creditors in the Corporate Restructuring Process In the current process of business restructuring and workouts of an unprecedented number of firms under financial distress. the delegation has the right to approve wide-ranging financial activities of the firm. are summarized below. Separate from but emulating the CRA. and 1 percent by the Government. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. II by other affiliated companies. First. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. Second. The new ways through which creditors. Representative of the policy was the stipulation under the Securities and Exchange Act that no one can accumulate more than 10 percent of the voting shares of a listed company . In this connection. 2. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. Vol. 2 percent by holding companies. have been the driving forces for restructuring activities of the largest 64 chaebols. This committee was set up in accordance with the provisions of the CRA. banks and other institutional lenders are playing more important roles than ever before. and in continued monitoring of debtors. the Korean Government maintained a policy of protecting the incumbent management of listed companies.108 Corporate Governance and Finance in East Asia. major creditors. Behind these new strengthened roles of creditors is the newly set-up FSC. the main vehicle for implementing the workout concept (or the London Approach) is the Corporate Restructuring Agreement (CRA) signed by 210 financial institutions in July 1998. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. Third. will get involved in the restructuring and workout processes. 4 percent by subsidiaries. In cases where the creditors are unable to reach an agreement on a workout plan. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration.3. especially banks.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. including commercial and merchant banks. The leading creditor banks will continuously monitor the progress in implementing the signed Plans.

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

and a bank had government ownership. For the others. It is harder now to find such firms. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. Golden parachutes are almost unknown in Korea because the total amount of director compensation has to be voted on at the general shareholders meeting each year. Some had two or more large shareholders who had joint control of the firm but could not cooperate. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. the limit will be eliminated when it is fully privatized in two years. Currently the limit is 3 percent. Vol. In their charters. As of February 1999.110 Corporate Governance and Finance in East Asia. an electric power company. The Government-owned listed companies. In 1999. a steel company. Charter amendments have also been employed by some firms to limit the maximum number of directors. 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. As of the end of 1997. was newly listed.3. 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. in which the Government still holds the largest ownership. Another reason is that many listed firms belong to chaebols. 2. are designated as public companies. Hostile takeovers in Korea will be rare in the future. 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. . 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 1998. except for the banks. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. For the steel company.7 percent on average as of the end of 1997 for nonfinancial listed firms).6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. Korea Telecom. Many of the takeover targets in the past did not have a controlling shareholder (group). 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols.

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

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

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

Also. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. depreciation. II Interest Rate Deregulation Plan. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. short-term finance companies. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. especially the domestic bond market.1). development of the money market. With the privatization of nationwide commercial banks.5 percent in November 1981. listed companies. finance companies. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. and liberalization of foreign and capital transactions. budget. which resulted in the establishment of a number of new banks. the business scope of financial institutions was greatly widened from the early 1980s. Since 1985. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. the Korean Government announced its Financial Liberalization and Market Opening Plan. and the 30 largest chaebols. In addition. Internal funds include retained earnings.118 Corporate Governance and Finance in East Asia. The capital market. In June 1993.4. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. Meanwhile. revision of the credit control system. Korean firms have been allowed to issue CBs in international financial markets. It included such important issues as interest rate deregulation. implementing the first stage in November 1991. Vol. as a first step toward liberalization of capital account transactions. mutual savings.2. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. etc. Some policy loans were also abolished. Moreover. The Government adopted a cautious approach. .2 Patterns of Corporate Financing Corporate Financing Practices In this section. On the basis of flows of funds. 2. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. and organization of commercial banks. was liberalized drastically in 1998 after the financial crisis. the Government simplified various directives and instructions regulating personnel management.

The corporate sector used . except in 1991. Equity capital represents the shareholders’ commitment to the business. was 71 percent during the period. The SFR averaged 28. This means that internal funds after dividend payment were insufficient to finance growth in total assets.26 shows the four measures of corporate financing calculated from Table 2. Meanwhile. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. 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. particularly in the 1990s in response to the liberalization of the capital market.Chapter 2: Korea 119 and net capital transfers from the Government. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock).4 percent in the precrisis period 1988-1997. In securities finance. the corporate sector’s most important source of external finance was bank borrowings. particularly in the short term. It measures the degree of financing growth in total assets by additional debts. depreciation. and allowances) and new equity capital. capital surplus. and 1997. Securities finance became a more important source from 1988 onwards. including all sources other than retained earnings. It measures the degree of financing growth in total assets by additional equity. and government transfers. but it remained less than 10 percent of total financing.25. the proportion of foreign borrowings in total finance rose steadily. The share of external financing. Table 2. Financing Patterns of the Aggregate Corporate Sector Table 2. Before 1988.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. depreciation. 1994. In 1988 when the stock market boomed. financing by corporate bonds and CPs was more significant than by new equity. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. except for the stock market boom of 19871988. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. comprising internally generated capital (retained earnings. on average.

9 6. a Includes retained earnings.8 — 26.3 1.9 73.6 9.2 6.0 3.0 0.1 8.3 — 30.0 1997 26. Bank of Korea.8 30.0 3.3 2.8 1.1 0.3 5.0 22.6 11.4 8. 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.5 9.2 10.3 72.3 3. b Includes capital surplus.4 0.4 27.1 1.3 1.3 — — — — 8.1 — 27.2 — 28.1) 4.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.9 72.2 5.7 2.6 10.7 10.6 1.0 — — — — 8. Bank of Korea.8 27.8 15.6 77.3 1.1 3.1 0.0 5.0 3. depreciation.7 1989 1990 1991 1992 1993 1994 1995 1996 22.4 2.0 11.4 21.2 13. and net capital transfers from the Government.8 -2.2 (0.6) 5.8 8.1 12.9 38. .7 1.7 6.25 Flow of Funds of the Nonfinancial Corporate Sector.7 32.0 9.9 0.4 (0.7 14.4 27.7 7.7 73.1 10.6 0.0 1.0 16.3 6.7 13.7 2.6 3.4 2.8 56.1 1.8 0.2 13.9 28.3 27.6 25.1 23.5 0. Source: Understanding Flow of Fund Accounts.6 0.6 4.4 1.1) 4.4) 13. which is the excess of current value over issue value of stock.1 27.7 — — — — 9.7 4. 1994.7 1.3) 11.2 1.8 4.1 3.1 — — — — 12. and Flow of Funds.3 25.7 4.3 6.2 2.2 14.0 9.7 8.5 2.7 15.0 2.6 (0.4 11.0 70.2 — — — — 9.1 72.7 12.9 9.3 6.0 0.9 10.5 16.9 2.4 71.4 10.5 16.1 36.4 — 28.6 0.6 11.1) 6.2 15.4 27.2 0.8 1.1 3.4 15.6 0.8 (0.5 2.6 4.1 2.1 2.5 0.4 0.Table 2.1 17.5 13.7 71.6 3.2 26.6 4.3 16.8 1.4 (2.1 (1.7 8.3 30. 1988-1997 (percent) 1988 43.7 14.3) 15.7 10.7 10.6 9.3 3.6 5.1 (0.4 1.5 2.4 2.2 34.6 14.6 2.7 2.8 17.6 8.6 9.7 (0.1 1.7) 11.4 2.4 9.8 1.0) 12.3 10.8 1.5 2.9 10.0 (0.7 11.4 3.2 6.9 34.5 0.5 29.0 10.0 17.

4 27. In periods of high economic growth such as in 1988. additional equity to finance 12.0 5.9 percent by 1997 when net profit margins were negative. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.1 26.3 73.7 40. . NEFR registered 20.1 12. 45.Chapter 2: Korea 121 Table 2. an average of 59. and IEFRs were declining.5 68.27).0 27.3 59.6 Excludes capital surplus.4 IEFR 63.5 31. Bank of Korea. but also continuously fell. Its IEFR and NEFR dropped to 23.7 percent in 1997. higher than the aggregate 40.3 60.7 26. On average.3 percent in 1997. and the total debt ratio was much higher in 1996 and 1997 at 62.8 28. indicating a high financial risk position. average SFR was 37. Source: Calculations from Understanding Flow of Fund Accounts.1 17.5 and 76.8 percent of its total asset growth through debts.9 22.3 59.3 12. Lower income diminished the industry’s equity position toward crisis year 1997. higher than the aggregate 28. Manufacturing financed 54.3 11.1 53. SFR peaked at 44 percent. NEFRs.5 percent in 1997.4 NEFRa 20.4 percent (Table 2. the corporate sector relied heavily on external financing for its expansion. Incremental financing from equity was 40.2 IDFR 36.7 28. declining to 26.5 percent.26 Financing Patterns of the Nonfinancial Corporate Sector.4 percent. 1994.1 percent in 1988 during the stock market boom.2 37.7 9. in the manufacturing sector. While SFRs.6 percent and 1.0 11. was financed by additional debts.2 percent of incremental asset growth was financed by equity. The balance.1 39.4 12. but plunged to 5.6 percent over the 10-year period.3 27.7 40.9 46. IDFR reached 73.8 10.6 percent. respectively. and Flow of Funds.6 percent.4 37. Bank of Korea. There were significant time trends. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.4 percent.7 30.6 26.9 28. Across industry.0 57.8 62.0 42.2 percent of the growth in total assets.7 40.9 60.6 62. respectively.5 12. It dropped to 28 percent the following year. dropping to 26.

9 percent.7 47.4 54.7 percent in 1996.8 50.0 3. Categorized according to company size.5 1. then increased to 20. one year ahead of the other industries.6 53.5 7.and medium-sized firms.3 28.9 percent of asset growth. Total debt financed an average 74.6 37. their average SFR was higher.8 4.7 47.5 76. from 17. Since large firms were more profitable.4 47.4 3. In 1997.6 4.8 percent in crisis year 1997.4 46.4 45.4 37.122 Corporate Governance and Finance in East Asia.0 30.2 percent in 1993.5 NEFRa 9. this dropped further to 15. the two sectors also had low equity financing ratios and high debt financing ratios.3 52. II The construction industry showed the most cyclical pattern in annual asset growth.1 29. and communication sector had relatively high incremental equity ratios. retail.2 62.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent) Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.6 37. explaining partly the collapses of several construction companies in 1995.6 54.2 3. On the other hand. which decreased to 8. Table 2.8 percent in 1990. gas.6 36.2 5.6 62. storage.6 3.9 IDFR 34.7 37. large firms showed more cyclical patterns in these financing ratios than small. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.2 .1 percent of total asset growth for the period. Financing patterns of the wholesale.7 37.6 45. It had the highest average SFR in 1988 at 31.2 21. and hotels sector and realty/renting/business activities sector were similar.4 63.8 IEFR 65.0 42.5 23. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.6 53. and low total debt and short-term borrowing ratios. and fell to about 10 percent in 1997. Since 1992.0 57.0 42. and steam) and the transportation. Vol. Equity financed an average 25. the utilities (electricity.9 6. the proportion of short-term borrowings in total financing has been high.

6 1997 29.8 2.5 20.4 28.8 54.2 1995 16.0 74.0 1.9 52.6 9.3 84.6 7.2 18.7 Wholesale/Retail Trade.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.8 74.5 1996 42.3 4.2 5.7 53.6 8.1 66.5 87.8 1994 15.1 84.0 3.1 Trasport.3 (9.1 69.3 7.2 3.2 8.6 37.7 78.8 25.3 1996 16.7 42.7 7.0 68.0 .2 Average 53.3 21.9 1993 63.6 14. and Communication 1988 64.0 0.8 70.3 19.2 46.6 2.2 10.1 70.0 82.8 4.9 1.1 1991 14.9 9.7 1994 53.3 10.6 37.9 30.3 4. Household Goods.7 1997 8.2 70.9 2.2 20.5 21.5 70.6 9.0 10.6 8.5 23.27 (Cont’d) Year SFRa NEFRa IDFR 53.7 15.9 47.3 8.0 65.1 19.0 1990 12.1 4.3 47. Storage.7 6.9 20.2 74.5 12.9 33.5 76.9 1.0 31.9 80.9 1992 56. Hotels 1988 33.8 29.8 81.4 1995 53.1 59.4) 2.0 60.5 62.9 29.8 9.1 25.9 Average 19.0 4.7 1989 26.6 4.9 1.3 57.0 1992 24.0 40.0 34.6 71.0 17.9 1989 63.7 78.8 1991 51.5 29.9 15.5 1.6 73.7 41.2 29.9 16.4 2.2 4.8 76.0 1990 50.5 1993 22.7 15.4 62.2 25.7 80.Table 2.2 23.4 26.4 IEFR 46.

4 0 0 0 0 1.6 1989 118.8 Average 22.0 67.6 IDFR = incremental debt financing ratio. Their average IEFR was also higher and IDFR smaller.0 79.4 IEFR 69.7 18.0 33.6 1995 17.6 1990 82.2 63. when large firms had much lower equity financing ratios and higher debt financing ratios than small.8 1990 19.3 92.4 1.27 (Cont’d) Year SFRa NEFRa 6.0 46.3 7.6 52.8) 7.0 (0.8 1993 11.4 0.1 34. Financial Statement Analysis Yearbooks.8 36.4 (107.6 1997 23.0 1997 24. Gas.4 47.0 0.1 54.3 31.9 29.1 70. and Business 1988 51.0 1.9 45.8 135.0 21.1 35.1 42.7 70. Long.4) 3.6 1.124 Corporate Governance and Finance in East Asia.0 53.8 17.6 1991 18.3 207. . a Excludes capital surplus.3 Electricity.0 0.5 22. SFR = self-financing ratio. Vol.9 IDFR 31. and Steam Supply 1988 118.0 1992 51. IEFR = incremental equity financing ratio.4 1996 45.1 71.1 0. The trend was reversed in 1996-1997. NEFR = new equity financing ratio.9 57.4 7.1 1993 55.3 29.7 37.3 62.5 77.8) (35.4 5.0 43. Renting.9 Average 75.9 28.4 1995 62.2 1992 18.9 65. Source: Calculated using data from Bank of Korea.7 1994 8. The large firms had a higher proportion of external financing in 1996-1997.3 85.and short-term borrowings of these firms shot up in that period.7 14.3 3.4 1994 72. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.7 69.0 56.6 7.5 8.9 64. however.1 1991 56.6 Real Estate.7 1996 18.1 1989 34. II Table 2.and mediumscale firms.3 81.

The chaebols’ drive to expand their empires resulted in heavy borrowings.6 percent of total asset growth. for listed companies.2 percent. In 1997.4 percent. about the same as that of the corporate sector as a whole.7 percent.9 percent.1 percent of their equity capital.28). compared with 89. The debt financing ratio of listed companies was high since they relied more on external financing. The proportion of their short-term financing averaged 72. Their shortterm borrowings accounted for 86.5 percent and their total external financing. the top 6-10 chaebols. compared with the entire corporate sector’s 35 percent and 65. 91. the lowest ratio of 58. the average SFR was 28. The average IEFR and IDFR were 10. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially.9 percent. respectively. Group-member firms borrowed less. In 1997. All of the top 30 chaebols relied heavily on short-term borrowings. Financing Patterns of Chaebols For chaebols. and the top five chaebols.8 percent of their total finance in 1997.3 and 89. . and higher than that of listed companies (Table 2. Cross-payment guarantees have been declining since 1993 and reached 91. but higher than that of listed companies. and using cross-payment guarantees among affiliated companies.5 percent is lower than that of the corporate sector in general. External financing reached 94.3 percent of their equity capital in 1997 (Table 2. In 1996-1997. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.8 percent. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.7 percent for all listed companies. the top 11-30 chaebols had the highest guarantees commitments at 207. The average IEFR of the top 30 chaebols of 29. The largest borrowers were the top 11-30 chaebols.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 were large borrowers.6 percent. They were able to borrow easily from banks by issuing corporate bonds and CP. the IDFR of listed companies increased to 93. at an average 70.29).30). 153.7 percent.

Table 2.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus. Source: Calculated using data of Seung No Choi.3 5.28 Financing Patterns of Listed Companies. Largest Business Groups in Korea.2 1. 1994-1998 (percent) SFRa IDFR 85. .4 1.3 IDFR 57.4 88.4 38.8 76.1 8.7 13.3 28.5 2. 1994-1997 (percent) SFRa 41.1 93.7 12.6 70.6 1.8 89.2 10.6 61.9 NEFRa IEFR 14. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.8 22.5 91. Korea Federation of Industries.9 6.2 NEFRa 1.5 8.5 8.1 1.4 12.4 29.3 1.9 7.29 Financing Patterns of the Top 30 Chaebols.6 0.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.5 2.3 86.2 36.7 1.Table 2.6 IEFR 42.2 23.6 11.

First. There were several reasons for this. Third. These are followed by loans from banks.30 Cross-Payment Guarantees of the Top 30 Chaebols. .3 64. more than half of bank loans were priority loans with low interest rates.3 200. Further. Financial institutions did not strictly screen their loan projects and monitor their debtors. Fourth. Firms now prefer internal funds and new equity capital. inefficient investment and excessive diversification of corporations. Factors Influencing Corporate Financing Choices Until recently. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. This change implies that firms now give more attention to financial risks. According to the ADB survey. poor financial and corporate governance resulted in overlending by banks. the Korean economy was plagued with high inflation. bond issues. and reserves and retained earnings. Few firms ranked loans from NBFIs as their first preference.Chapter 2: Korea 127 Table 2. and underdevelopment of the stock market. and loans from NBFIs. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. especially in the 1970s when real interest rates of bank loans were negative. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. and extended loans based on cross-payment guarantees.0 1997 91. loans from banks.9 — — — 1996 105.9 153. Second. And fifth.1 — = not available. so that the firms engaged in lobbying to gain access to them. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. Source: Fair Trade Commission and the Federation of Korean Industries. bond issues. the Government provided implicit guarantees on bank lending and large businesses. in order of ranking. Korean firms preferred debt financing (bank and nonbank borrowings). the Government applied high tax rates on net profits of corporations.7 150. company preferences in financing investment projects before the crisis were. Interest payments on debts were considered a loss when calculating taxes.0 207.9 — — — 1994 258. rights issues.1 — — — 1995 161.3 58.

According to the survey. A futures exchange launched in 1999 trades foreign exchange options. Vol. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. Nonetheless. 2.128 Corporate Governance and Finance in East Asia.3 Financial Structure. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. 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.4. Among the responding companies that had foreign currency denominated loans. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed.36 percent on average for these companies. Other factors include. Among those that never hedged against exchange rate risks. maintenance of the existing ownership structure. For these firms. even with a heavy debt burden. Korea now provides a better environment for financial risk management. ensuring the liquidity of the company. firms give their first consideration to minimization of transaction and interest costs. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. more than half (53 percent) hedged against exchange rate fluctuations. 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. the percentage of foreign currency denominated debt in the portfolio was 14. This preference has changed little after the crisis. and others (29 percent) expected the local currency to appreciate in value. in selecting financing sources. in order of importance. II In seeking external financing. some (36 percent) thought that a hedging facility was not available or not working properly. and reduction in tax burden. Only a few firms sought foreign loans because domestic loans were not available. many firms (or 42 percent) never considered hedging. they survived for two to three . and futures and other financial derivatives. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general).5 percent at the end of 1997. Diversification.

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

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

5 (4.9 0.7 0.6) (12. Background and Task of Structural Adjustment.3 (3.1 (1.7 1.6) (20.6 0.4) (1.1) 1.3) 0.7 0.1 0.3 0.4 0.9 0.2) (3.9) (9.3 0.6 0.2) 2.2) (4.1) — = not available.3 1.7 (0.1 (9.3 0.7 0.2 (0.9) 0.2 1.7 (1.3 3.3 1.7) (1.3) (0.4 (2.3) (12.7 (4.4 1.5 (0.9) 2.5 1.31 Net Profit Margins of Chaebols. .3) 1.5) (2.1 0.3 1.8) (1.5 (0.4) (0.1) (2.8) 0.1 1.3) 12.4) (2.5) (2.1) 2.9) 2.6) 0.2 1.1 1.7) 0.3) (0.1 1.5 1.8 0.4 (0.7 — (0.8 3.0 1.2 (17.4 (0.8) (3.2 (1.6 1.8) (4.6 5.0) (4.6) (0.1 0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.1) (5.1 0.0 0.2) 1.7 1.6 0.0) 0.7 3.4) (4.5 2.8) 1997 0.8) 0.8 (0.4 (1.5 (6.3 0.6 1989 1.2) 1.2) (0.5 0.4) (1.3) 0.1) 0.1 4.3 1.4 1996 0.6 0.0) (3.5) (7.3 1.1 (3.2) 2.6 1.3 1. Chung Ang University.3 1.1) 2.2) (0.1 0.6) (0.6 0.8) 2.0 4.2 4. Source: Whan Whang.8) (20.5 (0.9 1.6 1.1 (0.7 0.6 1.6 7.2) 1.9 8.5) 0.9 1.8 0.6) (12.9 0.1) 0.2 (0.2 (0.3 (0.0 1992 1994 1.8 1.9 (0.0 (0.8) (11.4 0.1) (6.8 (0.0 6.8) (0.6 0. Management Research Institute.2) (4.4) (6.8) 1.8 (0.2) 0.0 (7.8 1990 0.5 1.3 (0.5 1.2) (13.2 1.0) (0.5 1.7) (0.3 1.1) 1.2 (0.1 1.0) 0.4 0.2 1.3) 1.Table 2.6 3.0 1.5) (0.3 (0. p.8 1.1 1.1 1.7 (0.7) 0.4 2.3 0.8) 0.8) 0.1 0.9 1.3) (1.3 1.3 1.1) (1.2) (4.7 1.7 0.0 0.9) 2.9) (8.4 (0.1 2.11.4 1.1 0.1 (4.2 0.0 (2.7 2.5) (1.7 0.4 0.2) (13. Beyond the Limit.0 1987 1.2 1.1) (1.1 0.2 1995 3.2 1.3) 0.6 1.4) (1.9) (1.1 0.6 (0.4 1.5 (0.1 (4.3) 0.5 4.6) 0.9 1.8 3.6) 0.9 0.3) 0.4 (1.8 0.8) (37.3 1.6 0.1 1.0) 0.6 0.4 (1.3) 0.6 (10.0) (0.3 (0. 1998.7) (0.6 (0.8 0.7 1. Court Receivership.8) (1. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.4 1.8) 0.6) 0.8 0.3) 0.

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

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

2. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. Vol. capital. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. and a high degree of inefficiency in the economy.5. bond issues. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30.2 The Role of Government Intervention Strong government intervention in the early stages of economic development was useful for overcoming inefficiencies in financial and capital markets and for managing high investment risks. share issues. financing choices of listed firms in order of preference were bank loans. The new preference ordering is as . prevalence of rent-seeking and morally hazardous behavior by economic decision makers. Further. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. Financing preferences changed drastically after the crisis. as the latter are well established in most business areas. 2. II strong financial links among its member firms through investments and cross-guarantees.5. and other individual markets.134 Corporate Governance and Finance in East Asia. the typical chaebol firm had an extremely high DER. while (non-chaebol) independent firms had much lower borrowing ratios. However. As mentioned earlier. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. The Government’s supervision and regulation of financial institutions were poor.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. Such problems may eventually cause ripples through the entire economy. and internal funds. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates.

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

total assets. The inevitable result of inefficient investment was a fall in corporate profits. Before the crisis. Doubtful loans are those for which interest is not received for six months or longer. Further. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. especially chaebols. they are defined as loans for which interest payments are overdue by three months or more.000 in September 1998 (Table 2. the ratios of net profits to sales. reaching highs of 6 percent in 1997 and 8. nine out of the 30 top chaebols failed. The Government could hardly help them because of the number and magnitude of business failures. the NPL ratio reached 7. the NPL ratio8 of banks and other financial institutions began to increase.000 per year starting 1992. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. However.000 from December 1997 to February 1998. It jumped to 17. Vol. Fixed loans are those for which interest is not received for six months or longer.6 percent in June 1998.7 percent in 1997. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans.200 in 1997. the NPL ratio of commercial banks increased rapidly from 4. and the pursuit of growth through excessive diversification and inefficient investment. starting 1 July 1998. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. decelerated from March 1998. Financial Sector Vulnerability Because of financial losses in the corporate sector.32). Meanwhile. and shareholders’ equity of all industries. excluding the financial sector. without strictly evaluating the creditworthiness of businesses and the profitability of projects. Following the “three months” definition. The banks and merchant banks lent to large businesses. has given rise to various types of self-dealings by the controlling shareholder. and returned to about 1. and estimated losses. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. In 1997 they became negative. According to the “six months” definition. and there is collateral. were low in 1996 and 1997.1 percent in 1996.000 during January-September of 1998. Moreover. and there is no collateral. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. These were the definitions until 30 June 1998.136 Corporate Governance and Finance in East Asia. legal and other barriers prevented the exit of financially nonviable firms. The monthly number reached more than 3. . then 20.

ROEs and ROAs of Korean and Japanese banks were low compared with those of the US. the ratio reached 7-8 percent.386 5.114 811 706 696 866 1.517 2.647 8. those of domestic banks were lower in the 1990s.255 13.573 3. and large government-directed loans.China.131 1. low efficiency.238 4.259 2. and declined to 4-6 percent in 1994-1996 (Table 2. This speculation was said to be one of the causes of the financial crisis in Korea.859 3.553 3. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.244 3. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. The current account deficits in terms .027 Manufacturing 1.759 6.856 7. 2.544 2.992 11.472 2.637 6. Compared to ROAs and ROEs of domestic branches of foreign banks.589 171.769 9.502 11.457 2.265 6. and continuous and large current account deficits.210 1.5.159 10. This was mainly due to the high ratios of NPLs.850 3.855 6.107 6. 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.754 3.133 3.Chapter 2: Korea 137 Table 2. As a result they had largely overvalued currencies. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.673 Construction 380 354 242 195 294 585 1.135 1.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.985 Services 3. In 1990-1993.32 Number of Firms with Dishonored Checks. Meanwhile. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action. Source: Bank of Korea.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.69 20. European countries.053 5.890 4.751 1.657 3.979 8. and Taipei.33).250 2.

639 1.736 8. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.4 5.310 6. In addition to the overvaluation of the won. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.0 7.584 2. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.997 9.176 7.077 NPL Ratio (%) 8.China. Vol.600 10. Land prices and real estate rents were also high compared to trading partners.484 11. because of the rigid labor market. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.160 11. Source: Bank of Korea.190 9. of percentage of GDP were as follows: Malaysia -8. Korea -4.556 118.33 Nonperforming Loans of General Banks.430 12.929 11. which led to large corporate losses. and 30 percent in 1996. Thailand -8.1 7. Businesses served as a social safety net. even in times of economic slowdown.562 18. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.170 1.6 percent (1995). Mass layoffs became legally possible only after the economic crisis.0 8. II Table 2.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.China.537 10.266 10. although per capita income in Korea was much lower.874 22.954 9.520 194.0 7.827 289.705 160.649 375.192 Doubtful (B)b 952 1. and Indonesia -3.584 Fixed (A)a 5. . The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.116 1. In 1997.2 4.8 5.475 143.8 percent (1996).138 Corporate Governance and Finance in East Asia. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997. Related to this.739 241. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.1 6. Meanwhile large businesses could not legally lay off workers.6 percent (1995).221 8.910 1.832 337.652 29.390 12. the ratio of short-term debt to foreign reserves was very high.1 percent (1995).

A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities.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. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. To achieve this. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. Downsizing by curtailing employment has been prevalent. They have been pressured to stop such practices as providing loan guarantees. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. .6 2. Corporations. had been forced into bankruptcy proceedings or merged into healthier entities. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. including banks.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. 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.Chapter 2: Korea 139 2. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. and subsidizing money-losing units. Nonviable firms and financial institutions. although efforts to lay off thousands of blue-collar employees at Hyundai Motors encountered fierce opposition from labor and ended up in mediation after intervention by politicians from the ruling coalition.6. However. which were laden with huge amounts of debt and were on the verge of bankruptcy.

the number of potential sellers decreased somewhat from 2. In many cases. potential foreign buyers waited for the price of acquisition targets to come down further.138 by the end of October. Locally. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. In their first review. More important. Banks did not have the incentive to force financially nonviable firms to liquidate. On the other hand. This number was at 779 firms in April and grew to 1. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. The reasons are manifold. banks and other creditors were reluctant to absorb losses realized by debt compositions. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal.140 Corporate Governance and Finance in East Asia. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. Noticing this disincentive. Internationally. 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. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. 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.045 in October. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. the creditor . The data also show that about 24 percent of acquisition negotiations ended up in actual deals. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998.281 in April to 2. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. 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. More than 59 percent of potential buyers were foreign firms. Vol. 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.

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

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

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

(ii) legal changes have been made so that domestic accounting practices conform to international standards.01 percent in May 1998. the new rules made it clear that a court receivership order is available only when the going concern value of the firm under consideration is greater than its liquidation value. Vol. and economics professions should be organized to provide for expeditious proceedings in court. The purpose of this rule is to shorten the reorganization planning period. 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. Fifth. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations.” comprised of experts in the legal. Korea’s Economic Progress Report. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. In the past this stage usually extended for as long as two to three years. Second. Fourth. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. (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. etc. October 1998. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. the court may annul its previous decision and force the firm into immediate liquidation. number of creditors. Third. a “Management Committee. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. Also. Also. .144 Corporate Governance and Finance in East Asia. (v) all listed companies are required to appoint outside directors beginning 1998 9 This and the following two subsections draw on the Ministry of Finance and Economy. the right to revoke court receivership is allowed to the creditors. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. First. The changes in the reorganization procedures can be summarized as follows. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. accounting.

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

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

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

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

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

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

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

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

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

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

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

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

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

With economic reforms introduced in the 1980s and 1990s.5 9.6 7.8 10.2 (0.2 Thailand 11.5 8.000 Philippine companies grew 17.9 6.000 corporations. only to be unsettled by the crisis of 1997.5 percent per year (Table 3.4 4.9 (1.3 9.7 Malaysia 9.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.8 8.1 5. only nonfinancial companies were used.7) 10. net sales of the top 1.0 8.5) 3.4 Philippines 3.9 7. Vol.1 4.7 (13.0 7.5 8.3 9.8 8.2.7) (10.2 Source: ADB.2) 4.8 4.7 5.000 Corporations covers financial and nonfinancial companies. In this section.8 5.2 7. Table 3.2 During 1988-1997. Rep. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.9 5. . 3.0 (6.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.1). of 9.1 5. 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.6) 0.1 8.2 9.3 2.2 Korea.8 5.0 8. Its growth rate began to catch up with others in 1996.5) 5.158 Corporate Governance and Finance in East Asia. however.2) 0. which was taken as a representation of the Philippine corporate sector.3 7. Key Indicators of Developing Asian and Pacific Countries 2000.1 GDP Growth of Southeast Asian Countries.0 (0.3 8.7 8.2). competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. II market. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.2 8. This rate of growth was sustained by a comparable 18.5 (7.2 7.

6 75 6.4 602.0 148.2 338.978.9 78 6.3 46.6 900 1.5 51 4.2 136.1 51.2 Growth and Financial Performance of the Top 1.8 77 7. turnover = net sales/total assets. of Companies Sales per Company (P billion) 899 0.3 107 13.3 68 7.3 941.1 181 11.9 149 6.000 Companies.123. return on equity (ROE) = net income/ stockholders’ equity.5 Leverage = total liabilities/stockholders’ equity.2 1.5 4.5 119 12.341.8 5.8 411.6 426.9 896 2.4 776.3 121 12.7 73 6.1 4.1 66 12.5 1.1 468.512.5 1.8 22.177.000 Corporations in the Philippines.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.0 900 1. net profit margin = net income/net sales.7 903 0.6 954.5 64.7 218.1 33.5 192.5 570.1 197 14.9 952.2 2.332.1 73 5.9 480.6 290.4 260.6 1.6 144.7 443.191.3 382.5 14.7 20.893.3 862.209.5 508.781.2 378.1 54 11.1 714.225.6 35.5 72 7.8 6.6 896 0.7 1.5 1.9 898 1.2 707.1 Other Indicators No.5 446.3 898 1.Table 3.4 411.9 2. .131.8 26.7 1.7 28.3 60 10.5 193.6 149 12.647.1 5.1 881.4 1.1 72.4 63.2 27.6 18.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.317. Source: SEC-BusinessWorld Annual Survey of Top 1.9 1.6 102 16.160.9 629.8 741.8 618.2 4.1 6.2 Average 146 12.697.4 188.9 617.5 887 0.9 3.394.6 109 12.4 555.8 4.561.9 96.6 1990 1991 1992 1993 1994 1995 1996 1997 1.1 1. return on assets (ROA) = net income/total assets.4 861.3 306.4 898 1.4 3.2 Compound Growth (%) 17.0 1.2 900.7 238.1 95.1 615.2 2.8 902 1.6 5.1 1.4 8. 1988-1997 1989 519.0 1.

077 1. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.000 Corporations in the Philippines.1 19. various years. Return on equity (ROE) and return on assets (ROA) averaged 12. Total assets grew at an average annual rate of 22.352 1.3).8 19.3 The Corporate Sector and Gross Domestic Product. This is high compared with developed countries but compares favorably with other Asian countries. Vol. and by equity that grew at a higher average annual rate of 26.4 24. Asset growth was funded by debt that grew at an average of 20. Sources: ADB.248 1.427 13.906 2.5 17.172 2.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.5 Value-added is assumed to be 30 percent of net sales.178 1. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.000 companies averaged 7. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. leverage increased from 109 percent in 1996 to 149 percent in 1997.5 Ratio of Estimated Value Addeda to GDP (%) 17.8 17.2 percent. for the 10-year period. Further. 1988-1997 Top 1. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. Key Indicators of Developing Asian and Pacific Countries 1999.8 percent per year.3 percent. II assets. and the SEC-BusinessWorld Annual Survey of Top 1. Assuming Table 3. .9 21.394 1. These rates of return are high compared with other Asian countries.9 percent for the period.6 percent and 5. Net profit margins for the top 1. respectively. but the extent of the increase was not as dramatic as in other Asian countries.693 1.160 Corporate Governance and Finance in East Asia.474 1.9 23.979 17.7 percent.4 20.1 Net Sales (P billion) 465 519 630 741 862 954 1.5 16.697 1. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.

4 28. %) 17.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.3 27.3 146 6.4 Total Liabilities 26. . Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.6 Total Assets 29.3 22. various years.3 22.8 Growth Indicators (Compound Annual Growth Net Sales 20.3 42. The premise is that these variables have a direct bearing on corporate performance and growth. and (iv) privately owned.4).9 17. corporate control structure.0 142 22.1 12.4 Stockholders’ Equity 32.0 Net Income 19.8 3.5 23 4.2 103 5.5 GovernmentOwned 4. Averaging 42.8 No.5 27.8 ForeignOwned 21.Chapter 3: Philippines 161 a constant ratio of value added to sales. (ii) foreign-owned.5 Retained Earnings 30. 1988-1997 Indicators Publicly Listed Privately Owned Rate.8 percent of the corporate sector’s total sales between 1988 and 1997.1 Financial Ratios (%) Leverage 89 ROE 15. (iii) Government-owned.1 22 10. size.000 Corporations in the Philippines.9 26.1 ROA 8.0 31.0 5.0 Turnover 53 Net Profit Margin 15.0 28.4 190 5.7 22.2 9. The foreign-owned companies were the Table 3. these figures suggest a significant and increasing contribution of the corporate sector to GDP.8 22.8 2.0 4.3 11.8 606 0.8 14. privately owned companies constituted the largest group (Table 3. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.9 158 13.5 Other Indicators Share of Sales (%) 17. of Companies 73 Sales per Company (P billion) 2.0 5.7 2.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.9 196 1.4 Fixed Assets 19. A study of company performance by ownership type.3 9.9 22.

With an average leverage ratio of 142 percent.2 percent and ROA of 9.3 percent. were among the top 1.000 list. The privately-owned companies had a high average leverage ratio of 158 percent. followed by publicly listed ones. while there were few of them. and low return on investment is the norm. exceeding the 17. Vol.000 companies in 1997. with an average ROE of 22. Bases Conversion Development Authority. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies.162 Corporate Governance and Finance in East Asia. Their ROA and ROE were both more than twice as high as those of government-owned companies. these companies were comparatively large.75 billion per company for foreign-owned companies. But by being most efficient in employing assets. although small in number. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). Privately-owned and Government-owned companies grew at slower rates. but lower than those of foreignowned and publicly listed companies. . Publicly listed companies had a minor though steadily increasing share in total sales. The compound annual sales growth rate was 21. compared with P2. 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. Governmentowned companies in the top 1. or 38 percent. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. they generated the highest return on investments. II second largest at about 27. a level high by Western standards but at par with those of other Asian countries.9 percent. Publicly listed companies had the lowest leverage at 89 percent. the highest net profit margin of 15. the second best ROE and ROA. registered the largest per company sales at about P9 billion in 1997. meaning that the remaining 62 percent were relatively small in sales and assets. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. the asset base is large. and the second lowest asset turnover.5 percent average growth rate of the entire corporate sector.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. These were mostly large public utilities.5 percent. selling an average of P4. foreign-owned companies borrowed more than publicly listed ones.1 billion per company in 1997. 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. However.

8 Growth Indicators (Compound Annual Growth Rate.1 Retained Earnings 32. 1988-1997 Indicators Group Member Independent 18.000 Corporations in the Philippines.2 Net Income 21. various years.3 Other Indicators Share in Sales (%) 32.6 26.7 Total Assets 32. and small companies. %) Net Sales 20. compared with 32.7 Stockholders’ Equity 34.5 Growth and Financial Performance of the Corporate Sector by Control Structure.3 percent for the conglomerates.0 Turnover 67 Net Profit Margin 12.1 Source: SEC-BusinessWorld Annual Survey of Top 1. grew faster.0 166 15. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997. Sales and resources of the . Table 3.2 Fixed Assets 25.8 ROA 8.0 55.0 25.3 Total Liabilities 30. depending on assets and sales.3 No.2 23. medium. Performance by Firm Size By firm size.4 24.5).Chapter 3: Philippines 163 Performance by Control Structure By control structure.1 124 5.0 22. But the conglomerates were larger measured in sales per company.8 6. of Company 159 Sales per Company (P billion) 2. a company can be a member of a conglomerate or independent.3 Financial Ratios (%) Leverage 98 ROE 15.7 2. and achieved higher returns on invested assets than independent companies (Table 3.6 715 0. had a lower leverage ratio. the corporate sector is divided into large.

7 44.9 Financial Ratios (%) Leverage 158 ROE 13.5 Growth Indicators (Compound Annual Growth Rate.3 Turnover 65 Net Profit Margin 8.4 billion in 1997. while small companies.6 Growth and Financial Performance of the Corporate Sector by Firm Size.6 47. are defined as the largest 100 companies in the top 1. Vol.1 25. defined in this study as the next 200 largest companies in the top 1.5 73 6. referring to the remaining companies in the list.6 49.164 Corporate Governance and Finance in East Asia.000 list.9 32.000 Corporations in the Philippines. Medium-sized companies also performed better in terms of ROE.0 156 16.2 Other Indicators Share in Sales (%) 56.9 89 1. .8 percent of the total number of companies in the list (Table 3. indicating that they deployed resources more efficiently than large and small companies. Large companies accounted for 56.6 Small 19.4 Total Liabilities 18.9 Retained Earnings 13.0 32.6 36.1 percent of the total sales of the corporate sector.5 12.1 ROA 5. of Companies 79 Sales per Company (P billion) 7. Table 3.5 25. which.4 28.1 81 9. averaging 16 percent. Medium-sized companies.000 list.5 Total Assets 18.3 Source: SEC-BusinessWorld Annual Survey of Top 1. various years.0 730 0. although they comprised only 8.5 128 10. sales of mediumsized companies grew faster than large companies.2 25.2 29. 1988-1997 Indicators Large Medium 19.3 Fixed Assets 15.6 31.0 7. %) Net Sales 15.6).2 Stockholders’ Equity 18. for this study. Sales per company in this group averaged P13. However.9 26.1 4. averaged only P920 million in per company sales during the same year. averaged a far less P3 billion in per company sales.7 Net Income 1.1 No. II Philippine corporate sector are highly concentrated among the large companies.

The growth and financial performance of selected industries. Leverage was the highest for large companies. specifically those industries least and most affected by the financial crisis.8 percent. Poor returns appear to have been caused by the low profit margin at 6.. are shown in Table 3. from 14. at 128 percent for the period. ROE dropped from 10.7 billion and P35. Net income declined from P54.7. and profitability in 1997 when the crisis started. manufacturing. showed the lowest ROE. as indicated by the negative annual growth.7 percent a year earlier. with their ROE dropping to 3. reflecting to some extent a “bubble” phenomena in the former two sectors.Chapter 3: Philippines 165 Small companies.7 percent in 1996 to 8. and utilities and services sectors.2 billion in 1997 for this sector. assets.1 billion in 1996 to P4. of net income. and utilities and services sectors. but suffered its largest decline in net profits in 1997. The sector showed consistent growth in sales. profits. at -12.5 percent for medium-sized companies and 8. For small companies. averaging 10. net income.8 percent in 1997. and construction. 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. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. and assets was much higher for the real estate and property.2 percent for large ones. Sales revenue and net income declined from P76. real estate. but lower than that of construction. and equity up to 1996. utilities. and the construction sectors than for the manufacturing.e.4 percent in 1997 from 11.8 the previous year. unlike their counterparts in other Asian countries. at 156 percent. The Asian financial crisis affected large companies most severely. The real estate and property sector also suffered significantly in sales. although the largest in number. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. Growth of sales. especially during the period 1994-1996. But small companies’ leverage was significantly lower. compared with 9. Performance by Industry This study also looked at corporate performance by industry.1 percent.8 billion in . net income. at 158 percent on average during 1988-1997.6 percent.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. i.7 percent in 1997 for medium-sized companies. Mediumsized companies’ leverage level was slightly lower. Large. ROE dropped to 7.

7 192 9.3 5.7 ROA 5.1 2.4 19.3 55.8) 17.7 10. II Table 3.4 16.9 billion and P24. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1. 1988-1997 Utilities Real Estate and and Services Property 39. of Company 454 17 Sales per Company (P billion) 1. the sector’s ROE dropped from 15.2 8.2 45.9 23.8 Stockholders’ Equity 21.7 Growth and Financial Performance of the Corporate Sector by Industry.7 Net Income (12.1 24 42.0 21. 1996 to P56.9 2.2 28 0.9 17.5 Other Indicators Share in Sales (%) 82. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.4 Total Assets 19.6 Financial Ratios (%) Leverage 142 181 ROE 13. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.7 19.3 20. and was also much more limited compared with the property sectors in other Asian countries.000 companies’ total sales on average during 19881997.3 Retained Earnings 17.0 25.166 Corporate Governance and Finance in East Asia.7 billion in 1997. As a result. .7 83 2.000 Corporations in the Philippines. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.4 percent.0 31 0. Vol.8 48.8 41. respectively.0 23. various years.2 37.7 percent to 10.6 69 16.4 Source: SEC-BusinessWorld Annual Survey of Top 1.6 No.6 Growth Indicators (Compound Annual Growth Rate. it does not appear to have been excessively exposed to foreign currency-denominated loans.9 2.3 Fixed Assets 20.6 Total Liabilities 18.7 52.7 28.0 Turnover 112 24 Net Profit Margin 5.9 5.1 10.7 Indicators Manufacturing Construction 27.5 12. %) Net Sales 16.4 3.2 12.

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

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

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

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

and Tobacco Manufacturing. and Trading Holding Power Transportation Property Total — = not available. Distribution. a Data for top 20 shareholders were not available for five holding companies. 10 manufacturing companies. Beverage.Table 3.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. . and two companies in the property sector. Source: PSE databank. 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.

0 1.1 9.6 1.2 0.0 10.6 0.0 45.1 7.3 0.0 5.7 1.0 0.3 1.7 67.9 0.0 0.2 5.6 5.3 37.2 3.2 0.0 1.6 18.6 0.7 0.7 0. 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 0. and Trading Hotel.3 0.8 0.4 1. Beverage.1 0. .3 5.7 0.6 0.4 29.2 1.1 6.0 0.6 0.9 36.2 59. Source: PSE Databank. Distribution.3 5.9 0.0 0.5 13.3 1.3 26.6 33.5 4.6 0.1 8.3 0.0 5.0 0.0 1.0 1.0 1.5 26.2 3.5 0.8 11.5 12.0 5.1 5.0 2.8 0.2 3.1 1.0 0.0 1.4 5.0 0.3 12.5 0.0 0.6 2.7 3.2 0.6 0.3 2.0 0.9 52.2 10.6 2.0 0.0 1.0 0.1 a Weighted by market capitalization.7 0.0 5.4 0.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.2 0.7 0.9 6.Table 3.6 9.2 3.0 0.5 53.6 12. and Tobacco Holding Companies Manufacturing.7 0.3 0.4 8.0 0.8 0.6 0.5 2.2 0.0 4.7 3.3 0.8 66.8 21. Recreation.5 4.0 2.4 19.0 0.4 2.1 0.0 7. and Other Services Property Mining Oil Average Shareholdinga 33.0 1.

7 percent of shareholdings). with an average of only 7. 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. there was no real market for investment information. The 7.3 percent).Chapter 3: Philippines 177 companies and share in the risks and profits of the group.7 percent of market capitalization of the nonfinancial publicly listed companies. commercial banks (1. Investment trust funds were the most important institutional investors. accounting for P258. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. Holding companies were themselves 66 percent owned by other nonfinancial corporations. 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.5 to 12. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. and insurance companies (0. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.6 billion or 26. securities brokers (1. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. respectively. and San Miguel Corporation (SMC) in food and beverages.1 percent). Holding companies as a sector had the largest market capitalization in PSE in 1997. As a group. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. Petron and MERALCO in power and energy.1 percent).6 percent of market capitalization in 1997. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS).2 percent in 1997. 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. financial institutions did not have a significant ownership in nonfinancial corporations. The investment funds’ presence in these sectors ranged from 8.2 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. . Such advantages have contributed to the popularity of holding companies among publicly listed companies. while still allowing the public to own minority shares. Because of limited ownership by institutional investors.

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. All major industries were represented. Vol. but they comprised only 23.11). Corporate financing depends on intermediation by banks. identified the companies belonging to each of these groups. Prudential regulations. Large shareholders and their families own these banks directly or through their controlled companies.000 corporations’ sales. including 16 commercial banks. suggesting that business groups are common in all major markets.7 6 7 The study used publicly available shareholder information and published reports. 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.000 companies. Still.4 percent of the top 1. remain in force to control excessive lending of banks to insiders. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. the study put together a list of prominent business groups. Some 20 financial institutions were affiliated with these groups. suggesting that most publicly listed companies are parts of business groups. Family-based groups have larger companies since their total sales were about 33. Commercial banks hold the largest share. To understand the ownership and governance characteristics of family-owned business groups. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. using data on the Philippines’ top 1. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. A common feature of corporate ownership of a business group is the centrality of a commercial bank.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. of the financial resources in the country.178 Corporate Governance and Finance in East Asia. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). The Central Bank deregulated interest rates and foreign exchange.000 Corporations in the Philippines. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. .8 percent of total companies in number. including SBL and DOSRI rules. and increased the capital requirements for all types of banks. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. many companies in family-owned groups are not publicly listed. so far limiting their involvement to selected products. about three fourths. and tracked the financial performance of each company from 1992 to 1997. For this reason. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. However. This is significant considering that there were only 31 local commercial banks in the country in 1997.

the nonfinancial sector was real estate (60. for the Gokongwei Group.1 percent). and for the Henry Sy group. the study used the four largest business groups—Ayala. retail merchandising (69.8 percent). broadcasting (49. the biggest private company in the Philippines. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. or an average of about 12 per group. In 1997.000 corporations in 1997. for each of these groups. a substantial proportion of group profits came from its financial subsidiaries. the largest was the Eduardo Cojuangco group. in most . for the Lopez group.6 percent of the total sales of the top 1. Significantly. Lopez. Also. and Henry Sy—as examples. Together. including business groups and independent companies. 25 out of the 50 top corporate entities were familybased groups. Gokongwei. For the Ayala group. which was majority-owned by the Henry Sy group. construction. with 27 affiliated companies in the top 1. Commercial banks are often affiliated to a particular business group. and banking. the top 10 family-based business groups had only 119 companies in the top 1.Chapter 3: Philippines 179 Compared with other Asian countries. It is also noteworthy that. 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. Cojuangco. namely. To show this. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. The main constraint may be the availability of family members that could be drawn for top management positions. Foreign-owned companies mainly serve the export markets.12). nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. the principal owner of SMC.4 percent of the group’s 1997 profits). These corporate entities accounted for 53. In terms of sales.000. Lopez. and more than 20 percent for the Lopez group and Henry Sy group. Family-based business groups are most dominant in sectors such as manufacturing. In the meantime. as discussed in previous sections. an average group in the Philippines has fewer member companies.2 percent). the two were closely related through their affiliations to business groups.000 companies. and Ayala. real estate. ranged according to their sales (Table 3. with the exception of Banco de Oro. the largest family-based business group was the Ayala Corporation Group. it was manufacturing (36. the three largest entities were family-based groups. In terms of number of companies.

7. power. 2.3 3. 15. coconut oil.6 7. 16.5 17. and food Food.0 26.3 2. food.5 47.9 3. food. and mining Management.9 2. construction. Real estate.4 10. 11. 9.11 Total and Per Company Sales. and personal care prods Shipping.6 3.5 44. agriculture. Beverages.4 48.5 2. 13. Consunji 4 3 Food and dairy products Construction and mining 10.1 4.6 3.0 Average Sales Per Company (P billion) 6.5 13.8 84. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M. 5. 4.4 .Table 3.0 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. Eduardo Cojuangco Lopez Family Group Ayala Corp. and tourism Credit card 18.1 2. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines.2 16.2 1. 8. 17.3 15. real estate. beverages.2 1.0 17. and packaging Power distribution and mass communications Real estate. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. 3. 6. and Affiliated Bank of Selected Business Groups. of Affiliated Companies Total Sales (P billion) 123. telecom.7 98. Flagship Company. Sector Orientation.0 5.6 2.1 4.5 26. 14.3 11.5 46.4 6.5 6. 10. beverages. and dairy products Investments.5 49.

22.9 0. Ramos Gaisano Family Group Felipe Yap Felipe F. .7 4.2 4.1 0.6 2. 38. 20. 32. 26.4 3.6 3.8 1. 33.9 1.0 5.000 Corporations (1997).9 1.5 8. 35.6 0. 28.7 3. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.2 6.4 1. 27.5 2. mining.9 1.19. 37.1 1. 4 238 1. and various company annual reports.0 2.7 0.7 0.7 1.9 7.8 6.1 2.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.9 6.3 2. 21. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.3 2. 34. distribution.1 1.0 0. 23.0 1. 30. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 31.6 5.4 3.9 0. 29. 25.2 1.8 1. 39. P.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.3 7. SEC-BusinessWorld Annual Survey of Top 1.8 1.4 5.7 0. 24. 36.1 805. 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.

20. 3. Uytengsu/General Milling Group David M.Table 3. 2. and Affiliated Bank of Selected Business Groups. 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. 6. 9. 8. 10. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 11. Inc. 1. 15. 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 (continuation) Total and Per Company Sales. 4. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . Alaska Milk Corporation DM Consunji. Sector Orientation. 7. 5. 13. 19. Eduardo Cojuangco Lopez Family Group Ayala Corp. 18. 21. Flagship Company. 16. 14. 12. 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. 17.

Ramos Gaisano Family Group Felipe Yap Felipe F.48 billion. 31. 22. unless otherwise indicated. 38. 28. F. 30.65 billion. a b Size class is measured in terms of sales: Large = greater than P4.48 billion. Sources: PSE Databank. small = less than P1. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. Kepphil Shipyard Inc. Refers to commercial banks. 35. Cruz & Co. 32. medium = P1. and various company annual reports. Inc. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.65 billion to P4. SEC-BusinessWorld Annual Survey of Top 1. 34. 39. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. Fil-Estate Development Inc. 29. 23. 27. 33. P. 26. 24. 36.. PT&T Corp.000 Corporations (1997).East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. . 37. 25.

construction.7 98. Inc.0 24. bank. 19. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123.0 38.5 77. beverages. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 2. power. 7.12 Control Structure of the Top 50 Corporate Entities. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. Fujitsu Computer Products Corp. and personal care products Shipping. Philippine National Bank Mercury Drug Corp. food.).1 60.2 16. banking.5 17.6 18.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. coconut oil. 10. beverages. First Pacific/Metro Pacific Group 21.5 15. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. Texas Instruments (Phils.8 84.5 44. and bank Real estate. 14. 4. 20. 15. food. and dairy products Investments. and food Food.Table 3. 23. 12.3 15. 3. 6. and mining Gold and other precious metal refining . 9. food.6 26. of the Phils.2 49. Inc. 22. and car manufacturing Power Refined petroleum products Refined petroleum products Banking.8 53.1 17.5 46. agriculture. 17.). 13.0 37. 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. 8.2 Business Group Business Group Business Group Government.5 47.5 26. and packaging Power distribution.4 48.8 22. and real estate Banking. 24. and telecommunications Department store and banking Airlines. Beverages. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. telecommunication.4 19. 5. mass communications. car manufacturing. 18. 11. 16.

7 10. 30. and various company annual reports. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines.0 13. 33.8 6.5 8. 27.5 8.6 1. Inc. 49. 36.0 12. EAC Distributors Inc. 46.9 7. Inc.8 9. National Steel Corporation National Food Authority Phil.7 10. 35. ..2 7. corn (unmilled). 43. 32. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 48. 41.0 5.0 11.5 10.25.1 9. 42.4 10. Amusement and Gaming Corporation Mitsubishi Motors Phils.3 8.6 9. 39.9 7.6 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.9 6. Consunji Uniden Philippines Laguna. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. real estate. Inc. 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. Jollibee Foods Citibank N. 34.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. Uytengsu/General Milling Group David M. 40.000 Corporations (1997). 31. Philips Semiconductors Phils. 37. 26. 44.6 12. W. 47. 50. 45.9 14. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.290 53. 28. 14.8 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. PSE Databank. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. 29.3 13. 9. Philip Morris Philippines. Corp.7 13.4 8.A.

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

7 percent). Making day-to-day management decisions was not regarded as an important board responsibility.7 percent). More than half of respondents indicated that board directors were elected during the shareholder general meetings. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. or a per diem for meetings (18 percent). ensuring that a company follows legal and regulatory requirements. or representatives of creditors. In a few cases. appointed by the Government. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. with a maximum of 36 percent. the average number of years of holding office was 6. But professional expertise is also an important criterion (28.6 for board chairpersons and 7. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. a fixed fee plus performance-related bonuses (30 percent). In practice. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. The longest was 27 years for board chairpersons and 14 years for board directors. appointing senior management.5 for board members. According to the ADB survey. . board directors were the founder of a company. and determining remuneration for board directors and senior management. or the Government without approval by shareholder general meetings. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. in a descending order. 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. protecting shareholder interests. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents).9 percent).

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

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

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

The responding companies had on average 43.2 43.3 56. representing about 24 percent of outstanding shares.13 ADB Survey Results on Shareholder Rights Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings Source: ADB Survey of Philippines Publicly Listed Companies.4 70.8 92. An average of about 4.8 30. representing 3. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.4 No 0. protection.7 43.0 63. a company that is widely held but has a large shareholder.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.0 36.13 summarizes rights that the shareholders of the responding companies enjoyed. 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. Table 3. 1999. The ADB survey provides further evidence on shareholder rights.8 56. and their activism in the corporate sector.6 30.2 69.2 7. Nominees held about 45 percent of the outstanding shares. Table 3. The brokers or securities companies were the most important proxy voters.0 51. Nevertheless. Yes 100. the successful hostile takeover by First Pacific Group of PLDT. About 93 percent of the respondents contracted . About 333 shareholders per company voted by proxy.Chapter 3: Philippines 191 in a few controlling shareholders and families.900 shareholders per company did not vote during the last annual general meeting.0 48. followed by management and banks.522 shareholders each. appointed either by the board or shareholders during the annual general meetings.

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

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

Ayala Land fully owns Makati Development Corporation and holds a minority stake. financing. The first three companies are publicly listed while the fourth. with 59 percent of shares. Honda Cars (Philippines). In a passive minority-owned operating company. namely. 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. They are operating companies but at the same time have majority or minority share ownership in other operating companies.194 Corporate Governance and Finance in East Asia. as an example (Figure 3. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. . Depending on the performance of the company. In cases of minority ownership. It is majority-owned by Mermac. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. and customers. Minority-owned companies may also need access to resources of the group.1 percent of Ayala Land.1). Some holding companies are not pure holding companies. controlling shareholders of the parent company may eventually increase their shares to a majority position..and minority-controlled operating companies are also holding companies. minority control at 42.6 percent of Globe Telecom. It has a majority control at 71. is privately owned. Ayala Corporation’s majority. They may have a representative in the board. In an active minority-owned operating company. II equity investment for public listing. the parent company plays an active role in management. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. active minority or passive minority holdings. controlling shareholders of the parent company do not participate in management. Controlling shareholders gain additional leverage in management control over minority-owed companies. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. an active minority share at 44. Ayala Corporation. at 47.4 percent of Bank of the Philippine Islands. Ayala Corporation is a publicly listed pure holding company. Public investors collectively hold a minority of 41 percent. a family-owned pure holding company. Inc. and a passive minority investment at 15 percent in Honda Cars (Philippines). Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. especially its management.2 percent. of Cebu Holdings (a publicly listed government-owned company). Vol.

.96%) Privately-Held Pure Holding Company Public Investors (41. Inc. Inc. . (58.06%) <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 (71.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. Inc. (47.Figure 3.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.

Simeon Djankov. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Rockwell Land. 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. The Separation of Ownership and Control in East Asian Corporations. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.14%] / [1.8%] 5.3% x 5.10 The Ayala family’s control rights over BPI was 1. however. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank.2). 1998. Vol. First Philippine Holdings Corporation. Fan.44%] / [58. companies in the Lopez Group are large and minority-controlled.5%] / [(88.44%] = [42. The control of companies through indirect corporate shareholdings. and Larry H. Simeon Djankov. Lang: 1999a. see the World Bank research papers by Stijn Claessens. Being in the public utilities sector. is illustrated in the Lopez Group (Figure 3.7 times 12 . and a minority-controlled holding company. defined as control by large shareholders of an operating company through minority ownership by several companies. Who Owns and Controls East Asian Corporations? 11 Ibid. MERALCO. See also Stijn Claessens. P.64% +37.5% x 14.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.14%] / [6. P.44%] / [25%] = 1. The situation offers large shareholders tremendous incentive to move resources 10 For details. Expropriation of Minority Shareholders: Evidence from East Asia. H. and Larry H.98% x 42. and 1999c. Generally.11 The Lopez family’s control rights over MERALCO was 5.76%)] [39. Joseph P.3% x 1.12 These examples show that even when large shareholder groups are minority shareholders. Lang. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights.64%) + (37. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1. Benpres Holdings. a privately owned company.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. 1999b. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. Diversification and Efficiency of Investment by East Asian Corporations.196 Corporate Governance and Finance in East Asia.7 times Ibid.5%] [39.

Figure 3. Inc.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.7% 62. Privately-Held Pure Holding Company 88.64% MinorityControlled 14. .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% 11.76% Operating Company MinorityControlled 24.

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

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

Korea and Thailand). As a result. They invested in only a few large companies whose shares were relatively liquid. Foreign portfolio investments also remained small. especially short-term debt. most listed companies are controlled by their five largest shareholders.7 billion. The Philippine stock market is not a liquid market.4 billion (or $59 million using the average exchange rate). only 84 had sales large enough to be placed in the top 1. Vol. but not to the same extent as it did in other Asian economies. while interest rates were at high levels and volatile. and less engaged in risky investments. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. preferred stocks. the minimum required to qualify as a public corporation. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e. is far ahead of the flock. Interest rates. The period 1993-1997 was one of lower inflation and declining lending rates. and Indonesia ($61. Malaysia. Equity instruments include common stocks. less exposed to foreign debt. the country experienced double-digit inflation. The corporate sector raised a substantial amount of . this is because. However. Equity financing through IPOs was active. compared with Malaysia ($186 billion). and convertible securities.g. Rising stock prices during the Ramos administration reflected to some extent the business optimism. Philippine companies were less leveraged. the Republic of Korea (henceforth. II sector. Korea) ($143 billion). Of the 221 companies listed in the Philippine Stock Exchange in 1997. was one of the smallest in the region at $47.5 billion). compared with other economies. Foreign funds were wary of the Philippine stock market because of its limited liquidity. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. Even in the real estate sector. about the size of Thailand’s. The market capitalization of the Philippine stock market in August 1997.200 Corporate Governance and Finance in East Asia. From the 1970s up to the early 1990s.000 companies. Most publicly listed companies issue only up to 20 percent of total shares to the public. In part. 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. The stock market was depressed up to the early 1990s. The crisis affected the Philippine corporate sector. however.. Table 3. companies expanded only at a moderate pace. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods.14 shows that the average volume of daily trading in 1997 stood at P2. inflation.

2 ($ million) — — — — 6.1 0.8 102.906. Source: PSE databank.5 12.2 59.9 608.9 12.0 0.2 57.1 88. .5 571.9 682.5 1.2 1.14 Philippine Stock Market Performance. P billion) Gross Domestic Product (current prices.8 799.2 0.9 114.7 0.5 Year 369.474.351.7 1.5 16.6 1.421.171.077.3 158.8 1.Table 3. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.6 1.7 391.3 — = not available.2 0.9 2.2 297.2 3.686.692.1 0.9 1.8 1.1 0.1 0.251.8 0.2 925.445.0 1.3 4.3 Market Capitalization (year end.373.7 2.5 26.4 9.121.5 1.088. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.1 524.0 0.7 207.5 72. 1983-1997 Daily Trading Volume (P million) — — — — 129.545.248.1 5.9 2.0 2.3 0.3 2.8 1.4 Ratio of Market Capitalization to GDP 0.3 0.4 1.3 314.515.0 161.386.6 261.2 1.0 0.3 59.7 41.2 61.4 728.

. Only a few large companies floated commercial papers because of the limited market. The corporate bond market was stunted. are in a position to provide such discipline. From 1988 to 1997. lack of competition among financial institutions. leases.2 Patterns of Corporate Financing The study looked at retained earnings. which were the principal source of corporate financing in the Philippines. Only the commercial banks. which in most cases is an affiliate of the issuing company. new equity. Corporate bonds are another type of debt securities. because business groups often own large commercial banks. The measures used in the analysis are: . Because existing shareholders wanted to retain their proportionate control over their companies. the rights issue was a popular way of raising equity capital. tight regulations. by virtue of their large stakes in the financial system. of which 85 percent was raised from 1993 to the first half of 1997.202 Corporate Governance and Finance in East Asia. discounting of receivables. Under SEC regulations. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. which ultimately influences the pricing of commercial paper issues. and debt as sources of corporate financing by using flow of funds analysis. Debt securities include commercial papers and corporate bonds. and inventory financing. about 127 companies went public with a total value of offerings of about P134. and the dominance of large commercial banks. moreover. include bank credits. and high transaction costs. by volatile interest rates and the absence of a secondary market. Vol.4. However.6 billion. a strong regulatory system for bank supervision is imperative. corporate bond issuing was even more limited. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. sells these commercial papers through brokers. Negotiated credits. The largest buyers have been commercial banks. However. The picture of the financial system that emerges is thus one of limited capital markets. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. Debt instruments include negotiated credits and debt securities. The underwriter. which buy commercial papers either for their own account or for their clients. asset-backed credits. 3. Capital markets cannot provide the market discipline that corporate investors need.

3 0.9 0.6 0.3 0.1 0.000 Corporations in the Philippines from 1988 to 1997.2 0.5 0.3 0.4 0.5 0. 1988-1997.15. the SFRT was low at Table 3.6 0.8 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.3 0.0 0. As shown in Table 3.9 0.15 Financing Patterns of the Corporate Sector.8 0. the average SFRF was high at 109 percent.5 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.4 0.3 0.7 0.2 0. . It measures a company’s capacity to finance asset growth by equity capital.3 0.1 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.1 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. It measures a company’s reliance on borrowings in financing asset growth. during this period.2 0.4 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. On the other hand.5 0.4 0.9 0.1 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.4 0.5 0.4 0.5 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.4 1.6 0.5 0.8 0. By definition. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.5 0.1 Average 1.5 0.0 0.1 0.9 0.3 0.5 2. It measures a company’s capacity to finance asset growth by internally generated funds.2 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.000 Corporations in the Philippines.4 0. it is one minus IDFR.2 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.

except for foreignowned companies that had a negative new equity financing ratio.1 a Excludes negative balances. On Table 3. retained earnings declined and few new equity investments flowed into the corporate sector.3 0. and 1997.7 0. In all the years.2 0. implying that internal funds were far from sufficient to finance growth in total assets. 1988-1997. except in 1991.000 Corporations in the Philippines. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets.5 Privately-Owned 0.2 (0. II only 19 percent. . Total assets grew by 23 percent that year.16. debts were the most important source of financing. Companies financed fixed assets from internal sources in hard times.3 0.3 0. It can also be observed that the relative importance of stockholders’ equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997. Corporate Financing by Ownership Type As shown in Table 3. privately. Source: SEC-BusinessWorld Annual Survey of Top 1.9 0. the SFRF was higher.204 Corporate Governance and Finance in East Asia. There were significant year-to-year variations.8 0.6 0.3 0. internal funds were not a significant source of financing growth in total assets. 1991. Retained earnings were the least important. This was mainly caused by the declining contribution from retained earnings. for all three types of companies—publicly listed. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.0) 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.and foreign-owned.16 Corporate Financing Patterns by Ownership Type. Vol.5 0. when it financed 45 percent of it.5 Foreign-Owned 1. In periods of an economic crunch such as in 1989. As a result. In 1997. with debt providing 93 percent of the financing requirements. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. reflecting the capital flight caused by political instability in the early 1990s. the level of corporate leverage increased.

8 0.17.1 13.4 100.0 13.0 9.0 6.0 9.4 2.8 38.0 1994 19.2 12. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.9 24.8 39.6 48.8 16. It presents a composition analysis of assets and financing sources for the period 1992-1996. .1 50.6 37.1 49.4 100.8 26.2 42.2 3.6 48.8 4.9 16.17 Composition of Assets and Financing of the Publicly Listed Sector. Foreign-owned companies relied more heavily on debt financing.000 Corporations in the Philippines.3 12.8 51.7 23.1 7.1 9.0 Source: SEC-BusinessWorld Annual Survey of Top 1.4 3.7 7.1 10.7 100.8 0.2 100.5 9.3 4.8 17. The sector built up its short-term debts.6 26.3 10.3 13.9 0.0 1995 1996 13.4 43.3 12.5 0.3 10.7 2. contributing 90 percent of growth in total assets.0 9.2 51.3 48.6 0.4 100.9 12.9 100.2 3.5 41.3 12. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.Chapter 3: Philippines 205 average.4 2.0 1993 14.8 46.4 12.8 100.0 12.7 13.0 9. 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 14.1 15.9 38. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.4 10.5 16.7 2.0 100.8 3.0 53.and foreign-owned companies.0 10.8 3.6 43.3 11.9 16.3 51.9 4. especially bank loans. significantly Table 3.7 13.0 10.5 27.4 41.2 100.5 12.0 38. publicly listed companies relied more on new equity financing than privately.7 4.9 3.0 8. 1988-1997.4 100.9 16.

II in 1996 and became more vulnerable to the financial crisis in 1997. The normal standard liquid position is a current ratio of 2 or higher. The traditional measure of liquidity. for independent companies. Vol. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. and economies of scale in fund raising. indicating that many publicly listed companies were likely to be in a tight liquidity position.206 Corporate Governance and Finance in East Asia. Group companies financed an average of 45 percent of growth in total assets by debt. the easier access to external credit.9 0. group companies usually financed their investment in member companies by equity rather than debt.3 0.5 0.13 was at 1. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. 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.5 0.18.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1.6 Independent Company 0. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.3 0. Further. As shown in Table 3. For these two reasons.1 0.2 0. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets.3 0. 1988-1997. Group companies were generally more profitable than independent companies. the average SFRF of business groups was higher compared with that of independent companies. respectively. .18 Financing Patterns by Control Structure. On average. the current ratio. as opposed to 94 and 30 percent. their inherent ability to pool risks. Table 3. compared with an average of 54 percent for independent companies.000 Corporations in the Philippines.45 in 1996.

3 0. These years were 1991 with 110 percent.08 and SFRT of 0. Large companies’ IDFR of 0. Source: SEC-BusinessWorld Annual Survey of Top 1.88 for large companies (Table 3.5 Medium 3. 1988-1997. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.2 0.8 0.19).3 0. The corresponding ratio was 0.Chapter 3: Philippines 207 independent companies.5 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.2 0.6 0.06. and 1997 with 131 percent.6 0.1 0.76 for small companies and 0. averaging 61 percent of growth in total assets.000 Corporations in the Philippines. Excluding .55 was substantially higher than the small companies’ 0. medium-sized companies used more debts. 1993 with 96 percent.19 Financing Patterns by Firm Size.9 0.3 0. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. compared with 55 percent for large companies and 47 percent for small ones. Large firms consistently increased their reliance on debts from 1994 to 1997. equity financed 42 percent of incremental asset growth.5 Excludes negative balances. with an average of 3. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.4 Small 0.47. With assets growing at a fast pace during this period. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. There was also increased reliance on debt financing.2 0. On average.20).50 (Table 3. Table 3.

47 two years later. Up to 1997. debt financed about 78 percent of asset growth in real estate.5 0.4 0.4 0.58 and SFRT of 0.32. Vol.5 0. The sector had the highest leverage among all industries that year. Source: SEC-BusinessWorld Annual Survey of Top 1. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. Incremental equity financing amounted to an average of 44 percent of total asset growth. the industry generated internal funds. The situation improved beginning 1994.000 Corporations in the Philippines. During the crisis year. The effects of the crisis of 1997 were adverse.5 Utilities and Real Estate Services and Property 0.29. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1.20 Financing Patterns by Industry.6 0. In the eight years preceding the crisis. when debts declined. The construction sector was a heavy user of debt financing. the total debt ratio was much higher in 1996 at 0.04.5 (0. ranging from 41 to 118 percent.208 Corporate Governance and Finance in East Asia.4 3. the incremental equity ratios of the industry were high.79 and in 1997 at 0.6 0. increasing to 0. II 1991.91.6 a Excludes negative balances. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. The real estate industry financed its growth by substantial equity funds. Excluding 1997 when fixed assets declined.1 0. 1988-1997. While this level is considered prudent.6 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994. achieving an average SFRF of 3. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.7 0.3 0. many of the leading real estate companies successfully went public during that time.3 0. the manufacturing industry financed 57 percent of its total asset growth by debt.4 0. Since the real estate boom coincided with that of the stock market. while SFRT averaged only 0.27. .3 0.3 0. Table 3.2) 0. with an SFRF as low as 0.4 Construction 0. Equity financed an average of 62 percent of total asset growth. SFRF for the sector averaged 0.

1992-1996. ROE.00036 2. and the Failure of Internal Control Systems. measured by the percentage of shareholdings of the largest five shareholders. Table 3. at the same time. As shown in Table 3. The Modern Industrial Revolution. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and.14 Large shareholders may borrow excessively to undertake risky projects. was regressed against measures of profitability and of financial leverage. Financial Leverage.421 0. ownership concentration = the total shareholdings of the top five shareholders. . ROA.009 5. Using the PSE database. as the dependent variable.21. more profitable. the degree of ownership concentration. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. while if it fails. and leverage.008 5. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. Exit.4.Chapter 3: Philippines 209 3. ROA = return on assets. ROE = return on equity.769 0.21 Ownership Concentration. Profitability.3 Ownership Concentration. knowing that if an investment turns out to be successful they could capture most of the gain.004 3. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.860 Leverage = the ratio of total assets to total equity.287 0. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. 14 See for example Michael Jensen (1993).00056 1. Journal of Finance 48: 831-880. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.00125 2.130 ROA 0. ROE. creditors bear the consequences. and financial leverage are all positively and significantly related to the degree of ownership concentration. alternatively. Source: Author’s estimates based on the PSE databank.230 Leverage 0.

5 percent per year from 1992 to 1997. Garments was the second largest export sector at about 9 percent. Although much lower than those of other Asian countries. which averaged 4. the economy still showed vestiges of its import-dependent and substituting character. but its share had been declining by 4 percent per year since 1995. the country’s GDP growth pace indicated that it did not have a “bubble economy. and intermediate goods. more than half (52 percent) of exports were semiconductors. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. In 1997. After a . raw materials. Manufactures accounted for about 85 percent of exports. Net trades in goods and services averaged a deficit of 4. Vol. Commercial and industrial activities in the country were largely oriented to domestic markets. industry at 34 percent.210 Corporate Governance and Finance in East Asia.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 1997.5.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. with commodities accounting for the balance. In sum. their growth gathering momentum only beginning in 1992.8 percent of GDP from 1995 to 1997. The country experienced balance of payments surpluses but these were due to transfers. the country was less dependent on foreign private capital. foreign investments in the country have been low. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). Compared to other East Asian crisis-affected countries. Because of limited local capital. Exports were growing at about 20 percent per year in the three years preceding the crisis. II 3. notably remittances of overseas workers. The export sector had a very narrow breadth.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates.5 3. Net investment inflows were $3.” that is. 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. Historically. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. and agriculture at 21 percent. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. with a narrow exporting industry base. The largest contributors to GDP were services at 43 percent. an overexpansion of capacities.

unlike their counterparts in the region. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors.1 percent. the discipline of the loan moratorium and the restructuring of the country’s loans to long-term maturity kept this ratio below 100 percent up to September 1997. average ROE was 13. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. adjustments were focused on the quantity and quality of the banking system’s corporate loans. the Government restructured its debts into longer tenors with a maximum of 25 years. and a relatively healthy banking system. Eventually.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991.6 billion as of March 1997. the Government sought stability and achieved this in 19921997. however.8 percent.3 percent. From 1988 to 1996. Profitable operations since 1992 had allowed it to build equity. The lessons from debt restructuring became the basis for the Government’s economic policies. a positive balance of payments from 1992 to 1996. the country and the corporate sector had no access to foreign currency debts from the international financial market. . fueled also by successful IPOs during the stock market boom of 1993-1996. The corporate sector was in a relatively stable financial condition around the time of the crisis. a government fiscal surplus from 1994 to 1997. From 1993 to 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. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. depended on the quality of the corporate sector’s investments. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3.5 percent. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. Closer analysis. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. Total debts were only 52 percent of assets or 108 percent of equity. an average inflation rate of 7. in turn. In the Philippines. an average Treasury bill rate of 13. which. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. resulting in stability in the short-term debt to reserves ratio. assets grew at a compound annual rate of about 31 percent. while sales grew by only 20 percent per year. During this time. After hovering in the range of 100 to 127 percent.

Vol. or 114 percent of net foreign direct investment (FDI).718 30. But portfolio investment amounting to $406 million flew out of the Philippines.22).101 billion or 196 percent of net FDI in 1996.22.22 Foreign Investment Flows.300 1. Data for 1998 cover only January-August. . In sum. net FDI remained stable at more than $1 billion.749 26.212 Corporate Governance and Finance in East Asia. Table 3. precisely. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. In 1997. but to a lesser degree.5. Net foreign portfolio investment amounted to $1.47.650 32.06.0 1998 739 555 328 69.4 1997 762 1. It rose to $2. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.71.485 145.073 (406) 121. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.609 1.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. These patterns in investment and financing are similar to those of other countries in the region. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. Sources: Bangko Sentral ng Pilipinas and SEC.5 billion in 1995.101 92. 1995-1998 Item Net Foreign Investments ($ 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 1.0 1996 3.074 2.” 3. Debts financed a large part of this expansion. Most of this leverage happened during the boom years in the region.7 Note: Peso-dollar exchange rates used are: 1995 = 25. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. mitigated the effects of the pullout and liquidation of investments in the aftermath. 1998 = 41. growing by about 34 percent per year from 1994 to 1997. 1997 = 29. It financed 26 percent of corporate capital growth.303 23.517 1. 1996 = 26. the other immediate impact of the crisis was that on foreign investment flows. 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.

they were willing to restructure and renegotiate existing loans by corporate borrowers.3 percent of assets. Companies deferred investments in new fixed assets. Although corporate borrowers were not highly leveraged. By March 1988. in varying degrees for each sector. in turn. the sectors with the highest outstanding loans had reduced their credit exposures. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. and the wholesale and .Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. with commercial banks holding P2. ROE at 6. Loans outstanding of commercial banks declined by the first quarter of 1998. The real problem of the corporate sector during the crisis was the rise in interest rates. albeit at current market interest rates.7 percent in January 1998. Net profit margins were at a 10-year low at 4. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. the corporate sector became vulnerable to loan calls and high interest rates. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. meanwhile. By October 1998. Because of weak internal fund generation. When the Treasury bill rates eased in March 1998. The resources of the financial system that year totaled P3.513 billion. Lending rates were well above the 20 percent level from July 1997 to March 1998.2 to 28. sparking a rise in interest rates on corporate loans.2 percent was barely above inflation rate. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. the commercial banking sector’s capital remained strong at 17. which held about 75 percent of the assets of the financial system in 1997. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. then rose to a high of 22. Average bank lending rates climbed to their peak of 25. lending rates also came down. Because commercial banks were strongly capitalized. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past.9 percent. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position.369 billion. depended on the liquidity and capital position of commercial banks. With the increase in borrowings and reduced liquidity.2 percent in November 1997. Loan calls. ranged from 11 to 13 percent from 1993 to July 1997. and leverage increased to 149 percent compared with 109 percent in 1996. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. The interest rates on Treasury bills. new borrowings financed asset growth.

214 Corporate Governance and Finance in East Asia. 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.9 percent of bank loan portfolios. and set up a hedging facility for borrowers with foreign currency-denominated loans. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience.5-6 percent. These figures show that adjustment problems were industry-specific and that the real estate industry. thereby reducing overall intermediation costs. and subsequently went down to 13. These peaked at 14. In March 1997. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. II retail trade sector. single-digit NPL ratios began only since 1989.5 percent by September 1998.6 percent in June 1998. Vol. However.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues.3 percent in December 1997. This allowed the Central Bank to convince the banks. The Central Bank adopted other measures to strengthen the financial system. the fiscal position. set limits on overbought/oversold foreign exchange positions of banks. the ratio increased to a high of 11. by 12 percent. As for nonperforming loans (NPLs). and its experience of low. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. as with its counterparts in other Asian countries. Still. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. and the financial system. 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. through the Bankers’ Association of the Philippines. 3.5. The move retained the liquidity position of banks but lowered their cost of reserves. including (i) a regulatory limit of 20 percent on banks’ loans to the . real estate loans averaged 11. But the Philippine banking system had gone through worse crises in the past. was a problem sector.

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

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

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

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

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

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

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

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

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

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

Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. and Liquidation. 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. 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. and transferred these to courts. including the resolution of intracorporate disputes. suspension of payments and private damage actions. The law is obviously not in line with the Government’s policy of allowing market mechanisms to work and not intervening in private sector business. Reforming the legal framework for suspension of payments. it creates a moral hazard problem. The law on suspension of payments replaces a market-oriented solution with a political process. the new law needs to be effectively implemented and enforced. Improving the Legal Framework for Suspension of Payments. violators were made to pay only nominal penalties. reorganization. SEC and PICPA need to formulate more specific disclosure standards. Reorganization.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. Instead. For that matter. . In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation.

M. P. Agency Problems. Asian Development Bank. and Larry H. Manila: Asian Development Bank. Lang. Simeon Djankov. Michael. Dennis. Joseph P. 1998. Fan. Bangko Sentral ng Pilipinas. Vol. Simeon Djankov. David J. and Larry H. and Clifford Holderness. Vol. Lang. 1999. October. II References Abonyi. Joseph P. 1998b. Large Shareholders. The Structure of Corporate Ownership: Causes and Consequences. Key Indicators of Developing Asian and Pacific Countries 1998. and Atulya Sarin. 693-728. 1985.. Simeon Djankov. Working Paper. Harold. Tokyo: Institute of Developing Economies. Claessens. Working Paper. 1997. and Larry H. Journal of Financial Economics 25: 371-395. 1998a. Lang. Discussion Paper.. 1999. World Bank. P. Joseph P. Stijn Claessens. Lang. World Bank. Stijn. P. July. Fan. 1997. March. Working Paper 2088. Burkart. Simeon Djankov. Dennis Gromb. Stijn. H. edited by Toida Mitusuru and Daisuke Hiratsuka. Barclay. 1998c. Journal of Political Economy 93 (6). 1989. 1999.226 Corporate Governance and Finance in East Asia. World Bank. Thailand: From Financial Crisis to Economic Renewal. Quarterly Journal of Economics. Alba. P. Simeon Djankov. H. H. Denis. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. and Simeon Djankov. World Bank. Antonio. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Claessens. Equity Ownership. Stijn. Emilio. Institute of Southeast Asian Studies. Philippine Macroeconomic Prospects: The Next Ten Years. Jr. Stijn. Lang. Demsetz. The Separation of Ownership and Control in East Asian Corporations. May. Joseph Fan. Asian Industrializing Region in 2005. and Kenneth Lehn. World Bank. P. Diane K. and Larry H. The Philippines: Onward to Recovery. Claessens. XXIX. George. Private Benefits from Control of Public Corporations. Claessens. and Fausto Panunzi. Monitoring and the Value of the Firm. Stijn. Fan. and Larry H. and Corporate Diversification. 1994. Expropriation of Minority Shareholders in East Asia. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Claessens. 1988. Diversification and Efficiency of Investment by East Asian Corporations. 1998. Pedro. Ownership Structure and Corporate Performance in East Asia. Journal of Finance 2 (1). .

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

To protect domestic industries. the Government increased tariffs on products that could be produced locally. . its growth and financial performance. The National Economic and Social Development Board was created to plan the country’s economic and social development. lack of transparency and adequate disclosure.2. as well as its legal and regulatory framework. The country initiated national economic development planning in 1961 when the economy was growing rapidly.230 Corporate Governance and Finance in East Asia. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). with government policy providing support but avoiding direct interference. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. This study examines these and other factors that might have weakened corporate sector governance in Thailand.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. Section 4. 4. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.2 4. Vol. while new industries were encouraged to reduce the need for imports. Section 4.4 provides an overview of Thailand’s financial markets and examines patterns of corporate financing and investment in the years prior to the 1997 crisis. and a family-based corporate ownership structure. Section 4. Import tariffs on machinery and heavy equipment were removed. The study then considers policy recommendations with emphasis on corporate governance improvement. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. Section 4.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. The First and Second Plans (1961-1971) Under the first two plans.

The Government had to shift emphasis to restoration of economic stability. resulted in increases in the current account deficit. canned foods. and automobile assembly) emerged. The results were increased exports.Chapter 4: Thailand 231 During this period. the industrial sector grew at a faster rate than the agricultural sector. Average growth for the period was 4 percent per year. became a major problem as domestic investment declined. however. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. the value of the baht remained stable. Industrial sector growth was also rapid and many industries (tires. chemicals.5 percent in 1973 and 24. Inflation levels were low. with the agricultural sector the major contributor. including luxury goods. The focus shifted to export promotion. however. averaging 1. with the devaluation of the baht in 1984 a major step in this direction. lower than anticipated due to a worldwide economic recession. The average budget deficit reached an all-time high of $2. Budget deficits also increased throughout the Fourth Plan. the current account registered a surplus in 1986. and increases in world food and oil prices. Inflation reached 15.3 percent in 1974. the government’s debt burden escalated. External factors. including a weakening of the dollar. Consequently. the Government borrowed $6. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. processed steel.4 percent of GDP. At the same time.4 billion from overseas and increased taxes on numerous items.6 percent per year. Budget deficits remained a major problem during the Fifth Plan. textiles. capital inflows. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. it proceeded with its development plan for the industrial sector. remaining high until 1981.15 billion per year or 4. As a result. especially foreign aid from the United States. leaving the Government no choice but to resort to overseas borrowings. helped offset these deficits. gross national product grew by about 7 percent per year. The Third. an improved trade balance. The decline in imports was steady. However. Unemployment. Thus. . To close the fiscal gap. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. Fourth. and reduced current account deficits.

Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. On top of its predominantly “borrowed” nature.6 percent. the property sector began to collapse in 1996.5 percent. better than the 5. and Hong Kong. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. property development. From 1989.7 and 11. the bulk of domestic investments went to speculative ventures such as real estate. and the stock market. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. an oversupply of housing emerged.2 percent per year. Private sector investment grew at an average annual rate of 7 percent. Thailand became a debtor’s market. while exports expanded considerably.2 and 13. Singapore. Average annual growth in real GDP was 8 percent.2 percent target. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. averaging 10. reaching an annual inflow of $2 billion in 1991. The manufacturing sector became a dominant force in the economy. The exchange rate was steady at around B25 to the dollar. compared with the 8. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. The country also attracted a large amount of foreign direct investments (FDIs). compounded by a slump in property sales. compared with the 14. rather than to productive activities.8 percent.232 Corporate Governance and Finance in East Asia. United States. Europe. Inflation was 4. invited a deluge of capital seeking profitable investments. lower than the target of 8. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. Vol.6 percent target of the Seventh Plan.4 percent targets. The country’s high ratings in the international capital market. By 1995. China—went to export-oriented manufacturing industries. Growth of exports and imports averaged 14. combined with its liberal financial policies. respectively. Growth rates during 1987-1991 ranged from 9. with private foreign debt reaching $92 billion by the end of 1996.5 to 13. from only $31 billion in 1992. . Most of the FDIs—originating mainly from Japan. increasing its share in total export value from 42 to 76 percent.8 percent.

the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. SET officially became “the Stock Exchange of Thailand” in 1991. In 1978. In 1972. In 1969.8 percent in 1995 to 1.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. Robbins. And because the Government considered the banking system vital to the development of the economy.3 percent in 1996. Sidney M. Under the 1962 Commercial Banking Act. with growth shrinking from 23. its policy had always been to protect domestic banks. Exports went into a tailspin. Before the capital market emerged. the capital markets didn’t play a significant role until 1975. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. In May 1974. the Government passed the Public Limited Company Act. 4. many companies considered the Act too restrictive and a hindrance to growth. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. on account of an overvalued baht that weakened export competitiveness. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development.” which later became the master plan for the development of the Thai capital market. a policy that held throughout the first six economic development plans. which raised the debt service ratio. the signs of an economy about to falter were there. The deficits caused the Government to rely on even more external borrowing. However. a former Chief Economist from the US Securities and Exchange Commission. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. placing all publicly listed companies under regulation. the corporate sector’s main source of funding was the banks. 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.2. Foreign banks were barred from competing directly with domestic banks.Chapter 4: Thailand 233 Toward the end of the Plan period. the Government amended the “Announcement of the Executive Council No. In his report. the Bank of Thailand and . Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. prepared a comprehensive report entitled “A Capital Market in Thailand. which was amended in 1979 and 1985.

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

Financial deregulation and liberalization were key to realizing that vision. the country became recognized as an economic development model for other emerging economies. and Communication Financing. in that order.0 21.1 78. with B1.5 111.2. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4.5 50.Chapter 4: Thailand 235 fast-growing neighbors. In terms of capital.2 11. 4.1 30. Worldwide. Forestry. The majority of the companies are in manufacturing. Thailand.9 16. Hunting.9 261. Ministry of Commerce. about 661 companies with total registered capital of B2.0 Paid-up Capital (B billion) 1.9 1.4 trillion in registered capital and B791 billion in paid-up capital.1 trillion and paid-up capital of B1.9 34. and Water Construction Wholesale and Retail Trade.3 83. and Restaurants and Hotel Transport.6 350.1).3 trillion have been registered with the authority (Table 4.6 23. Insurance. however. The result was a corresponding growth and development in Thailand’s capital markets.1 Public Companies Registered.0 110.291. . and wholesale/ retail trade and restaurant/hotel sectors. finance.0 19.5 791.2 Type of Business Agriculture.394. Real Estate. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. Source: Department of Commercial Registration.6 2. and Fishing Mining and Quarrying Manufacturing Electricity. 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. Gas.6 1. Social and Personal Service Total Note: The data for 2000 is as of October 2000. Storage. the financial sector is the largest. and Business Service Community.101.

7 billion and B27. These peaked at B89. II B261 billion.2 5. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.3 22.7 billion in 1996.5 — — 56. Table 4.3 6. meanwhile. After the passage of the SEA of 1992. moreover.5 1.0 0.3).6 8.4 277.5 39.1 — — — 6.9 1998 1999 15. The development of the corporate sector closely followed the development of capital markets. the capital market became instrumental in the rapid growth and development of the corporate sector.3 31.0 1994 82.6 7.6 — = not available. the value of public offerings rose steadily. allowed Thai financial institutions and corporations to obtain funds overseas. The 1997 crisis battered the primary market for securities.3 1996 1997 65. The stock market also became an invaluable source of funds for corporations.0 20.9 37.8 — 26.1 286. Securities and Exchange Commission of Thailand.8 201. the year before the crisis struck.4 34. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.9 31.8 151.7 5. Domestic and offshore debt issues reached B54.2 40. reached .236 Corporate Governance and Finance in East Asia.6 39.5 1. from only B20. Market capitalization.2 12.7 27.7 9. respectively. The signing of Article VIII with the IMF. The number of listed companies and securities steadily increased until 1996 (Table 4.7 136. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.5 billion and B1 billion the previous year.4 96.2 25. reaching a precrisis peak in 1996 (Table 4.1 54.2).1 599.6 174.1 2. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.8 1995 64.3 194. 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. Vol.7 7. While a rebound was apparent beginning in 1998. reducing the value of offerings to a little more than a quarter of the previous year’s level.2 Public Offerings of Securities. Source: Key Capital Market Statistics.8 billion.4 51.

The upward trends for ROE and ROA continued through 1989.683 1. The trend reversed in 1995.Chapter 4: Thailand 237 Table 4. 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 3.4 percent to 5. The key financial ratios of all companies listed on SET bear this out (Table 4.3 Statistical Highlights of the Stock Exchange of Thailand. then stalled in 1990. The financial leverage of all companies declined until 1994. return on equity (ROE). pulled down by active public offering activities. Meanwhile.268 2.301 3. gross profit margin rose until 1991 before falling in 1992. resulting in their inability to fulfill debt obligations.193 2. the average times interest earned (TIE) was down to 5.325 3. in the end. Source: Securities and Exchange Commission of Thailand. ROA dipped from 10.133 1.4).360 1. was the ominous deterioration in the key financial ratios of publicly listed companies.3 percent in 1989 to 3. as measured by return on assets (ROA).8 percent.6 trillion. By the early 1990s. Foreigners accounted for an increasing proportion of SET’s turnover value.4 percent in 1996. Corporate profitability.201 2.281 832 373 356 482 Due to listing requirements and other reasons. the averages for all three profitability ratios took a downswing all the way until 1996. While the decline in gross profit margin was not as sharp.565 2. and gross profit margin. however. their share rising from 17 percent in 1993 to 43 percent in 1997. not all public companies are listed on the SET. But instead of shifting to a low gear.610 1. From 10. when long-term debt grew as Thai corporations began to borrow heavily to finance growth.535 1. corporate profitability had been declining. its high point in 1995 at B3. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . had been on the rise throughout the 1980s.114 1. the companies could not generate enough net returns from their assets and equity.5 at its peak in 1987. Throughout the 1990s.560 1. Side by side with this surge of financing for corporate growth.303 930 855 1.1 by 1996. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. however. ROE similarly fell from 21.

0 63. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.8 88.4 119. which was particularly significant in the two years preceding the crisis.2 10.3 12.7 12.9 7.7 59.8 25.4 24. Despite the availability of the equity market.5).4 Key Financial Ratios of Publicly Listed Companies.1 60. and footwear industries also experienced losses.4 4.6 27.0 139.4 47.5 52.8 5.9 66.7 21.4 51.2 161.2 35.7 12.4 28.8 11.4 44.4 5.8 51. Thailand’s ROE. Korea and Thailand had the highest debt-to-equity ratios.5 30.4 3. Severely affected by global competition throughout the decade.7 35.9 8.9 51.4 26.7 27.4 139.1 120.0 29.5 15.1 16. resulting in higher collateral values for borrowers.0 125.6 12.8 14. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. and footwear had the lowest at 11 percent. Among the crisis-hit countries.7 80.2 10.4 12.8 151. was also distinct in the region. the textiles.2 215.7 5.7 5.1 9.3 4.7 34.2 10.1 52.9 144.5 63.5 38.4 7. clothing.1 44.2 6.0 7.0 145. Hotels and travel showed the highest ROE of 15 percent while textiles.5 51.6 138.7 12. practice of heavy borrowing.7 27.3 91.4 7.3 10.4 34.9 140.2 27.9 77.7 12.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.0 117. these companies opted for debt. Vol.9 14.2 49. II Table 4.6 41.6 168.7 15.3 8.6 125.8 54.7 20.7 5.9 7.2 64. clothing.5 50.8 5.1 242.6 7.4 18. They were generally more efficient in managing their assets and . which fell from 16 percent in 1991 to just under 6 percent in 1996.2 27.9 27. The downtrend in corporate profitability. was felt across industries. US.6 36.1 114.5 9.9 39. 1985-1996 LongTotal Term Total Return Return Gross Debt Debt Debt on on Profit Times to to to Assets Equity Margin Interest Equity Equity Assets (%) (%) (%) Earned (%) (%) (%) 3.6 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. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.0 3.7 54. Overall. A major reason for this was the rapid rise in asset prices.8 8.4 12.238 Corporate Governance and Finance in East Asia.1 16.7 4.4 9.

5 94.8 62.0 48. 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 6.8 47. although the performance of listed companies in the late 1980s was strong.8 10.3 176.5 Average Key Financial Ratios by Company Size.2 10. During the 1990s. For instance.4 8.6 5.6 30.3 88. it was thought. could lead to a high turnover in the board.8 6.0 20.0 83. They also tended to use more financial leverage than small companies as their total DERs show. total asset turnover declined after 1989.8 26.3 23. weaknesses became evident.6 10.2.8 6.1 6.2 134. In sum.2 12.7 6. the law disallowed cumulative voting.2 121.1 5. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.4 Legal and Regulatory Framework Before 1992. Cumulative voting.6 7. also deteriorated. by the 1990s.3 25. 4.2 18. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.1 29.6 30.7 14. However.1 25.6 61.5 6. capital despite the higher gross margins of small companies.3 164.4 52. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate. measured by total asset turnover. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.6 6. Although stable in the 1980s.9 20.6 31.6 12. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.7 10.3 15.8 142. .7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.1 Small Medium Large 5.3 49.3 135.3 49. the overall activities of listed companies.4 116. which would be disruptive to company management.1 13.5 7. US.Chapter 4: Thailand 239 Table 4.3 43.3 52.9 13.5 87.

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

9 4.9 55. .0 3. these companies obtained funding solely from banks or from their own retained earnings.7 7. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28.3 7.1 5. Ownership Concentration Between 1990 and 1998.6 4. on average.7 12.0 5.1 3.4 26. In the past.2 4.4 6.1 percent of control rights.9 6. respectively.3 28. 33.3.4 26. Across industries. Ownership was most concentrated in the packaging. But with their increased reliance on new varieties of equity and debt instruments. this was not the case.3 percent and 18. there were only slight variations in the pattern.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.3 7.8 11.2 11.1 12. creditors.5 9.1 7.2 56.9 52.8 32.9 3.6 27. 56.9 52.4 10.8 5. Thai.1 4.0 7.1 5.3 5. China firms have the highest single shareholder ownership concentration at 35. Source: Comprehensive Listed Company Information Database.5 28. The Public Company Act of 1992 allowed ownership and control of these companies to remain with the founding families even as they became increasingly dependent on nonfamily resources.0 53.7 percent. one would expect the public. Table 4.9 26.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.9 11. and minority shareholders to stake their claim in the control and regulation of these companies.7 6.Chapter 4: Thailand 241 4. In contrast.9 percent of shares of a company.1 11. Indonesian.4 26. and 28.2 4.4 4.6 68.9 54.3 11. Most large Thai corporations listed on SET started out as family businesses.7 11.4 percent of outstanding shares.3 16.9 3.4 5.9 52.0 7. Stock Exchange of Thailand.0 56. with the top three shareholders accounting for almost 50 percent (Table 4.5 Average for 1990-1998 period.6).2 4.6 28. and Hong Kong. with the largest shareholder on average controlling 10. the top five shareholders of each of publicly listed Thai companies held.1 5.6 57.0 3.China have the least concentrated ownership. Unfortunately.3 percent.4 6. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.

031 3. II agribusiness.001) 0.647 Note: The regression included dummy variables for industry.7).116) Debt-to-Equity (1. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. * Denotes significance at the 10 percent level. Ownership Concentration. founding families maintain effective control of entire groups. Company size is significantly related to ROE and leverage.072) (0.022*** 0.001 0. as measured by debt-to-equity and debt-to-asset ratios. with a top-five ownership concentration of at least 60 percent. and ownership types. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. results show a significant positive relationship between ownership concentration and financial leverage. *** at the 1 percent level.005** 0. Based on a regression analysis. year.242 Corporate Governance and Finance in East Asia.8).115 9.533)*** Debt-to-Assets (0.090 0.080 6. Through these holding companies. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.800 0.7 Statistical Relationships between Corporate Profitability. These are consistent with the hypothesis that companies with more concentrated ownership tend to engage in higher debt financing because their controlling owners do not want to dilute their control by bringing in new equity holders. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.003 0.169*** 0.058* ROE (0. ** at the 5 percent level. Leverage. including those that are publicly listed .001*** 0. Table 4. 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. On the other hand. US.037 0.029 3.034*** 0. owning 26.7 percent of outstanding shares on average (Table 4. and building and furnishing industries. Vol.

The top 10 shareholders include a holding company owned by the Tejapaibul family.6 percent of outstanding shares. In 1994.8 0.5 5.5 0.1 0. Typically.4 1. in SET.9 18. These individuals usually hold important management positions in concerned companies. Established in 1980 with a registered capital of B300 million.5 Individuals 13.2 5.Chapter 4: Thailand 243 Table 4.5 NBFIsa 6. operates five of the most successful shopping malls in Thailand.5 0.2 1.3 27.3 27. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.0 19.3 1. averaging about 18. individual members of the Chirathivat family aggregately hold 25.5 Government Other 0.7 5.4 1.5 1.0 3. the company.0 18.6 1. Source: Comprehensive Listed Company Information Database.3 1.3 percent of outstanding shares. a joint venture among three families. a company listed in the real estate sector of SET. This practice is illustrated by Central Pattana.2 18.3 0.3 — = not available. the affiliate firms rarely hold shares of their parent companies. one of the founding members.3 1. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.5 26.0 17.7 1.6 28.8 23.4 1.8 28.6 1.4 20.5 2.8 1.9 6.2 1.1 4.6 25. a NBFIs denotes nonbank financial institutions. In addition. Although holding companies set up affiliate firms.7 Bank 2. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.2 7.5 0. owned by the Chirathivat family. Individual family members also hold a significant amount of outstanding shares. the company increased its registered capital and became a public company listed in SET.9 7. The largest shareholder is Central Holdings Company.9 0.4 22.9 15. including finance and investment companies. The ADB survey indicated that listed companies held shares in an average of 11 companies. . with 29.5 1.1 1.7 — 1.5 percent.3 27.9 19.6 1.3 20.6 5.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.7 0.1 1. Stock Exchange of Thailand. unlike in Japan where crossshareholding is common.

. the top 10 shareholders consist predominantly of members of founding families and their holding companies.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. By owning 62 percent of voting shares. and responsibilities of directors of public companies. has the Ministry of Finance as its only large shareholder with 92. Except in the hotel and travel service sector. these shareholders are able to control the company. they exercise limited influence in operations because of the restricted size of their shareholdings. on average. roles. the predominance of individual family members and holding companies in the top shareholder list remains valid. 1. the Government owns the majority of the shares. and a state bank. II another of the company’s founding members. 3 Discussions in this section are based on results of company surveys by SET and ADB. For example. On average. 4.5 percent of total outstanding shares. Vol. Only a handful of companies have the Government among their large shareholders. they account for 80 percent of total outstanding shares.9 percent of outstanding shares. Together. There was a trend of rising government shareholdings throughout the period 1990 to 1998. both conducted in 1999. the Petroleum Authority of Thailand. Although the list of top shareholders of publicly listed companies includes financial institutions.3.5 percent of total outstanding shares of listed companies. duties. The Government holds. Thai Airways International Plc.1 percent of total outstanding shares of listed companies. However. In such cases. Moreover. Across industries. Another example is Bangchak Petroleum Plc. only one tenth of listed companies have commercial banks on their top-five shareholder list. qualification. In effect. 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. where the top three shareholders are the Ministry of Finance. commercial banks account for only 1.. Nonbank financial institutions hold an aggregate 5. with the envisioned privatization master plan.244 Corporate Governance and Finance in East Asia.

directors may be imprisoned or fined. The ADB survey indicated. an executive board consists of senior management and some main board members. while 15 percent of respondents went beyond the requirement. but not in 22 others. while 30 percent of respondent companies held board meetings monthly. the majority (71 percent) had board chairs who were also members of top management teams. In five other companies. Generally.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. directors are required to act with care and honesty for the company’s best interest. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. Three companies indicated that the CEO and the chair were close relatives. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. meanwhile. Although 28 percent of the chairpersons came from the ranks of independent outside directors. directors shall be elected at the annual general shareholders’ meetings (AGSMs). In their business conduct. . Most companies (83 percent) satisfied SET’s requirement of having two independent board members. Meanwhile. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. selection was based on relationships with controlling shareholders. 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. and to comply with the laws and articles of association. Many companies have a formal policy on corporate governance and business ethics. Some companies (36 percent) had five to six main board members holding seats in their executive boards. If found in violation of these provisions. In addition. Nineteen companies stated that selection was based on professional qualifications. Unless stipulated in public companies’ articles of association.

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

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

it would be difficult for minority shareholders to gather the shares needed to take action. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. 4.3 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. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. Only a small number of shareholders attended the latest AGSMs. minority shareholders are assured adequate legal protection. takeover of the company. But the exercise of these rights requires even higher shareholding levels. the only group of shareholders that can exercise rights is the top five shareholders. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. But with the ownership concentration of Thai companies. Almost 82 percent of shareholders. 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 insider trading.3. they comprised only 8 percent of total shareholders. 66 percent of total outstanding shares. In practice. given their importance in providing finance and their stake in companies. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. did not vote in previous AGSMs. Vol. While stimulating the growth of the sector. and call an extraordinary session. such protection has been insufficient. and mandatory disclosure of related interests and significant shareholders’ transactions. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. representing only about 28 percent of shareholdings. Banks would be obvious candidates to implement these mechanisms. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. Although the attendees held. however. On paper.248 Corporate Governance and Finance in East Asia. In theory. 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. In effect. . on average.

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

a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. SEC has no authority to either approve or reject tender offers. with a total tender offer value of B42. It will take years. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. with a significantly lower total tender offer value of B8.3 billion. there are two categories of merger and acquisition activities with associated regulatory measures. There are detailed requirements regarding such notification. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. In 1996. and failed to provide managers with strong incentives to perform efficiently. SEC was later made responsible for regulating corporate takeovers. The second category is the tender offer. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares.250 Corporate Governance and Finance in East Asia. Since the introduction of the Public Limited Company Act of 1978. Although merger and acquisi- . there were only six tender offers. According to the SEA of 1992.3 billion (Table 4. Such efforts would serve to strengthen external discipline on controlling owners. In 1994 and 1995. Vol. 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. there were 41 cases of tender offers. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. however.9). whether directly or indirectly. before the extent to which the bankruptcy framework has been strengthened becomes clear. of shareholders: (i) all shareholders must receive tender offers. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. Recently. The market for corporate control has not been active in Thailand. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. if the purchase of shares implies a change in the directors or business activities. its main role is to ensure transparency and fairness. The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. The first category is the acquisition of shares in the open market. only a limited number of successful mergers of public companies have taken place. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC.

they have mostly been concerned with short-term gains. it remains small. Employee Participation in Corporate Governance There has been little. .4 23. Because of the current crisis.8 81.0 B billion 4.1 19.3 6. Pension funds are perhaps even weaker in Thailand. but employees have never been represented in the board of directors since their shareholdings are minimal.5 6.2 6.6 17. Source: Securities and Exchange Commission of Thailand. While the Thai mutual fund industry compares well to those in other developing countries in the region. but the average shareholding is smaller than 1 percent of total outstanding shares.2 6. Provident funds for government workers and workers in public enterprises have been established only recently. employee participation in corporate governance in Thailand. Twenty-nine firms indicated that employees held shares of their companies. Few companies offer employee stock option plans (ESOPs).1 75.9 Merger and Acquisition Activities. Even when companies offer ESOPs. Since 1994.2 8. if any.Chapter 4: Thailand 251 Table 4. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. employees are even less willing to accept common shares as a form of compensation or benefit.7 Purchase Value Number of % of Tender Offer Value Companies 84.1 84.1 58.3 11. trading by mutual funds in SET represented less than 10 percent of total trading.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.9 3. not with a view to becoming involved in actual management. employees regard the plans as monetary incentives. Eleven of the 46 responding companies in the ADB survey offer ESOPs.3 60.7 11.0 55. tion activities increased after 1997. But instead of opting for an active role in the market for corporate control. most of these were forced mergers or related to rescue packages.2 7.

Thai Bond Dealing Centre.485. the next four largest banks accounted for 63 percent.4 4.1 3.4 3. although its role increased in the wake of the crisis..300. and Bank of Thailand. Bangkok Bank Ltd.477. II 4.1 3. The Banking System Until recently.979.4 519.8 941.3 5.430. In 1996.6 2. 15 of which were domestic banks.171. there were 29 commercial banks.5 6.3 1.1 6. The bond market played only a marginal role in corporate financing.663.2 2. Vol.193. total assets of commercial banks amounted to B5.161.775.037.6 6.5 4.564.0 3.0 424.5 5. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.8 3.230.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.252 Corporate Governance and Finance in East Asia. The share of domestic banks in the banking system’s total assets was 80 percent.372. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.4.1 7.0 8.1 5. the banking sector was highly concentrated.10) shows that Thailand is a highly bank-dependent economy.6 1.0 SET Market Capitalization 1.5 Outstanding Loans from Commercial Banks 2.2 262.3 546.825.5 trillion. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market. Table 4.906.10 Size and Composition of the Thai Financial Sector.9 2.268.0 339.360. The country’s largest bank.4 1.559.4 4.119. .669.325. accounted for 28 percent of the banking sector’s total assets.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.1 Domestic Debt Securities Outstanding 215.5 4.390.133.912.

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

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

The proportion of domestic convertible debt instruments increased until 1995. compared to 110 percent in the US and 74 percent in Japan in the same year. 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. it represented only 9 percent of GDP. while secured debt instruments accounted for just above 10 percent. and the Government did not issue new bonds during 1990-1997. However. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. the Bank of Thailand assumed responsibility for regulating the bond market. the first bond rating agency in Thailand. The bond market in Thailand started in 1933. In 1996. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. The Thai Rating Information Services. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. however. Upon its founding in 1942. . 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. which encouraged limited companies and public companies to issue debt instruments. in 1994.11). The recent financial crisis. To gain some perspective of the size of the bond market in Thailand.9 billion.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. 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. it accounted for a small share of the entire financial sector. was also instrumental to the growth of the corporate debt market. Four years after the passage of the SEA. A turning point of the corporate debt market was the enactment of the SEA of 1992. the size of the corporate debt market rose to B132. Beginning 1961. the Government issued more bonds to finance industrial development projects and perennial deficits. Investors had limited knowledge of debt instruments. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. The budget surpluses of the 1990s eliminated the need for new bond issuance.

4 110.3 — — 3.2 — — 50.11 Offerings of Debt Securities.7 132.3 46.2 2.5 10. a surge attributed to capital inflows encouraged by high returns on Thai bonds.2 45.7 90.1 — — 6.6 — 0.1 121.0 281.6 billion.7 95.8 31.1 21.6 19. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.1 12.3 50. II Table 4.2 28.3 13.0 0.5 43. However.2 43.3 3.7 — — — — — — — 77.9 37.0 27.0 33.9 329.4 — — — 1.7 0.5 billion.7 5. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.9 40.0 17.5 — — 32.8 2. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.0 — 5.9 30. The following year.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.3 46.5 — 0.3 8.1 289.7 0.4 7.2 89.5 — — — 3.1 61.5 55.1 — — — 29.0 60.0 — 26.8 191.3 29.4 — 9. 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 — — — — — — 400.5 — — — — 1.7 821. .5 5. turnover value had reached B51.0 86.7 28.4 — 26.0 — 5. this had climbed to B200.1 107.256 Corporate Governance and Finance in East Asia.5 37.9 20.7 — — — — — 4.1 315.4 49. the year the crisis unraveled and the baht was floated.7 5. Vol.9 37.4 57.1 41.6 — — 0.3 22.1 55.1 6.8 167.1 10.0 333.9 5. then declined substantially in 1996 and 1997.7 7. total offshore debt offerings had plunged by 68 percent to a mere B28.2 57.7 — — 40.0 26.2 39.8 47.5 138. Total offshore debt offerings peaked in the run-up to the financial crisis.3 — 14.7 538.3 6.8 55.1 8.0 5.4 billion.0 7.5 — 39.9 0. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.3 140. By 1995. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs. by the end of 1997.1 59.1 141.

For the construction industry. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. these accounted for 33 percent of total liabilities. short-term loans accounted for more than 40 percent of total liabilities. with equity levels remaining high despite an increase in debt. Turnover fell further to B72. At lower than 5 percent of total liabilities. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth.4. they also had a relatively small proportion of equity and . Construction and property development industries tended to have high proportions of long-term loans and debentures. In 1997. Companies in construction and property development seemed unable to generate internal funds. steadily easing up between 1990 and 1996.2 billion as a result of the default of debentures due to the Asian crisis. turnover value plummeted to B106. these comprised 31 percent. a trend most apparent in the leap between 1991 and 1992.1 billion in 1998. From 1990 to 1996. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. 4. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. In the same year. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. Across industries.Chapter 4: Thailand 257 compared with investment in equities.12). while for the property development industry. Longterm loans accounted for about 20 percent of total liabilities. significant variations can be noted. and marketable securities holdings. In addition. Retained earnings accounted for about 30 percent of total equity financing. judging by their relatively low levels of retained earnings. Equity financing remains an important part of listed companies’ long-term financing. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. The proportion of accounts receivable also declined steadily. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. cash balances. In any case.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. There was also little change in the trend in retained earnings within the seven-year period. The average for all industries was only 22 percent.

8 3.6 0.6 100.6 18.9 12.7 36.3 38.5 1.7 50.0 1.9 6.4 14.12 Common-Size Statements for Companies Listed in SET. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.2 15.4 49.0 12.3 18.0 10.7 15.6 8.6 0. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.7 7.2 43.3 50.0 100.0 100. Vol.3 6.3 21.3 18.2 17.0 2.2 35.3 14.9 0.3 34.2 3.9 2.8 6.8 9.9 17.9 10.0 100.9 49.3 14.0 100.0 15.6 2.5 14.2 1.3 48.6 13.7 52.2 17.5 11.8 14.2 1.0 100.8 19.2 34.0 100.7 1.8 20.2 17. Printing and publishing companies had lower financial leverage than companies in other industries.6 15.4 17.13).4 49.8 46.6 38.2 43.8 8.3 1.1 49.8 34.9 14.6 12.9 38.5 37.0 100.6 10.9 20.0 51.1 18.6 22.8 7.1 13.2 45.9 17.2 17.1 50.2 22.6 21.2 12.6 6.2 2.5 43.9 18.1 2.5 9.3 12.9 16.9 14. medium.4 2.4 7.6 0.3 49.0 100.0 100.5 0.8 9.2 1.0 48.9 43.6 14.7 17.6 100.0 6.8 17. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.4 21. compared with the 44 percent general average. US.0 100. The level of total liabilities for the group characterized by high ownership concentration .7 14.6 50. II Table 4.9 15.0 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.0 100.4 8.2 2.1 36.8 35.0 7.8 37.8 21.6 11. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.5 1.3 17.8 1.8 10.2 16.3 2.9 50.7 18.7 16.4 48.9 6.8 37.0 100.6 36.3 1.0 10.4 43.4 6.2 42.7 0.0 100.6 51.9 40.6 0.2 2.9 3.3 25.5 9.0 100. were highly leveraged.1 17.9 14.2 16.8 25.258 Corporate Governance and Finance in East Asia.4 17.1 5.9 14.2 2.5 1.3 34.0 13.9 14.1 7.7 9.7 16.0 14.

8 12.0 100.9 0.5 18. . Companies with medium ownership concentration tended to have a higher proportion of short-term loans.5 13.6 47.9 50.3 16.6 15.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 7.2 11.4 3.1 36.4 18.0 19.8 13.3 35.0 Low 1. 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. was 53 percent of total assets compared with 49.9 21.6 0.8 13.0 16.9 2.7 19.3 1. For the high ownership concentration group.4 35.5 11.6 2.1 53.8 37.7 percent for medium ownership concentration companies and 49.2 0.0 7.0 6.4 49.3 1. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.4 1. US. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.9 100.0 100.6 100.5 100.2 14.2 22.3 8.1 18.1 44.9 7.0 41.5 percent for low ownership concentration companies.0 Medium 2.13 Common-Size Statements of Public Companies by Ownership Concentration.0 6.1 49.9 36.5 21.7 12.4 37.4 50.6 14.4 13.9 16.7 17.6 9.0 14.6 22.3 100.Chapter 4: Thailand 259 Table 4.2 8.2 45.

7 5.1 23.260 Corporate Governance and Finance in East Asia.8 5.0 28.7 34.8 65.1 16.6 138.0 50.2 49. More important. however.1 31. 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 8.1 in 1996.7 in 1994 to 5.8 151.14).9 51.14 Financial Ratios of All Listed Firms. As a result. was the headlong deterioration of firms’ ability to meet their interest payment obligations.1 44. The ratio of total debt to total assets increased from 50. Public companies relied more on short-term debt financing in the period before the financial crisis.7 percent in 1996. Vol. Generally.4 12. minimization of transaction and interest costs.6 41.4 44.2 68.4 51.8 51. however. the choice of financing is determined by the company’s liquidity considerations. and rights issues. Short-term debt accounted for most of the increase.6 7.7 12.4 7.5 52.3 61.1 31.7 12. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing. thus rendering them more vulnerable.7 34.0 145.15.1 16. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.8 65.1 52. especially from 1994 to 1996. While further detailed investigations are necessary.3 31.9 14.9 140. bond issues overtook loans from commercial banks as the second preference.7 66.7 28. 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 4.6 125.1 144.2 35. US. and maintenance of the existing ownership structure. Such deterioration of financial positions during the period was a common feature of listed companies.1 64. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.0 25. . The TIE ratio declined from its peak of 7.9 63.7 11.4 5. Table 4.9 7. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.8 percent in 1990 to 52.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 139. these firms more easily increased their leverage. bond issues. After the crisis. followed by bank loans.5 38.

5 4. The composition and term-structure of this debt. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. on the other hand. 4. and a preponderance of short-term debt liabilities.8 14.15 Financial Ratios of Listed Companies by Ownership Concentration.Chapter 4: Thailand 261 Table 4.9 percent in 1997.1 High 6.5 34.5 148.7 percent from 1991 to 1996.0 64.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. 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.4 52. Additionally. such as direct equity and portfolio investment.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.2 124. Nonbank private debt increased from 27.4 27.8 Medium 7. This decline was accompanied.5 126. The proportion of external debt as a percentage of GDP consequently increased from 42. peaking in 1994 at 84 percent. is even more telling. From 45 percent of total net capital movements in 1985.4 63. US. From only 34 percent in 1986.8 28. continued to slide from 1985 to 1997.5. private debt accounted for 84.2 49.6 30. Their average annual growth rate declined from 28.16).8 29.8 percent in 1986 to 52 percent in 1995.3 42.4 percent to 46 percent during the same period. .5 percent of external debt in 1996 (Table 4.4 13. unhedged foreign exchange liabilities. The proportion of nondebt-creating capital flows.2 percent in 1986 to 251.6 11. however. 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 15.8 49.5 percent between 1985 and 1990 to 8. debt-creating capital inflows rose to 65 percent in 1990.8 66.

2 2.3 3.4 5.9 29.9 4.3 0.8 0.5 14.2 15.6 1.1 0.8 108.5 19.9 7.9 6.6 7.9 100.0 21.2 2.4 18.2 0.6 — 0.1 34. .1 Source: Bank of Thailand.3 0.7 24.7 109.1 23.1 2.3 20.3 — — — — — — — 6.0 0.2 10.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.0 13.5 4.0 3.6 Total 18.7 10.9 5.2 32.1 0.3 2.2 0.9 1.9 31.3 7.2 0.1 12.3 10.2 2.0 6.3 0.0 4.5 16.0 11.9 11.9 0.3 0.7 23.1 22.8 13.7 2.3 0.3 16.9 1.5 4.8 31.1 64.4 — — — — — — — 1.9 10.8 12.3 0. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.4 10.9 10.4 2.6 52.7 0.4 15.5 12.9 3.1 30.0 8.9 13.8 10.8 3.1 5.0 11.8 3.9 43.3 3.9 3.3 0.9 35.Table 4.1 0.16 External Debt.4 3.6 18.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.9 6.7 20.5 12.3 105.1 95.7 13.3 37.1 0.2 14.7 1.3 12.5 1.3 0.

(ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. If lending rates remained high. Most of these foreign debts were not properly hedged. Meanwhile. and (iii) bankruptcies. suggesting that serious investors have not returned to the market.6 in December 1996. the index declined to 1. After that. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4.17). With easy access to foreign funds.281 in December 1995 and to 831. according to the Bank of Thailand. from its peak in 1995. Similarly. and poor business confidence on the other. banks would be recording more of such NPLs.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. leaving domestic investors with large capital losses. Trading volume has since been thin. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. Foreign investors retreated from the market. closures. The effects of the crisis were felt across all industry sectors. Due in part to liquidity problems on the one hand. At the end of 1994. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. The value of public offerings sank in 1997 to B56. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. trading activity at SET had been on the downturn.360. the liquidity problems faced by the corporate sector are likely to continue for some time. Aside from the problem of NPLs. It hit a 10-year low in the second quarter of 1998. 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. the SET Index stood at 1. outstanding credit also declined throughout the second half of 1998. the number of newly registered companies dropped to a 10-year low in 1998. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. reaching 45 percent of total outstanding credit in December. and drastic decline in the number and capital of newly registered companies. Even before the crisis. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998.6 billion from the 1996 level of B201 billion. On average. exposing the companies to disaster when the baht started tumbling on 2 July 1997. . The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. based on the three-month past due definition. large Thai companies had actively borrowed at low interest rates from foreign financial institutions.

095 14.066 19. The price-to-earnings (P/E) ratio deteriorated from 19.334 4.677 Bankrupted/Closed 2. II Table 4. As part of the assistance package.312 25.410 37.096 22.5.797 4.224 4.2 Responses to the Crisis Initially. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.218 3.105 4.2 billion for balance of payments support and buildup of the country’s reserves.777 11.915 37.407 28.410 5. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.902 3.977 Source: Department of Commercial Registration. But when assistance from other sources did not materialize. It also explains the higher dividend yield ratio. 4.307 4.134 31. Vol.17 Number of Newly Registered and Bankrupted/Closed Companies. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.080 9. Thailand. The IMF financial package was a credit facility of $17. the Government was left with no choice. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.695 3.052 36.933 25. A steady price decline over the past few years has dragged down the ratio of market price to book value.904 20. .264 Corporate Governance and Finance in East Asia.201 24.6 in 1997.925 12.409 6. Ministry of Commerce.112 9.792 7.5 at the end of 1994 to 12 in 1996 and further to 6.288 35. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.

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

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

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

the controlling shareholders have the exclusive domain to appoint or exercise management. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. Most companies decide against cumulative voting. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. with the approval of the board. However. without cumulative voting. they face the prospect of being unable to compete for the scarce funds available in the equities market.e. i. The regulators are drafting a proposal to amend the provisions on related transactions. 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. it permits directors. Where equity will come forward. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. Because of high ownership concentration. claiming that it creates fragmentation in the board of directors. minority shareholders have no chance of being represented in the board. In addition. Vol. the main problem is overlooked. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. But as demonstrated. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. This may be true in countries where publicly traded companies are widely held. The radically changed circumstances after 1997 offer the possibility that firms and their controlling shareholders will be under greater pressure to concede to the exercise of minority rights. the dominance of controlling shareholders. 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. in turn. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. this is not so in publicly traded companies in Thailand. who are also the managers. vis-a-vis the minority shareholders. In the absence of such a stock market boom now. and determine voting results on virtually any matter. Otherwise. disrupts the company’s management and decision making. The proposal clearly delineates duties of care and loyalty for directors of public companies. Consequently. The proposal for the amendment of the Public . subject only to approval by the board of directors. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. which. But because this is the assumption embedded in the regulation.268 Corporate Governance and Finance in East Asia..

Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. As of November 2000. the number of cases has abated.6 trillion. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. contributing to the unprecedented rise in the corporate sector’s bad debt. In particular. Another 77. However. This point is crucial because compared with . accounting for B1. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. with the majority of the debtors coming from the commerce. 322. Within three months. 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. The first bankruptcy court in Thailand opened on 18 June 1999. the Government introduced debt restructuring-related measures to help resolve bad debts.764 debt restructuring cases involving B1. methods. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. In addition. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. personal consumption. and procedures for debt restructuring.767 cases involving outstanding credit of B2. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. By October 2000.1 trillion in outstanding credit. 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. although since then. only 7. In response. CDRAC’s target debtors comprised 10. Considerable progress has been achieved on this front. Some 82 percent of these cases have been successfully restructured. where bankruptcy procedures are swift and effective. will be settled by the courts.8 trillion had been completed. accounting for B1. as well as those that did not cooperate with CDRAC’s restructuring process. and manufacturing sectors. Commercial banks initiated 74 percent of these cases. Cases for which negotiations were unsuccessful.1 trillion of outstanding credit.6 trillion) have agreed to cooperate with CDRAC’s restructuring process.147 cases (B1.068 cases involving B475 billion are undergoing restructuring. the court had more than 80 cases for disposition.

Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. 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. 4. 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. 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. Vol. Examination of corporate ownership. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. Conclusions.270 Corporate Governance and Finance in East Asia. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. The study covers the period 1985 to 1996. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. In the next three decades. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. despite the weakness of their disciplinary powers. It required listed companies to establish their own audit committees by the end of 1999. Financial information from listed companies will also soon be required to conform to International Accounting Standards. and even Indonesia.6 4. behavior. For this reason.6. and promoted key industries through incentives. to push companies to harmonize their accounting with international standards. The . Such improvements in disclosure standards are part of the efforts of SET and SEC. the Government protected certain corporate sectors through tariffs and regulation. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations.1 Summary. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Philippines. and performance during this period helps understand the causes of the crisis. II Malaysia.

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

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

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

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

transparency. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. regulators must increase transparency and step up enforcement. Because these holding companies control a number of large public companies in Thailand. and a prohibition of connected transactions by directors or management. 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. and . Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. there has been much progress in this area. they should be monitored and regulated. increasing penalties for directors engaged in misconduct. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. requiring cumulative voting for the election of directors. There is also a need for legislation dealing with nominee or holding companies because they are the institutional means that founding family members use to maintain control. The situation prompts two specific recommendations. Through an amendment in the Public Company Act. To ensure a level playing field. Since the Asian financial crisis. The slow improvement in the legal framework has likewise obstructed progress in this area. the Government can change the shareholding limit for controlling shareholders. accountability. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. SEC is exploring the possibility of amending the law toward this direction.Chapter 4: Thailand 275 There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. 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. The second recommendation is to dilute ownership concentration through the use of regulatory power. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. This move is expected to be unpopular among founding family members and original owners.

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

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

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