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A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand
Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank
© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term country does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines
List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51
2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance
53 53 55 55 60 62 65
iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214
v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226
4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References
229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277
1992-1997 Table 1. 1986-1996 Table 1. 1997 Table 1.7 Growth Performance of the Top 300 Conglomerates.13 Presence of Board Committees in Listed Companies Table 1. 1992-1997 Table 1.4 Development of the Stock Market. 1992-1998 Table 2.8 OwnershipConcentrationofPubliclyListedCompanies.2 KeyMacroeconomicIndicators Table 2. 1990-1998 Table 1.2 Foreign Capital Flows. 1996-1999 Table 1. Indonesia Table 1. 1992-1997 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies. Republic of Korea Table 2.1 Growth of the Banking Sector.21 Nonperforming Loans by Type of Bank. 1992-1995 Table 1.5 Financial Performance of Publicly Listed Companies by Sector. 1993-1997 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies.14 Banking Sector Outstanding Loans. 1996-1998 Table 1. 1992-1999 Table 1. 1992-1999 Table 1. 1992-1997 Table 1. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .17 DER of Listed Companies by Degree of Ownership Concentration Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.1 Listed Firms with Positive Economic V alueAdded.19 DER and ROE of Publicly Listed Companies by Sector. 1988-1996 Table 1.4 Growth Performance of Publicly Listed Companies by Sector.3 Subsidiaries of the 30 Largest Chaebols Table 2.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1990-1997 Table 1. 1993-1999 Table 1.12 CharacteristicsoftheBoardofDirectors Table 1. 1996-1998 2.vi List of Tables 1.20 ROE of the Banking Sector.15 V alue of Stocks Issued and Stock Market Capitalization.11 CharacteristicsoftheBoardofCommissioners Table 1.18 GDP Growth by Sector.
1997 Ownership Composition of Listed Firms in Selected Countries.15 Table 2.23 Table 2.27 Table 2.5 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.10 Table 2.vii Table 2.14 Table 2.7 Table 2.26 Table 2. 1997 Ownership Concentration ofAll Listed Firms. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.6 Table 2.19 Table 2.22 Table 2. 1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio.30 Private Capital Flows to Korea.8 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.29 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1994-1998 Financing Patterns of the Top 30 Chaebols. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.24 Table 2.17 Table 2.11 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.13 Table 2. 1995-1997 Ownership Composition of Listed Companies. 1999 InternalShareholdingsofthe30Largest Chaebols.20 Table 2. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 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 . 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.21 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.9 Table 2.18 Table 2.16 Table 2.12 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.28 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.25 Table 2.
1 Public Companies Registered.15 Financing Patterns of the Corporate Sector.2 Growth and Financial Performance of the Top 1.22 Foreign Investment Flows.20 Financing Patterns by Industry. 1997 Table 3. 1997 Table 3. 1990-1999 Table 3.Profitability andFinancial .32 Table 2. The Philippines Table 3. 1989-1997 Table 3.19 Financing Patterns by Firm Size. 1989-1997 Table 3.1 GDP Growth of SoutheastAsian Countries. 1988-1997 Table 3. 1997 Table 3. 1988-1997 Table 3.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. 1988-1997 Table 3.2 Public Offerings of Securities. 1997 Table 3. 1989-1997 Table 3.21 OwnershipConcentration. 1988-1997 Table 3.31 Table 2. 1983-1997 Table 3. 1986-1998 Nonperforming Loans of General Banks.14 Philippine Stock Market Performance.3 TheCorporateSectorandGrossDomesticProduct.12 Control Structure of the Top 50 Corporate Entities. 1992-1996 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1992-1999 .8 Ownership Composition of Philippine Publicly Listed Companies by Sector.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.11 TotalandPerCompanySales.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.17 Composition ofAssets and Financing of the Publicly Listed Sector.33 Net Profit Margins of Chaebols. 1985-1997 Number of Firms with Dishonored Checks. 1978-2000 Table 4. andAffiliated Banks of Selected Business Groups.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry. 1989-1997 Table 3. 1988-1997 Table 3. 1997 Table 3.1989-1997 Table 3.18 Financing Patterns by Control Structure. 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 3.13 ADB Survey Results on Shareholder Rights Table 3.viii Table 2. Thailand Table 4. 1988-1997 Table 3.SectorOrientation.16 CorporateFinancing PatternsbyOwnershipType. Leverage Table 3. Flagship Company.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.000 Companies. 1995-1998 4.
1993-1999 Size and Composition of the Thai Financial Sector. 1990-1996 External Debt. Ownership Concentration.12 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.4 Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies.15 Table 4. 1992-1999 Offerings of Debt Securities.9 Table 4.ix Table 4.5 Table 4.6 Table 4.2 Figure 3.14 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.8 Table 4.1 Figure 3. Leverage. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.10 Table 4.16 Table 4.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .13 Table 4. 1992-1999 Common-Size Statements for Companies Listed in SET.11 Table 4. 1985-1996 Average Key Financial Ratios by Company Size. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1990-1996 Financial Ratios of All Listed Firms.1 Figure 1. 1990-1998 Merger and Acquisition Activities.3 Table 4.7 Table 4.
Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADBs financialsectorworkinitsdevelopingmembercountries.
Arvind Panagariya ChiefEconomist
Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.
ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholdersmeeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter
xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation
Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
short-term loans were used to finance long-term investments.6 percent) and trade (-18 percent).2 Corporate Governance and Finance in East Asia. how it has affected corporate financial performance and financing. Section 1. Foreign debt reached more than $100 billion. posted negative growth. no doubt. In many instances.5 percent. prior to the financial crisis. In this setup. Foreign creditors. and how it contributed to the crisis. These banks were allowed to operate even if they violated minimum capital adequacy requirements.2 presents an overview of the Indonesian corporate sector. patterns of ownership and control. All sectors. II rate reached 58. The construction sector was the worst hit.3 looks at patterns of corporate ownership and control. patterns of financing. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. To facilitate even easier access to credit. followed by finance (-26. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. However.5 percent. This study reviews the Indonesian corporate sector’s historical development. this left the Indonesian economy extremely vulnerable. the Indonesian economy seemed to be in generally good shape. Malaysia. regulatory framework. and responses to the financial crisis. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. contracting by 36. When the crisis hit the country. highly leveraged companies. The study also identifies family-based companies and corporate groups. were the ones most affected. Section 1. particularly those with large foreign loans. these controlling families had political connections that allowed their companies to enjoy special privileges. placed a high premium on these political connections in assessing the chances of being repaid. except utilities. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. 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. It analyzes the weaknesses of corporate governance in Indonesia. or Thailand. and . the currency composition and term structure of corporate foreign indebtedness were causes for concern. and analyzes their importance to the corporate sector in Indonesia. On the other hand. 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. 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. Vol.
It also examines the statistical relationship between corporate performance and corporate governance characteristics. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. In the early 1970s. Section 1. substantial volumes of private investment entered the scene. how it was affected by the crisis. textiles. while Chinese and indigenous entrepreneurs ran some large businesses in trading. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. 1. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). and its response. Despite the oil revenues. in the course of the fight for nationhood from 1942 to 1950. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies.2 Section 1.4 analyzes corporate financing patterns. and tobacco industries. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. Section 1.2 1.and large-scale companies were dominated by state-run industrial concerns. a gradual shift in public investment away from manufacturing took place. The industries that emerged were highly import-dependent and reliant on tariff protection. However. .2. Not all items in the questionnaires were answered by the respondents. Up until the mid-1960s.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics.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.5 examines the corporate sector during the financial crisis in terms of its role. Subsequently.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. medium.
Vol. the number of firms quoted in the stock market was only 24. a distinct industrial elite started to emerge. By 1987. A number of underwriters emerged. 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. the Government shifted its industrial policy toward the promotion of labor-intensive exports. the value of manufactured exports overtook the value of oil and gas exports for the first time. While most of the companies were small. During this period. Last.2. . Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. many founding owners of companies were reluctant to go public and dilute their corporate ownership. there were also many rapidly growing large-scale companies and business groups or conglomerates. In 1992. In the 1980s. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. the dilution of corporate ownership. First. wood. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. produced consumer goods. which dominated their respective sectoral outputs and markets.4 Corporate Governance and Finance in East Asia. potentially subjects companies to greater regulatory scrutiny. But until the end of 1988. Third. the Indonesian industrial sector was quite diverse. Second. and employed the bulk of the industrial labor force. mostly nonbank financial institutions and stockbrokers. These were families with strong links to the political elite of the New Order. even when new shareholders do not threaten the control exercised by the original owners. But these proved counterproductive because they limited the potential for capital gains to prospective investors. 1. and related products) had shares in total exports that were rapidly increasing. Partly as a result of various government policies. exports of nonoil products (particularly textiles and footwear. Generally speaking. The equity market remained largely unappealing due to a number of factors. 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). Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials.2 The Capital Market The Government reactivated the stock exchange in 1977.
The initial banking sector reform was introduced in 1983. These included the opening of the banking industry to new entrants. companies could no longer enjoy low-interest credit from state banks. During this period.5 trillion. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. from 24 in 1988 to more than 300 in 1997. The banking sector. with a total value of Rp16. which were previously constrained to 4 percent per day. the number of private domestic banks increased. However. more significant reforms were introduced. the controlling shareholder of these SOCs is still the State.2. which up to then was channeling oil revenues to priority sectors.1 shows that from 1994 to 1998. But in terms of assets per bank. Consequently. However. six SOCs had issued equities in the market. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). . Thus. the capital market played an increasing role in raising long-term funds needed by the corporate sector. and increased access of domestic banks to international financial markets. Since 1977. state-owned banks were still among the biggest. the banking sector has undergone many reforms. the banking sector has been and still is the major source of credit for the corporate sector. Further reforms along the same direction and affecting state-controlled banks came in the 1990s.Chapter 1: Indonesia 5 At the end of 1988. Through the years. In 1988. began to face competition. private domestic banks dominated the sector in terms of number and total assets. reduced restrictions on foreign exchange transactions. Partly as a result of these reforms. with a total value of more than Rp8 trillion. Interest rate regulations on state banks and credit ceilings in general were removed. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. The dominance of state banks started to erode. to date. the number of listed companies in the stock exchange increased substantially. Table 1. Conglomerates carried out 210 out of 257 IPOs. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. 1. However.3 The Banking Sector Despite the development of the stock market. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. The Government also allowed foreign investors to buy up to 49 percent of listed shares.
.8 29 6. Because regulation was weak.5 27 66.5 165 308.9 248. Among private domestic banks.5 7 7 7 5 15.8 391. Of these.7 351.8 166 248.3 27 51.6 7 7.2 10 14.8 31 10.1 10 47. Bank Danamon.1 240 1995 122.6 7 12. 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.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.9 31 9.1 Growth of the Banking Sector. 1993 100. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).6 240 1996 1997 1998 1999 141. But the banking system proved incapable of performing its intermediation function.9 39 18. Bank Danamon (ranked 7th).3 201.4 34 12. Vol.8 27 200. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).6 Corporate Governance and Finance in East Asia. while BUN has been closed down by the Government.5 27 88.4 10 35. and Bank International Indonesia (ranked 9th). 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.8 27 147.6 34 14.9 27 113.5 7 9.8 10 19. The other banks among the top 10 were state banks.3 30 7.0 234 1994 104.9 762.7 27 37.3 10 17. In terms of assets.9 291.5 528. banks could earn profits even when they did not gather and process information about risk. II Table 1. Both BCA and BUN have shareholders linked to the former President Suharto.2 161 214.8 10 37.6 164 144 130 92 387.4 789. BCA. the 10 largest were all affiliated with major business groups.9 304.9 10 11.
foreign creditors were eager to provide financing to Indonesia.2.01 (2.15) — = not available.09 1. In 1994. foreign investment also had a strong presence in the services and infrastructure sectors. except in certain strategic sectors. when the financial crisis hit Indonesia. Indonesia received capital inflows averaging about 4 percent of GDP. IMF. Most FDIs came in through joint ventures with business groups having strong political connections. especially through bank loans. there was a phenomenal growth in direct borrowings by Indonesian corporations.09) (0. In effect. 1. as shown in Table 1. such as metal goods. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.09) 1.59 4.48 1. initially from Japan and the Republic of Korea.87 7. textiles. Net FDI flows increased to $5.74 5.2.50 (0. Increasingly.11 3. and footwear. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). In the 1990s.33 (13.10 5. the Government allowed foreign investors to own 100 percent of an Indonesian company. Source: IFS CD-ROM.Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way.88 4.2 Foreign Capital Flows.63) (1.81 3. November 2000. Table 1. September 2000. Between 1990 and 1996. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.78 2.59 billion in 1996. FDI flows were strong. But FDIs were only one form of foreign capital inflows to Indonesia. Successive policy deregulation facilitated FDIs in various light manufacturing industries.01) (0. From the mid-1980s until July 1997.88) — — — — — — 8.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).40) (0.00 2. they still amounted to a large sum for the economy to absorb. 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. . Until the onset of the crisis.
The Government relaxed this restriction in 1988. the average foreign ownership of listed companies was 21 percent. participation in the Indonesian stock market was exclusive to domestic investors. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. 1. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. foreign investors began to dominate daily trading. In the 1990s. of which two thirds were rupiah-denominated. and conglomerates.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. 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. .8 Corporate Governance and Finance in East Asia. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. This increased to 30 percent by the end of 1993. especially the short-term ones. In November 1998. Domestic corporate debt was about $50 billion equivalent. The following section looks at the growth and financial performance of the corporate sector. Between 1989 and 1992. Private borrowers preferred foreign loans since these were relatively cheaper. increasing the total trading value from Rp8 trillion in 1992 to Rp120. the average borrowing rate for dollar loans was 9 percent. state-owned companies (SOCs). foreign banks became a significant source of financing for the corporate sector. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. with the onset of the Asian crisis. Vol. but declined to an average of 25 percent during 19951997. In September 1997. Due to data constraints. the analysis focuses only on publicly listed companies. Consequently.4 trillion in 1997. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. total corporate debt reached nearly $118 billion.2. By the end of 1997. The external corporate debt owed to foreign commercial banks was $67 billion. 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. II Up until the late 1980s. the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. From 1987 to 1996. plus 4 percent for the depreciation of the rupiah.
3 6.4 31.6 48.3 Growth and Financial Performance of Publicly Listed Companies.0 12. 1993. 1994. The growth of listed companies was sustained by continuing investments. 1996.0 3.4 1996 18.2 30.6 1994 50.6 percent in 1997.8 220. 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. Note: The number of firms is not identical for each year.1 0. Source: JSX Monthly (several publications).0 11. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.9 310.4 1993 45.7 percent in 1997. total sales of listed companies grew at an annual average rate of 31 percent. Asset turnover was above 30 percent until 1996.8 6. Return on assets (ROA) was also relatively stable during 1992-1996. During 1992-1997. Average return on equity (ROE) of listed firms was 11.3 3. ranging from 220 to 250 percent between 1992 and 1996.6 24. while total assets grew at 43 percent. averaging 3.7 — 250. publicly listed companies as a group contributed less than 10 percent to GDP.4 percent.8 percent between 1992 and 1996. but turned negative in 1997. In 1997.0 12.6 3. although the contribution increased over time. but fell to 24. but declined to 0. 226 firms. 1995.1 percent in 1997 when the crisis began to buffet Indonesia.7 3.0 6. b Asset turnover is defined as sales over assets.0 12.1 4.4 38.3 shows the growth and financial performance of Indonesian publicly listed companies.5 240.8 230.0 10.5 3. 246 firms. 250 firms. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.7 — = not available.0 33.4 1997 7. a Value added was assumed to be 30 percent of total sales.5 34. but dropped to 1. the average DER increased to 310 percent from 230 percent the .2 7. and 1992. Table 1.5 37.5 34. 174 firms.2 1995 37. there were 204 firms. 248 firms.0 1.0 64.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. When the crisis battered Indonesia in 1997.9 37. Despite such rapid growth.1 220.
helped in part by the relatively strong demand for consumer goods. property. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. ROE fell drastically because the sector had one of the highest DERs. followed by agriculture (Table 1. However. Four sectors (basic industry and chemicals. and property. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks.5 presents the financial performance of listed companies by sector. investment. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. Vol. the banks eagerly provided credit to property development companies. meanwhile. The finance sector’s contribution to GDP. property.4). But the sector’s ROE fluctuated a lot. This sector was less affected by the crisis. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. investment. Overall. the companies in the sector did not operate with a high leverage.2 in 1997. indicating its reliance on equity to support growth. although asset turnover was slow. When interest rates increased.10 Corporate Governance and Finance in East Asia. and trade) even posted . and trade. consumer goods. and building construction. infrastructure.73 percent in 1992 to 1. and services.7 percent during 1992-1996. when the property sector was booming during 1993-1997. For instance. In terms of share of value added to GDP. due mainly to the domination of the International Nickel Company of Canada. still posting a positive but lower ROE. the dominant sector was the finance sector. real estate. The same applied to the trade sector. which operated in nickel and copper mining in 1992 and 1993. miscellaneous industry.64 percent in 1997. basic industry and chemicals. and services. Table 1. increased from 0. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. The consumer goods sector ranked second in terms of ROE. mining. in terms of growth of sales and assets. In terms of sales and asset levels in 1997. The finance. finance. the mining sector had the highest ROE. with ROE falling to -11. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. Also. Before the crisis. only two sectors (mining and finance) showed a consistently increasing trend from 1992. Meanwhile. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. II previous year. real estate. averaging 17. From 1995.3 percent between 1992 and 1996. the mining sector ranked first. averaging 21. miscellaneous industry. the mining sector had the lowest DER. the property sector was severely affected by the crisis. ROA of all sectors dropped in 1997. During those years. trade.
9 36.9 31.4 Growth Performance of Publicly Listed Companies by Sector.5 23.1 42.6 15. Real Estate.2 0.3 0.1 0.0 1.0 68.6 0..5) 6.5 0. Infrastructure Finance Trade.7 (82. Infrastructure Finance Trade.1 (41.8 (76.5 61.7 28.1 1.5 1.4 1. Constn.4 64.4 21.1 1. and Bldg. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.2) 0.0 (192..9 59. Investment.4 30.6 (41.8 50.5) 13. Industry Consumer Goods Industry Prop.7) 26.1 16. Industry Consumer Goods Industry Prop.6 (0.6 0.1 28.1 0.0) 46.6) 19.8 62.2 5.8 1.5 9.6) 119.0 0.9 54..6 85.3 92.3 1.3 (203.7 40.4 103.0 64.6 83.8 0. Real Estate.2 35.7 54.4 1.7 21.7 43.7 0.7) (113.8 24.0 31.5 (11. Real Estate.1 67.7 0. Infrastructure Finance Trade.1 1.1 0.5 53.0 22.8 27. Infrastructure Finance Trade.7 1995 51. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.7 133. Industry Consumer Goods Industry Prop.4 77.4) 6.0 24.1 23.5 1.8 32.7 34.4 31.3) 53.Table 1.4 43.3 0.8 66.1 1.4 1993 155.6 26.1 35.0 0.4) 8.3 0.3 51.6 24.9 54.1 32.8) 0.6 28.9 8.5) 49. and Services — = not available. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.6 0.1 0.9 (7. Constn. and Bldg.6 1994 (75.4 44.2 0.4 170.5 1.6 133.4 0.1 1.7 — — 11.0 0.7 62.7 24.9 .0 0.2 41.5 28.3 340.3 17.8) (12.4 30.9 123.0 43.0 1996 1997 58.4 38.1 — 39.1 0.8 51.9 53.4 (149.2 14.3 0.7 112.8 29.7 — 36.2 59.9 25..3 31.5 (8.5 68.5 45.5 95.0 (28.1 (11.6 1.6 135.9 0. Source: JSX Monthly (several publications).9 64.1 71.3 31. Real Estate.3) 39.5 13.9 0.8 28. Investment.2 41.0 16. Constn. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.9 14.7) 17.7 90.0 0.0 0.5 92. and Bldg.1 0.2 11.7 17. Industry Consumer Goods Industry Prop.0 18. Constn.6 22.1 0.5 0. and Bldg.6) 25.6 0.2 13.1 0.9 1.4 1. Investment. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.1 0. Investment.3 0.0 (20.6 51.8 1.1 0.7) (27.
0 150.0 110.4 46.1 13.4 13. Infrastructure Finance Trade.0 220.0 630.0 1997 230.7 71.4 46..3 7. Constn.0 3.0 190.4 20.0 100.0 110.2 3. Real Estate.1 3.2) 7.9 29.0 680.0 100.0 120.2 1993 130.4 17.0) 7.3 0.6 13.1 (5.0 8.0 50.2 53.0 210.0 70.1 (3. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.4 6.1 10.0 46.9 40.2 11. Investment. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.. Real Estate.8 25.5 17.0 8.9 7.7 12.7 4.4 71.0 70.0 160.3 38. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.8 168.1 10.4 35.5 7.1 7.1 1996 100.8 20.0 69.8 5.7 8. Infrastructure Finance Trade.2 30.2 111.0 150. 1992 20. Industry Consumer Goods Industry Prop.7 12.7 10.8 67.1 10.7 9.5 19.0 140.0 700.0 120.0 650.5 13.2 23.0 86. Constn. Constn.0 (0.8 11.0 160.0 14.0 180.3 7.9 38.9 10.6) 18.4) (1.0 160.0 100.5 11.0 60.0 39.3 5.1 89.0 110.2 3.6 14.8 8..0 9.7 1. and Services Source: JSX Monthly (several publications).1 9. and Bldg.0 140.3) 5.0 66.7 10.6 1. and Bldg. Constn.3 64.6 (11.9 38.7 4.0 12.7 1.5 4. and Bldg. Real Estate.0 380. Investment.0 110.0 170.5 4.5 5.8 16.9 87.0 100.0 180.5 Financial Performance of Publicly Listed Companies by Sector.0 80.1 65.3 33.8 81. Industry Consumer Goods Industry Prop.9 14.0 110.9 42.3 17.0 120.4 5.6) 36. and Bldg.0 650.2 7.9 17.3 18.8 9.1 1994 80.8 3. Investment.2) 15.0 70.2 (4.6 8.0 3.3 17.7 8.0 190.7 (3.7 46. Infrastructure Finance Trade. Real Estate.5 1995 80.5 43.7 10. Investment.7 5.0 80.6 19.5 56.0 15.1 8.6 23.5 14.7 13.6 74.8 11.2 6.3 1. Infrastructure Finance Trade.0 560.6 8.4 35.3 13.9 41.1 9.6 13.7 5.1 2.4 4.4 79.4 1.0 120.4 6.0 110..8 479.2 39.9 4. Industry Consumer Goods Industry Prop.2 7.1 4.0 180.7 4.2 8.1 63.1 4. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 80.1 1.0 19.6 (2.2 13.3 73.6 18.0 150.1 6.0 130.7 26.0 110.7 12.1 4.0 190.7 61.0 17.2 15.8 382.4 13.4 .Table 1.8 44.0 11.0 90.8) 8.1 11. Industry Consumer Goods Industry Prop.
3 percent in 1995.4 percent the following year.6 to 8. there were 58 SOCs with subsidiaries and affiliates. Assuming a fixed ratio of value added to sales. the ratio decreased from 8. Six SOCs were listed in the Jakarta Stock Exchange. However. and basic industry and chemicals sectors had relatively stable ROA before the crisis. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). between 1993 and 1995. This was due to large sales by the National Oil Company (Pertamina). Just like private companies. SOCs’ ROE ranged from 6. For instance. Taken together. the Department of Finance supervised 30 SOCs. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. SOCs diversified into many businesses. Similarly.3 trillion. the subsidiaries and affiliates number 459 with total assets of Rp343. much lower than that of companies listed in the stock exchange. averaging 24 and 31 percent. increasing from 21. registering an average annual rate of 10 percent. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. Only the agriculture sector showed an increase in ROA in the couple of years before 1997.6). and finance company (four companies). banks (seven companies). SOCs actively operated in various sectors4 under the supervision of “technical” departments.1 percent in 1993. growth of net profits and assets was erratic.7 percent in 1990 to 6 percent in 1996. insurance (11 companies). Trade had the highest ROA of 39. SOCs’ sales growth fluctuated during 1990-1996. indicating SOCs’ declining contribution to GDP.7 to 7 percent for publicly listed companies.1 percent in 1992 to 28. This was relatively high compared to the 3.7 percent. These growth rates were low compared to those for listed companies during the same period. By 1995. ROA had been at high levels from 1992 to 1995. . The finance and miscellaneous industry. Asset turnover rates were lower relative to those of publicly listed companies. The DER was slightly higher than for listed companies.8 percent between 1992 and 1995 (Table 1. State-Owned Companies At the end of 1995. there were 165 state-owned companies (SOCs)3 in Indonesia. which collectively had the largest assets. respectively. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.Chapter 1: Indonesia 13 negative ROA. but dropped dramatically to 4.
1992 — 7. SOCs’ asset turnover rates showed a downward trend from 32. 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. Source: Indonesian Data Business Center.7 16. In 1997.1 12. Source: Indonesian Data Business Center.0 28.0 24. b Asset turnover is defined as sales over assets.6 28.6 28.6 1995 25.1 19.4 1993 16.0 6.1 trillion in 1990 to Rp234 trillion in 1997.4 13.2 23.8 12. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.1 310.6 percent in 1994.7 (2. Assuming a constant ratio of value added to sales. the contribution of conglomerates to GDP increased from 12. a Value added was assumed to be 30 percent of total sales. Their total sales increased from Rp90. Table 1.4 13.3 250.6 Growth and Financial Performance of State-Owned Companies.4 16.8 21.0 8. Vol.4 percent in 1994.2 — = not available.7 13.4 13.2 18.0 7.766 business units.7 Growth Performance of the Top 300 Conglomerates. but climbed to 30.2 percent in 1997 (Table 1. .6) 260.1) 5.2 — 370. mostly private companies.5 3. Table 1.14 Corporate Governance and Finance in East Asia.3 12.1 30. but dropped to 11. a Value added was assumed to be 30 percent of total sales. II companies consistently declined over time.0 8.8 percent in 1990 to 13.3 30.7 1994 (9.0 17. these conglomerates owned 9.4 percent in 1992 to 28.8 11.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.7).0 12.1 6.1 32.5 percent in 1995.4 7.
In general. If the BOC does not perform well. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. the Government promulgated a number of laws and regulations to protect investors. and the attendance should at least be two thirds of total shareholders. For example.6 Legal and Regulatory Framework During the 1990s.2. For instance. tasked to provide direction to the company. an approval needs the majority (50 percent plus one) vote. acquisitions. This guards against shady intercompany dealings within a group of companies. For instance. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC).Chapter 1: Indonesia 15 1. The BOC. as representative of shareholders. For mergers. shareholders lose control. The law replaced an earlier statute that was based on the Dutch system. mergers. such as the appointment (or replacement) of directors. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. and consolidations. . and declaration of bankruptcy. and the board of directors (BOD). however. except in strategic issues stated in the law. By international standards. the decision to use certain company assets as collateral for bank credit might need BOC approval. the legal and regulatory framework of the corporate sector was far from adequate. is the only shareholder mechanism for monitoring and controlling the BOD. The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. tasked with supervising the firm. The law also holds the directors and commissioners jointly responsible for decisions made by the company. commissioners. The meeting decides on important issues. The company charter details the issues that need shareholder meeting approval. the decision to amend the company charter should be approved by two thirds of shareholders present in the meeting. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). and the accountant. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD.
(xv) mechanisms to resolve disputes between the company and shareholders. (xvi) independence of auditing. securities companies. some listed companies sell no more than a small proportion of shares to the public in order to retain the freedom of the founders to make strategic decisions. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. decrees of the finance minister. investment managers. Controlling shareholders have no vote on the matter. such as custodian banks and the securities registration bureau. 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. . Because of such requirements. It regulates the requirements of investment companies. and (xviii) severe penalties for insider trading. investment advisors. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. transparency requirements. and guidelines promulgated by the head of capital market supervision. (vii) the right to call an emergency shareholders’ meeting. (vi) one share one vote. A tender offer is also required for acquisitions of up to 20 percent of listed shares. insider trading (including market rigging and manipulation) investigation. and the attendance should at least be three fourths of total shareholders. The law is supplemented by Government regulations. and bankruptcy. II acquisitions. It also regulates reporting and auditing procedures. (xii) mandatory disclosure of connected interests. the decision should be approved by three fourths of the shareholders present. consolidations. Vol.16 Corporate Governance and Finance in East Asia. underwriters. brokers. (iv) cumulative voting for directors. and other supporting agencies. (xvii) mandatory independent board committee. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. (xi) mandatory disclosure of transactions by significant shareholders. (ii) proxy voting. (iii) proxy voting by mail. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. (ix) mandatory shareholders’ approval of interested transactions. (xiii) mandatory disclosure of nonfinancial information. and administrative and legal punishment. (x) mandatory shareholders’ approval of major transactions. (v) preemptive rights on new share issues. (viii) the right to make proposals at the shareholders’ meeting.
Discussions on corporate ownership cover listed companies and conglomerates.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study).3. or 20 shareholders.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. etc. holding companies. states that a bank is not allowed to provide credit without collateral. The two most important elements of ownership structure are concentration and composition. for instance. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector. A new bankruptcy law was passed in August 1998. the viability of a project). . or financial institutions. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan.g. net open positions. families. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. 1. five. the collateral could take the form of nonphysical assets (e. Banking regulations also set lending limits. amended in October 1998. It aimed to protect creditors by providing easier and faster access to legal redress. 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. capital adequacy. Ownership concentration is usually measured by the proportion of shares owned by the top one. Unsecured creditors could proceed against a debtor in default based on loan covenants and through the legal process of collection against the latter’s assets. 1. the Banking Law (1992).. However. whether they are individuals. For instance. It reveals characteristics of controlling shareholders.Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. A Commercial Court was also set up to deal with bankruptcy cases.
2 67. 13.0 1.6 4.1 4. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.6 13.0 0.6 68.9 Source: The Indonesian Capital Market Directory.4 percent.2 11.1 1.9 percent of total outstanding shares. and basic industry and chemicals sectors than in others.8 Ownership Concentration of Publicly Listed Companies. Meanwhile. Vol. the founder usually continues to own the majority of shares through a .18 Corporate Governance and Finance in East Asia. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.8. the controlling shareholders usually act as standby buyers.9 2. II Publicly Listed Companies Table 1. The percentage owned by each of the five largest shareholders was 48. consumer goods. and 0.3 1995 47.6.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.9 2.1 0.6 percent.0 4.1 13.5 1997 48. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. the five largest shareholders owned 68.5 16.7 3. Zebra Nusantara (taxi services). On average.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.5 72. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.0 67. This is because a few companies in the transportation sector issued high proportions of shares to the public.4 2.2 1.9 0. Table 1. This preserves the pro rata share of existing shareholders. When a company goes public.7 1994 48. When a company makes a rights issue. issued 93. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50. 2.6 3. 3.5 Average 48.8 1.8 68. mining. for instance. respectively.0 2.0 0.9 14.6.5 12. The pattern of ownership concentration changed little over this period.7 1996 48. Table 1.8 68.6 3. Rig Tenders Indonesia (shipping services) issued 51. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table).5 percent.9.
and Transportation Finance Trade. and Services Average Source: The Indonesian Capital Market Directory.6 9.1 0.1 1.4 1.1 13. In fact.2 46. Constn.2 2.2 This is confirmed in Claessens et al.3 14.4 6.6 8.9 3. on the one hand.4 11.9 1.9 0.5 4.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .1 2. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.6 percent of total market capitalization while the top 15 families control 61.9 50. and Bldg. Table 1.2 10.7 6.. as well as the existence of corruption. in a cross-country study.0 5. (1999). First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54. is strong. that the correlation between the share of the largest 15 families in total market capitalization.7 percent of the market.5 58. which shows that in 1996.7 13.7 9.1 1.1 1. Claessens et al. on the other. (1999) also found..9 44.6 0.9 44.8 14.3 0.1 percent) of Indonesian publicly listed companies were in family hands.3 36.3 0.4 54. Industry Consumer Goods Industry Prop. Indonesia has the largest number of companies controlled by a single family.9 Ownership Concentration of Publicly Listed Companies by Sector.4 4.7 1.1 2.1 0. two thirds (67. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. 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 48.6 1.5 1. and corruption.3 2. In terms of capitalization.4 44. the top family controls 16.6 percent were widely held. Infrastructure.1 1. and only 0. Util. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.1 11.1 2.7 4. the rule of law.2 15. Real Estate.6 2.2 0. and the efficiency of the judicial system. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals. Investment.
10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. the onset of the crisis negated this development. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. . During 1988-1996. In 1993. but later declined and steadied at around 25 percent. conglomerates established before 1969 dominated in terms of sales.20 Corporate Governance and Finance in East Asia. numbering 162 in 1988 and 170 in 1996. it rose to 30 percent. and Padang. the Government allowed foreign investors to buy up to 100 percent of listed shares. accounting for 64 percent of total conglomerate sales in 1988-1996.42 percent in December. 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. most were established during the New Order Government. was able to create a favorable environment for business development. resulting instead in a decline in the proportion of foreign investor ownership. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Among the top 300 conglomerates. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. But these benefits are few and often dubious compared to the high costs of concentration. Indigenous businesspeople include the Javanese.5 Conglomerates Table 1. II the small number of families and the tight links between companies and the Government. From 193 in 1988. the legal system is less likely to evolve in a manner that protects minority shareholders. with all its regulations. In September 1997. However. political affiliation. foreign ownership increased to 21 percent. or other ethnic groups.55 percent in August to 25. However. Coordination is easier because informal communication channels exist. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. This may indicate that the New Order Government. the proportion of foreign ownership declined from 27. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. ethnicity. and family origin. In Indonesia. Sundanese. their number increased to 5 In 1997. The nonindigenous businesspeople are usually Chinese. Vol. Indian. Batak.
3 120.3 80.9 14. the number of mixed groups declined from 86 in 1988 to 68 in 1996.4 22.9 billion.1 179. sales of the Bakrie group before it went public in 1990 were only Rp369.4 81.7 95.0 58. Conglomeration Indonesia 1997.4 59.6 77.7 64. 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 9.4 19.4 68.1 52.4 57.6 17.5 22.2 33.3 36.9 13. In 1996. due to their “go public” activities.7 24.6 54.4 32.5 106.1 21.1 87.7 28.4 59.0 18.9 trillion.2 159.6 114. its sales reached Rp1.4 18.5 120.3 134.4 48.8 25.1 58.7 49.2 12.2 76.8 68.2 30.1 25.3 43.8 36.0 116.4 86.7 40. Meanwhile.6 trillion in 1988 to Rp137.0 58.1 46.Chapter 1: Indonesia 21 Table 1.6 12.4 trillion in 1996.2 29.9 73.4 52.7 106.8 28.0 28.4 69.1 percent of total .4 31.9 35. 204 in 1996.8 30.1 103.4 15. For instance.1 42.9 42.2 48.4 37.1 33.10 Anatomy of the Top 300 Indonesian Conglomerates.3 101.9 77.4 16.6 95.0 44.2 23.9 47.1 41. Their total sales also increased from Rp38.1 46.3 20.7 89.8 49.8 38. more than five times its 1988 level.8 57.8 Source: Indonesian Business Data Centre.0 31.5 21.6 34.9 137.0 15. While they supplied 20.4 31.8 12.
But listed companies within conglomerates were few. II sales in 1988. In November 1997. The Salim group. for instance. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. Conglomerates were also classified into nonofficial. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. In 1996. and Fast Food (restaurants). The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. or have resulted from alliances between entrepreneurs and officials. Prudential credit analysis tends to be ignored. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. Out of 174 companies. Some of them later became public companies by listing in the stock market. and Wisnu Suhardhono of Apac-Bhakti Karya. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. including Indofood Sukses Makmur (food industry). most of the 16 liquidated banks had violated the legal lending limit set by the central bank. average sales of official-related conglomerates reached Rp1. In 1997 and 1998. In 1996. there were 175 groups that originated from a family business. Vol. compared with the less than Rp700 billion of a nonofficial-related conglomerate.7 percent in 1996. Only about 13 percent were formed by official or ex-official families. collectively controlling . 117 are jointly owned by the family and 57 are owned by individual family members. The Suharto family is the largest stockholder in Indonesia. Bank Indonesia. Bambang Rijadi Soegomo. their contribution declined to 13. which is the largest conglomerate in Indonesia. But only a handful of these companies are listed in the market.22 Corporate Governance and Finance in East Asia.and officialrelated groups. Indocement Tunggal Prakarsa (cement industry). Most of the top 300 conglomerates were established by ordinary citizens. Djuhar Soetanto. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families).2 trillion. owns four groups with many subsidiaries and affiliate companies. and Ibrahim Risyad of the Salim group.
many of whom. This is because cross-owned banks had to consider not only their own interests. He or she could either be the biggest shareholder. besides Suharto himself. or someone very close to and trusted by the controlling shareholders. or both. as well as other relatives and business partners. they maintain their position as commissioners. for instance. In 1996. but those of the entire group. While the source of the . and hence. they still control the work of the directors. Both are listed companies and members of the Salim group. Indonesian law allows cross-shareholdings. If the family members cannot actively manage the companies as directors.. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. The BOC chairperson often represents the controlling party of the company. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. Cross-holdings between financial and nonfinancial firms potentially create more serious problems. Although they are not actively involved in the daily operations of the companies. families mostly manage the groups and make strategic decisions themselves. Although some groups employ professional managers. The Salim Group is also in part controlled by the Suharto family. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. Cases in point are the Bank Papan Sejahtera and Bank Niaga.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al. management. Some of the groups related to officials have a unique share ownership structure. with no restrictions. In so doing. 1999). But it is difficult to obtain data on cross-shareholding among firms. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain. Semen Cibinong. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry). The families retain control of the companies through ownership. continue receiving some kind of protection and special treatment.1). served in some government function (see Figure 1. the controlling shareholders are able to maintain their special relationship with officials. It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms.
Figure 1. 1999). and Larry H. P. Who Controls East Asian Corporations? Financial Economics Unit. Financial Sector Practice Department. Simeon Djankov.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. . (Feb. Lang. World Bank.
the directors. the BOC supervises the work of directors. Shareholders are at the top of the organization. Figure 1. The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. management and managerial compensation. including the boards. seek an audience with directors. 1. one possibility is that legal lending limits had been violated. The managers execute the BOD’s decisions and lead employees in their departments.3.Chapter 1: Indonesia 25 problem is inconclusive.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. and accounting and auditing procedures. and. role and protection of minority shareholders. the BOC has the right to obtain any information concerning the firm.2. Therefore. both controlling and minority. As the owners’ representatives. This is based on the Dutch system. request a shareholders’ meeting. . The typical structure of a publicly listed company in Indonesia is shown in Figure 1. The BOD leads the company and makes strategic and operational decisions. if necessary.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.
Corporate Governance and Finance in East Asia, Vol. II
Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
Chapter 1: Indonesia
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
Corporate Governance and Finance in East Asia, Vol. II
Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
Chapter 1: Indonesia
provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
Corporate Governance and Finance in East Asia, Vol. II
Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were
The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. The Government appoints the BOD and BOC of these firms. the owner of Tirtamas group. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. with the minister’s approval. 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. In these two latter cases. which was acquired by Yopie Wijaya in 1995.Chapter 1: Indonesia 31 external acquisitions. the bank was liquidated. IBRA found itself tasked with managing large amounts of assets in the private sector. In the massive restructuring of the banking sector that commenced after the crisis. or direct subsidies. Before the financial crisis. Since the NPLs reached up to Rp300 trillion.6 In this case. Control by the Government Government control could be in the form of state ownership. the acquiring interest was apparently seeking economic profits. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. who was acquiring his second commercial bank. For instance. This used to be a common practice in companies associated with the Suharto regime. The bank was reported to have high NPLs and had broken the legal lending limit. They then replaced the BOD and later sold the bank. Bank Niaga was under a recapitalization program. Wijaya and his friends bought shares of the bank on several occasions until they gained control. Most Indonesian state companies are 100 percent owned by the Government. the Government took over NPLs and put them under IBRA management. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. However. to Hashim Djojohadikusumo. One famous takeover was Bank Papan Sejahtera. . appointment of management. State ownership for listed SOCs ranges from 25 to 35 percent. a state-owned insurance company may invest its funds in a private firm. at a large profit. it was common for the Government to invest in certain private companies. 6 7 Later in March 1999. except for publicly listed SOCs. restrictions on market entry. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. In April 1999.
4 1.1 220.0 93. stocks. the share of private national banks in outstanding total loans increased to 44.7 112.6 48.3 111.3 9. 1992 1993 1994 1995 1996 1997 1998 1999 68. bank credit surged from Rp122. jointly providing almost 90 percent of loans until 1997. Vol.9 378. Bank loans. II 1. because of the restrictions discussed below.1 Corporate Financing Financial Market Instruments Prior to 1977.0 3. From 34.4 86. equities became available to the corporate sector.32 Corporate Governance and Finance in East Asia.6 150.2 27.8 193.9 153.14.5 42.0 168.5 80.2 71.6 4. However. Data from Bank Indonesia show that from 1994 to 1997. this market was not well developed. . new instruments have been introduced to the corporate sector.9 150.6 3.4 56. when the Government reactivated the stock exchange. Table 1. remain the major financing instrument for the corporate sector.3 60.4 percent in 1992.6 6. Since then.4 trillion in 1998.7 18. however.4 225.2 6.2 5. private national banks overtook state banks as the dominant credit source. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. Private national banks and state-owned banks were the biggest domestic creditors.14 Banking Sector Outstanding Loans.6 percent in 1997.7 122.5 108.1 Equities In 1977. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia. including bonds.6 292.5 7.9 trillion in 1992 to Rp487.4 24. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).3 188.4. and others offered by nonbank financial institutions or finance companies.3 14.9 234. companies considered alternatives to bank loans.7 50.0 6.0 487.3 66. Bank Credit As shown in Table 1.
. and consumer credit.Chapter 1: Indonesia 33 Some companies went public.0 15.0 206. They were not.7 percent in 1997.8 48.0 70.1 1994 26.. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.. offering services such as leasing. 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 1996.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares.5 333.2 16.15 Value of Stocks Issued and Stock Market Capitalization.e.6 123. credit cards.5 1995 35.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.6 91. when foreign investors were not yet allowed to purchase listed shares.4 207. thus increasing the role of the capital market in raising long-term funds. capital adequacy ratio. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.1 18.4 1996 1997 1998 50.7 14.9 406. In 1988. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. Overall.6 310. During the 1990s.9 1999 76. finance companies were increasingly used as channels for the inflow of foreign loans. shooting up to 18.6 301. legal lending limit. 1992 1993 11. and net open position). the stock market has gained a bigger role in corporate sector financing (Table 1.g.1 17. however. In 1995. Prior to 1995.7 9. factoring.1 10. It gradually increased again starting in 1991. The ratio reached 8.7 15.6 859. allowed to accept deposit accounts from the public.15). i. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. the Government issued regulations to supervise and promote prudential practices in finance companies. Table 1. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.
6 23.3 (0. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).0 100.8 7. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. have been popular in Indonesia since 1990. they were not rated by a rating agency. at 81 percent of total borrowings. otherwise it would be classified as a loss in the banks’ books. .6 100.6 100.5 percent and 36. In the second half of the 1980s.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.4 23. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments).5 21. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. This is in contrast to the lower share of borrowings during the same period.3 37. II Commercial Papers Commercial papers.0 1991-1996 16. While banks had some exposure to these instruments.7 22.0 — = not available.2 26.4 8. short-term borrowings were greater than long-term debts.2 Patterns of Corporate Financing Table 1.6 12.8 17. 1.4.0 1986-1996 17. Table 1.16 Financing Patterns of Publicly Listed Nonfinancial Companies.9 16. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.4 13. 1996.3 16.34 Corporate Governance and Finance in East Asia.6 8.0 39.5 11. PACAP Research Center.5 (0.3 14. In terms of composition.0 3. Thus in November 1995.1) 23. averaging 26.8 percent. respectively.1) 23. Vol.5 — 26.
9 trillion. 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. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Table 1. For instance. These liabilities grew significantly because corporate expansion was largely financed by debt. Of the various financing sources. All companies in the cement industry suffered from foreign exchange losses.17 compares the DER of listed firms by degree of ownership concentration. which was masked by the rapid growth in investments.4 trillion in 1993 to Rp112. Two telecommunications companies. reaching Rp229. This amount doubled in 1997. Most corporate charters require commissioners to approve debt issues or sign debt agreements. 1. rising from Rp54. They also do not want to dilute corporate control and are more likely to finance growth with debt. . Hence. with longterm debts increasing rapidly. while Semen Cibinong’s losses reached Rp2. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. in the context of Indonesia and some other countries.9 trillion in 1996.3 percent during 1991-1996.6 trillion and Rp1.2 trillion (mostly foreign exchange losses).Chapter 1: Indonesia 35 In the 1990s. The results indicate that firms with higher ownership concentration tend to have a higher DER.3 Corporate Financing and Ownership Concentration It has been suggested. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. that ownership concentration may be associated with heightened risk-taking by companies.2 trillion. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. respectively.1 trillion.4. the corporate sector’s high leverage. corporate debts accounted for 39. which managed to post significant profits due to low exposure to dollar-denominated loans. the pattern changed. except Semen Gresik (an SOC). was due largely to a rapid rise in long-term debts. Indosat and Telekom. also suffered from foreign exchange losses but managed to post profits of Rp0. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. Corporate debts grew over time. Indofood registered losses of almost Rp1. Bank loans also surged when the banking sector was liberalized in 1988.
heavy reliance of companies on bank credits to finance investments. II However.17 DER of Listed Companies by Degree of Ownership Concentration (percent) Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699.0 351. 1. Table 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. In addition. the free capital flow system allowed private companies to borrow dollars offshore without any restriction.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. Vol. the private sector borrowed heavily in unhedged dollars. and high ownership concentration among families with political affiliation. Between 1987 and 1996. The test of the difference between the two means found the t-value of 1.358. Source: Author’s estimates. the borrowings swelled.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. 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. decisions on debt are made with the implicit endorsement of owners. since commissioners represent the controlling party. aided . Controlling parties rely on external financing to maintain their equity share and.5 1. ultimately. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders.0 1. As a result.0 386.56 significant at the 10 percent level. to maintain control of the company.5.
They were. This often led to the violation of prudential credit management practices. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. averaging about 4 percent of GDP. In the process. those with high DERs) established their own banks. It is not known if these regulations had an effect on nonbank intermediaries. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. It was doubly difficult to exercise supervision when groups with political clout owned the banks. 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 also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. after all. only created to serve the companies to which they lent. .e. It was only in 1995 that some regulations on the activities of finance companies were contemplated. Conglomerates that had difficulty in getting loans (i. 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. The Government later specified the legal lending limit and the net open position that banks had to follow.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. 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. As a result. However. did finance many viable ventures. A director at Bank Indonesia revealed that in 1995. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. to circumvent these banking regulations. large amounts of credit were directed to the companies within the group. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. many firms became highly leveraged. The removal of entry barriers in the banking sector caused the number of private national banks to soar from only 65 in 1988 to 144 in 1997. The supervising agency was caught unprepared. The large supply of foreign funds. However. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. the level of corporations’ foreign debt could not even be ascertained..
Corporations were certain that they could roll over short-term loans when these fell due. Projects involving massive capital investments and long-term operating deals (in telecommunications. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. where private banks are usually in the hands of big businesses. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. of which $64. Since the Government could not afford to undertake these projects. They enhance their control over companies through cross-shareholdings.5 billion was owed directly by corporations. In many cases. but on the basis of who the borrower was. politicians. toll roads. most often to people who were close to the ruling regime. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. or both. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. This fact was usually not disclosed in financial statements. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices.5 billion. . 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. banks did not lend on the basis of the soundness of the project. as they had done so in the years before the crisis. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. II By mid-1997. and power generation) require huge capital. Vol. This was often the case in the banking industry. there was also almost universal confidence that the economic growth would continue indefinitely. and in the process maintain control of the company. Families retain control by keeping the majority percentage of outstanding shares. by setting up their own banks.38 Corporate Governance and Finance in East Asia. In early 1998. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. contracts were granted to the private sector. and investing shares among nonfinancial companies within the group and in other groups’ companies.
18 GDP Growth by Sector. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.6 13. and Fisheries Mining and Quarrying Manufacturing Electricity.6 8.58 trillion (meaning their losses were greater than the paid-up capital).6) (3.4 7.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.24 trillion for the first six months of 1998. posted negative growth rates.7) 2. and Restaurants Transport and Communications Financial. as shown in Table 1.7) (8. Real Estate.1 (1.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. indicating a rapid rise in .6 12. and building construction. real estate.5.8 0. 1996-1999 (percent) Sector Agriculture. This continued in 1998. The construction sector was the worst hit.4 5.2 (1. followed by property. Only 86 companies reported profits.1) 1. and Water Supply Construction Trade. except utilities. DER and ROE were calculated per sector.1 6.6 (36.9 3.1 5. Livestock.8) (11. when all sectors.0) (15.1) (26.3 12. much higher than the 307 percent registered in December 1997.6 4.370 percent.0 2.3 11. and 128 companies reported a total loss of Rp46. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.19. The consumer goods industry reported the lowest ROE.4) 2.8) (13.52 trillion. The average DER was found to be 1.0 5.8 8.0 3. BPS).2 8. and Business Services Other Services GDP 1996 3.4 7.0) 1999 2.18 shows that growth in most sectors significantly fell in 1997. Sectors with lower ROE generally had higher DER.6) (0.8 7.7) (2.4) (0.8 1997 1. Forestry.Chapter 1: Indonesia 39 1. followed by the finance and trade sectors. Hotels.7 6.7 1998 (0. Most sectors showed significant increases in leverage. Table 1. 53 companies reported negative equity of Rp6. Gas.5) (18.
0 307.0 92.8 17. private banks posted negative ROEs in the same year. the NPL ratio rose to 25. losses in operation were due to declines in sales and increases in the cost of imported inputs. As the rupiah weakened and interest rates increased.0 219.0 72. First.20 reveals that the banking sector’s ROE decreased significantly in 1997.0 205. small foreign banks enjoyed the highest profits. .1) 7.0 635. several publications. Source: JSX Monthly.0 105.0 1.2 (4. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.0 697.370.1 (124.2 13.1 (92.19 DER and ROE of Publicly Listed Companies by Sector.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.6) 15.9 12.0 111. and would have kept on increasing if interest rates had not declined.0 2. Mostly suffering from a liquidity squeeze.21.2 23.0 864.0) 10.0 177. but annualized to approximate full year values. as shown in Table 1.0 65.7 1.0 631.8 (373.0) (78.0 108. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.0 a ROE 1996 1997 1998a 14.7) 6.4 (6.625.5 percent in April 1998.0 2.4) 8.8) 36.097. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.1 1.1 30.2) (264.271.0 163.6 (11. Third. Second.6) (115.395.0 1.0 12.7 percent in July 1998. the NPL ratio had reached more than 60 percent.8 percent in 1996.1 (3.0 97.0 1. Financial and banking analysts estimate that by September 1998.4) 18. Impact on the Banking Sector Table 1. a Actual data for 1st semester only. foreign exchange losses came about with the use of unhedged foreign debt. Vol.0 191.3 7.5 8. II Table 1.0 158.0 1998 186.0 193. This figure further increased to 47.0 108.0 177. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.4 5.40 Corporate Governance and Finance in East Asia. from only 8.1 (5.0 1997 234. The huge losses suffered by most companies were caused by three factors.0 229.
8 3.37 19.6 6.25 22.09 (11. private national banks overtook State-owned banks when their NPL ratio jumped to 57.91 21.89 27.8 8.69 14.2 10.2 — 8.0 129.9 11. coupled with negative spreads (deposit rate was higher than the credit rate).30 5.1 47.50 9.15 20.06 20.5 222.2 8.9 — 11.45 21.47 20.7 — = not available.5 57.9 percent.21 Nonperforming Loans by Type of Bank.5 34.44 15. put pressure on the banking sector.3 445.8 14.6 — 4. Source: The National Banking Association.1 1.0 — 32.5 31. 230/1998. .43 10.0 — 4.39 13.7 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 331.45 — 1993 15.38) 11.86 11.34 16.12 15.2 37.72 16.2 1.1 198.Chapter 1: Indonesia 41 Table 1. July No. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.07 1994 14.68 1996 1997 8. however.8 11.24 (4.0 622.28 5.20 ROE of the Banking Sector.1 30.70 1995 7.6 — 13. 227/1998 and October No. 1992 7.81 13.84 27.2 — 19.4 7. In July 1998.3 Private National Banks — 179.3 361.73 30.5 2. The high and increasing NPLs.24 15. Source: Infobank.9 Regional Foreign and Development Joint Venture Banks Banks — 9.2 47. State-owned banks initially had the highest NPL ratio.67 8.1 274.6 — 1.1 13.7 — 1.5 128.2 8.8 187. 1996-1998 (Rp trillion) State-Owned Banks — 140.20) Table 1.3 22.7 106.7 4.09 11.2 48.7 29.07 13.9 297.
42 Corporate Governance and Finance in East Asia. 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.7 percent ($64. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. a more comprehensive scheme to tackle domestic and foreign corporate debt. However. and Ciputra (property business).000 eligible firms had signed up for the scheme. The scheme encourages negotiation between creditors and debtors.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. II 1. Astra International (automotive). In June 1998. Aside from being described as overly complicated.2 billion debt. IBRA was formed to offer Mexican-style resolution for private sector foreign debt.6 billion) of Indonesia’s total external debt in March 1998. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. assembling the legal and policy framework to facilitate corporate restructuring.000/$1) in debt from domestic commercial banks. On 9 September 1998. about 80 percent of which was private. Vol. the committee launched the Jakarta Initiative. While the process of restructuring was in progress. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. Unfortunately. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. particularly in terms of debt resolution. none of the 2. by mid-September 1998. Since September 1998. 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. companies were not servicing their debts. the scheme failed. such as Garuda (a national flag carrier). In November. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. the Government and private sector formed a committee to help corporates deal with the crisis. a number of prominent companies. In addition. few companies were in a position to resume interest payments.5. only a .4 trillion of domestic debt and $6. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Corporate debt accounted for 46.7 billion of foreign exchange debt. have been subject to restructuring deals under the initiative. By end-November. Thus.
with the requirement that adequate compensation and protection will be provided to such creditors during that period. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. Rabobank and Citibank. Moreover. Debtors. and mining equipment. plantations. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. the companies’ financial performance deteriorated. forcing them to cut costs. lay off workers. Bank Niaga also negotiated with some of its creditors.e. and sell noncore businesses or nonoperating assets. A Commercial Court was set up to handle corporate restructuring and debt settlements. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process . under which the latter would become one of the bank’s shareholders.Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. Bank Bali agreed on a debt-to-equity swap with its creditor. When credit from the banking sector became unavailable and interest rates increased significantly. for equity infusion. i. For instance. a publicly listed company operating in the automotive industry. Bankruptcy Reform The Bankruptcy Law was passed in August 1998. as well as general commercial disputes. some companies attempted to restructure their businesses on their own.. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. mining. Astra International. Standard Chartered. especially in preventing unjustifiable delays in the adjudication of bankruptcy. 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). consolidate business units. Meanwhile. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. In the banking industry. 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. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization.
in consultation with IMF and the World Bank. is also reviewing the Bankruptcy Law. The bias in favor of debtors has retarded the pace of corporate restructuring. In the longer term. However. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. Previously. legislation against corruption. The Court has also declared only two companies bankrupt. .44 Corporate Governance and Finance in East Asia. II to achieve liquidation of the company. 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. since the market reflects the condition of the economy. the Court’s early record has been a disappointment. To push bankruptcy reforms. and recapitalization of state banks. Rather. (ii) the resolution of nonviable private banks. 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. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. the measure had only a minimal impact. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. companies were allowed to sell shares only by issuing stock rights. However. the Government did not impose restrictions nor did it attempt to regulate capital flows. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. Realizing that they undermine investors’ confidence. There will be changes in the implementation of the bankruptcy law. including procedures for handling operational issues and processing bankruptcy cases. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. (iii) the merger. The Government has also been concerned with the issue of capital controls. and (v) a strengthened banking supervision system. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system. and nepotism (anti-KNN) was signed in 1999. Vol. reform. The Government. Capital Market Reform In the capital market. collusion. with only 17 cases filed as of November 1998.
Chapter 1: Indonesia 45 In 1997. and follow-up action on bank restructuring. A new central banking law. It has also drafted regulations to remove obstacles for converting debt to equity. BBD. Banks deemed ineligible for recapitalization will be closed. The four state banks (BDN. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps. the Government required banks to be audited by international external auditors. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. BEII. 1. improvement of rules and prudential regulations. was enacted in 1999. providing Bank Indonesia with substantially enhanced autonomy.6 1. or sold (after transferring NPLs to the AMU). Some 175 groups that originated from family businesses controlled . Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU.1 Summary. Other Regulatory Reforms To push corporate restructuring further. The merger process will be finished within two years. To overcome these problems. The Bank Indonesia 21st package includes recapitalization. it is doubtful whether pure holding companies are able to enter into swaps. the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. the Government established IBRA to supervise problem banks. In particular. However. Bank Indonesia has announced a recapitalization program for potentially viable private banks. Liquidity support given to troubled banks should be repaid in four years. and Bapindo) will be merged into one bank named Bank Mandiri. The importance of this legislation may need to be emphasized. The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. depositors will be fully protected by the Government. merged.6. Conclusions. To obtain a clearer picture of the banking sector. In October 1998.
Financing Patterns Controlling shareholders opted to use debts to finance expansion. however. When the Government regulated the legal lending limit and the net open position of banks. Vol. These figures show the extent of power wielded over the corporate sector by a small number of families. thus. corporate debts grew over time. Among those listed in the Jakarta Stock Exchange. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups.1 percent of publicly listed companies in Indonesia. when barriers to entry in the banking sector were lifted. retain ownership control of companies. not all of the conglomerate-affiliated companies are publicly listed. meanwhile. Therefore. families control 67.7 percent. On average. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. On the one hand. allowing them to maintain their equity shares and. Rapid growth in investments masked the corporate sector’s increasing leverage. Foreign creditors. As a result. banks were unwilling to provide credit to highly leveraged companies. But because foreign creditors were reluctant to lend long term. lacked the information necessary to allow them to assess projects’ risks and chances for success.46 Corporate Governance and Finance in East Asia. while a single family controlled 16. The restructuring and resolution of financial distress may. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. Companies relied heavily on bank credit. However. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion . II 53 percent of total assets of the top 300 Indonesian conglomerates. Indonesian companies borrowed short term. 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. conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. the majority remains family-controlled. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. These banks also obtained cheap offshore funds. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. However.
1 percent in 1998. The Government introduced reforms to improve bankruptcy procedures. facilitate debt restructuring. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. The financial crisis led to the closure of several dozen banks. ROE dropped from 1. although at a declining rate. the highly leveraged companies. Sales of conglomerates as well as those of publicly listed companies were increasing. Meanwhile. were the most adversely affected. On the other hand.24 trillion in the first half of 1998. and registered a net loss of Rp39. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. DER increased to 307 percent in 1997 and further surged to 1. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. Impact of the Financial Crisis Prior to the crisis. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. corporate-initiated debt restructuring .370 percent in 1998. particularly those with large short-term foreign loans. NPLs rose and capital adequacy ratios fell. the corporate sector was in quite good shape in terms of growth and profitability.1 trillion in 1997 from Rp13. financed by issuing nearly $80 billion worth of bank restructuring bonds. Total profits of publicly listed companies dropped to Rp3. As the rupiah weakened and interest rates increased. and strengthen prudential regulations and supervision of the financial sector. At the height of the crisis. To restructure the corporate sector. Bank Indonesia extended emergency loans to many banks. The Government and the private sector responded with measures to mitigate the negative effects.21 trillion in 1996. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. and the rapid decline in equity due to losses. the high domestic interest rates that prevailed from 1998.1 percent in 1997 to -124. followed by the property sector.Chapter 1: Indonesia 47 without diluting their control. the consumer goods industry was the worst hit. When the crisis hit Indonesia.
(ii) delineating the functions of the board of directors and commissioners. 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. improving the legal and regulatory framework for bank supervision.48 Corporate Governance and Finance in East Asia. The Government should ensure that all laws and regulations are effectively enforced. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders.. In particular. II measures included internal business restructuring (e. but inadequate protection to minority shareholders from the dominance of large shareholders. Vol.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank . 1. but it is not clear whether in practice these standards are in place. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. Most companies claim to have adopted international standards of accounting and auditing procedures. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. and (iii) strengthening transparency and disclosure requirements. and protecting creditors’ rights.6.g. 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. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. Specific recommendations include protecting the rights of minority shareholders.
Protecting Creditors’ Rights To protect creditors’ rights. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. Banks should be required to provide data on such transactions and charged penalties for noncompliance. the Government lost monitoring and control powers over foreign fund flows. in contrast to the Republic of Korea and Thailand. The regulatory framework was also weak in supervising and monitoring foreign transactions. The Government should also continue strengthening the monitoring system for foreign exchange transactions. orderly restructuring.Chapter 1: Indonesia 49 financial institutions. With credit being coursed through the domestic banking system rather than directly to numerous local corporations. a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. Further. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. most of banks’ NPLs resulted from credit to companies within the same group. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. with necessary legal sanctions for violations. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. recapitalization. and liquidation of corporate assets. However. This is a significant factor in . the Court has been slow and ineffective in processing bankruptcy suits. it has been difficult to implement standstills. Consequently. In the first place. When finance companies were used to channel offshore loans in lieu of commercial banks. Because foreign creditors are faced with more information asymmetries than domestic creditors. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies.
50 Corporate Governance and Finance in East Asia. Only when creditors have the confidence that their rights are protected will they resume financing companies. The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing. Vol. II explaining the greater depth of the crisis in Indonesia. . despite the smaller level of capital inflows (as a percentage of GDP).
and Remuneration. Financial Sector Practice Department. Conny Tjandra Rahardja. Bank Indonesia. Working Paper #58. F. Lang. John Wiley and Sons. 1998. Indonesian Central Bureau of Statistics. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. . Stijn. Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Wright. Embassy of Indonesia. The Economist Intelligence Unit. Keasey.. Economic and Financial Statistics. Large and Medium Manufacturing Statistics. The Economist Intelligence Unit. 1999. The Private Debt Anatomy. Unpublished thesis MMUGM. Risks. Indonesian Business Data Centre. various publications. 1997. Simeon Djankov. Indonesia: Sustaining Manufactured Export Growth. P. John Wiley and Sons. Indonesian Business Data Centre. Indonesia Country Profile. Indonesia Country Report. Indonesian Capital Market Directory 1992-1998. 14 May 1999. Maryland. Institute for Economic and Financial Research. Asia in Crisis: The Implosion of the Banking and Finance System. Letter of Intent of the Government of Indonesia to the IMF. Corporate Governance: Responsibilities. 1995. Claessens. Economy of Indonesia. JSX Monthly Statistics. Who Controls East Asian Corporations? Financial Economics Unit. P. K. Indonesia: An Emerging Market. 1997. Forest. University of Maryland. Michael Krill. various publications. World Bank. various publications. Jakarta Stock Exchange. 1998. Embassy of Indonesia Homepage. Center for International Business Education and Research.Chapter 1: Indonesia 51 References ADB Programs Department (East). 1995. various publications. 1996. 1999. Jonathan. 1996. and M. and Richard Turtil. and Larry H. Manuscript. Yogyakarta. Delhaise.
the Government and business sector had good reason to reflect on the causes of the crisis. and Graham Dwyer for his editorial assistance. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. both of ADB. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. Chung and Yen Kyun Wang1 2. 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 Republic of Korea. a practice that was not checked by creditors. and corporates were sent reeling. As the Korean currency. Korea) in November of that year. Further. .2 Republic of Korea Kwang S.1). The country’s winners would then emerge based only on economic efficiency. internal control mechanisms. David Edwards. and David Webb of the London School of Economics for their guidance and supervision in conducting the study.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. the Korea Stock Exchange for its help and support in conducting company surveys. Seoul. markets. This has been the crux of the corporate governance problem in Korea. Business managers and controlling shareholders were maximizing firm size at the expense of profits. 1 Professors. Chung-Ang University. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. 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. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2. The authors wish to thank Juzhong Zhuang. timely exit of poor performers from the market. or capital market discipline.
This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.1 1996 561 163 29. II Table 2. capital market discipline. . accountability of controlling shareholders and boards of directors. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. Vol. Many firms left some questions unanswered. 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.1 Listed Firms with Positive Economic Value Added. T.54 Corporate Governance and Finance in East Asia. the corporate sector. Koller. June 1999. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. The EVAs are the same as the economic profit as explained in T. and individual companies. Government reform goals for the corporate sector include enhancement of corporate transparency. Weaknesses in the overall corporate governance system in Korea had many ramifications.1 1995 560 163 29. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. and improvement of bankruptcy procedures. This study collects and analyzes data on the Korean economy. especially chaebols. which distributed and collected the questionnaire. Source: Korea Stock Exchange.4 1993 513 174 33.1 1998 490 164 33. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. Copeland. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. and J Murrin (1995).5 Note: The EVAs are calculated as: EVA = NOPAT – WACC.1 1997 518 104 20.9 1994 531 165 31.
and naturally adopted an import substitution policy. creditors. Yang. This chapter is composed of six sections. Section 2. the board of directors system. It then presents recommendations for further reform in corporate governance and financing.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. 2. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Section 2.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis.2. Section 2. and Yim (1998). Section 2. It reviews such elements as shareholders’ rights.4 contains analyses of corporate financing and its relationship to performance. From 1948 to 1961. which account for a substantial portion of the Korean economy. and employees and their role in shaping corporate governance practices.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts.2. Section 2. reviewing government policies responsible for the development of the modern corporate sector. corporate control by the Government. Major economic indicators for some of these periods are shown in Table 2. .1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy.2 2. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. The Government tried to produce food. The evolution of the modern Korean economy can be divided into four periods. and other necessities domestically. In the period 19481961.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols.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. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. It traces the country’s economic development. clothing.
the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.2 452.0) 492.1d 9.4 10.8 12.1 — = not available.7 30. Economic Statistics Yearbook. lack of strong drive.9 794.4 29.949.9) 1. the Government called for an unprecedented average annual economic growth rate of 7. The Government tried . II Table 2.332.0 41. However.8 15.8 (724. International Financial Statistics. and implementing new budget and tax measures.8 (8.2 314.0) (297.5 38. 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. largely because of political instability. Export Drive: 1962-1971 Between 1962 and 1971. In the Plan. b Refers to 1979.2 6. Vol.4 1990-1997 7.5) 8.2 757. the Government was not successful in solving the problems of slow growth. and large current account deficits. and inconsistent economic policies.2 1980-1989 8. IMF.6 11. 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.855. Source: Bank of Korea.3 8.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries. e For maturities of one year or more.7 14.1 15.8 24. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).4 (1.9b 15.265.7 37.753.7c 11. a Refers to 1971. modernizing the industrial structure.1 35.447.1a 21. c Refers to 1989.1 29.0 27.9) (7.1 9.5 250.5) (1.4 29.2 32.2 1. high unemployment and inflation.9 — — 21.4 24.56 Corporate Governance and Finance in East Asia.2 30. d Refers to 1997.2 31.2 Key Macroeconomic Indicators Annual Average (percent. This goal required very high savings and investment rates.102.
But the liberalization trend turned out to be short lived as current account deficits continued. In 1971.5 percent. The exchange rate system was a kind of crawling peg until 1974. . The average growth rate of the economy from 1960 to 1964 was 5. and maximizing mobilization of domestic savings on the other. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. the growth of gross domestic product (GDP) raised domestic savings. the import liberalization rate was 55 percent. Exports increased sharply from $41 million in 1961 to $2. This change raised the import liberalization rate from 9. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. channeling funds from curb markets into the banking sector. while the average tariff rate was 39 percent.3 percent average between 1954 and 1959. However. During this period. During the first five-year plan period. The well-educated. resulting in high real interest rates. but the average growth rate for 1965-1969 shot up to 10 percent. imports of consumer goods and luxury items were highly restricted. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. 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. up from 30 percent in the late 1950s. In 1964. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. a modest improvement over the 4. Also. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. Bank deposits increased rapidly.3 percent to 60. which laid a solid foundation for a steady growth path. and cheap labor force was well utilized by the export-led growth strategy.2 billion in 1972. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports.4 percent. In 1963-1964. but tariff rates were raised to 40 percent in the 1960s. due to continuous current account deficits. boosting internal investment resources. the Government tried to provide exporting firms with a free trade environment.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. abundant.
electronics. There were three reasons for the switch: first. The HCI promotion policy was much more comprehensive than past economic development plans. By promoting HCIs. less developed countries forced Korea to adjust its industrial structure. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973. the Government felt the need to strengthen the defense industry. The Government encouraged a variety of business projects. Third. investing a total of $9. These practices contained an implicit government guarantee that large businesses and banks could never fail. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). It promoted HCIs by supplying massive capital for construction and development. in the face of a world economic slump. where preferential export credit was given to almost every exporter. announcing rescue packages for businesses and banks. faced the danger of bankruptcy. reducing or exempting debts of farmers and fishermen. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. overburdened with debts and high interest rates. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. The Government took emergency measures. Vol. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. 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. nonferrous metal. Second. In 1972. becoming a seed of the economic crisis in 1997. Unlike the previous system. and assigned them to specific chaebols. The Government targeted six industries—steel. shipbuilding. the domestic economy was stagnant and many businesses. and giving low interest rate loans to banks from the central bank. it tried to substitute imports and export high value-added HCI products.58 Corporate Governance and Finance in East Asia. the emergence of competition of other low-wage.6 billion between 1973 and 1981 into these sectors. machinery (including automobiles). These included rescheduling business debts. and chemicals—as future core industries.
Chapter 2: Korea 59 through state-controlled banks. imports were further liberalized while tariff rates were lowered. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. The plan of the 1970s was thought to be successful in the long run. New start-up firms. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. In order to improve economic efficiency. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. the Government adopted comprehensive measures to promote economic stabilization. This required industrial restructuring by the Government. including forced liquidations and mergers and acquisitions (M&As). fiscal expenditure maintained zero growth. coupled with political uncertainty due to the assassination of President Park in 1979. price controls were abolished. and the large excess capacity of HCIs. Economic Liberalization and Globalization: 1980-1997 In 1979. the policy wasted substantial amounts of resources in the short and medium terms. The severe world recession caused by the second oil shock. Meanwhile. The growth rate of the money supply was reduced drastically. Macroeconomic policies became hostages of the industrial strategy. especially between 1979 and 1985. However. faced with high inflation. Firms that followed the Government expanded greatly. the Government restructured some large businesses through forced liquidation and M&As. met increased difficulty. with many turning into the now well-known chaebols. various measures to increase competition were taken.2). such as widespread underutilization of capacities of HCIs and related plants. a heavy foreign debt burden. including denationalization of banks. In 1986-1989. Meanwhile. and their utilization ratios were very high. low . exacerbated the overcapacity problem. The two important ones were import liberalization and deregulation of the financial sector. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. Cheap credit and distorted prices resulted in overexpansion in the HCIs. Such an approach gave the Government increased control over the economy. as it had to control only a few large chaebols. The incentives available became more market-based. however. Evaluations of HCI promotion policies are mixed. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980.
60 Corporate Governance and Finance in East Asia. 2.” A large-scale business group is called a chaebol. In 1990.2 percent.1 percent.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. In 1988.9 percent. the Government committed itself to further liberalization of the goods and capital markets.9 percent. II world interest rates. The official rate fluctuated within a band. giving up its foreign exchange controls related to the current account. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. 46. with the 30 largest in the total economy in 1997 standing as follows: value-added. while continuous and large current account surpluses saved Korea from the foreign debt problem. further increasing its pace of import liberalization. 13. and acceded to the World Trade Organization (WTO) in 1994. 4. 45.3 percent. The Government tried to adjust economic policies and regulations to meet global standards. total debts. total sales. the importance of chaebols was increasing. whose business activities are controlled by an identical person. and total workforce. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. 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). Korea began participating in many multilateral trade negotiations during the Uruguay Round.1 percent and average tariff rates 8.9 percent. in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. 47. total assets. Industrial and trade policies were modified to be consistent with WTO. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. The most important element characterizing chaebols is the concentration of ownership.2. the import liberalization ratio reached 98. . By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. Vol. Meanwhile. The low value of the dollar led to a low won and high yen. In 1993. and declaring that it would follow Article XI of GATT. which gradually widened. but it chose to liberalize gradually. and low oil prices. Korea adopted a market average exchange rate system.
In the mid-1970s. However.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. Since the 1960s. of Subsidiaries per Chaebol 20. In this sense. Important managerial decisions are made primarily by owners. the ownership and management of a chaebol’s subsidiaries are not separate. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. .8 22. From the standpoint of the Government. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries.1 20. This galvanized the fast growth of chaebols. chaebols that maintained a close relationship with the political authorities were able to grow fast. Table 2. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols.3 Subsidiaries of the 30 Largest Chaebols. of Subsidiaries 604 616 623 669 Average No. financial assistance. 1993-1996 Year 1993 1994 1995 1996 No.3 Source: The Fair Trade Commission. it was more effective to deal with a small number of companies to secure tangible outcomes. and tax breaks to key industries to promote exports and industrial upgrading.Chapter 2: Korea 61 War II. the number of subsidiaries declined drastically due to corporate restructuring. Chaebols are also excessively diversified.when the Government put a great deal of emphasis on development of the HCIs. One reason for this controlling power is inter-company shareholding among subsidiaries. Since the Government controlled most business activities. and they are aided and supported by one another. after the financial crisis. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. The Government provided subsidies.5 20. reaching 669 in 1996. Table 2. This policy contributed greatly to the expansion of chaebols. Chaebols have a history of substantial concentration of ownership.
Under this law. diversification can make chaebols stable through the portfolio effect. They had to meet certain requirements in terms of firm size. in addition to the usual economies of scale. 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. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. 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.2.3 Role of the Capital Market and Foreign Capital In the 1960s. including the “economies of organizational size” inherent in multi-product and multiplant firms.62 Corporate Governance and Finance in East Asia. Since chaebols are engaged in many different businesses. 2. . listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. In the early years after the enactment of the law. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. Meanwhile. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. years since establishment. which may ultimately lead to the decline of social efficiency. However. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. and were allowed extra depreciation charges for tax purposes. II Theoretically. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. chaebols can benefit from synergies. profitability. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. they can reduce uncertainties and dilute risks through sharing of information and diversification. Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. there are many negative assessments of organizational structures and practices of chaebols. For example. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. This could ensure their stable growth and enhance their investment abilities. etc. On the other hand. Vol.
Inc.6 747.370 70.0 79. The policy to expand the size of the stock market.476 79.020 151.4 40.9 833.Chapter 2: Korea 63 During the 1980s and 1990s.4 Development of the Stock Market. . several important policy measures were implemented to promote the development of the stock market.4.1 16.570 95. The aggregate Table 2. In this regard.7 934. Third. continued until 1989. 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).5 406. Also that year.217 141. 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. The Korea Fund. As shown in Table 2. First.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. Beginning 1990. 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. the stock market grew rapidly during the 1980s. 1985-1998 No.0 49. however.1 30.. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.4 654.989 137.151 117. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. 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.798 Market Capitalization as a Ratio to GDP (%) 8.0 965.2 44.1 Market Capitalization (W billion) 6. the Government announced the gradual opening of the capital market to foreign investors in January 1981. a country fund.9 34.9 918. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. Second. Because of government policies and the booming economy.
150 5.785 (1. The growth in the number of listed firms also slowed in the 1990s.123 3. but increased sharply to 79.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.017) 1. and stayed at the 30-40 percent level up to 1996. trade credits.650 (1. but rose again to 34.347 3. Table 2.714 1. 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. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.455) 13.858 4.868 (518) (418) 63 1.382 Permit basis.008) (3. Table 2.326 1.296) (6.817 16.414) 5. and other liabilities.500 7.86 percent of GDP in 1997.352 471 3.59 percent in 1998 and to more than 50 percent in the early months of 1999.658) (3. 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 1986-1989.413) 56.642 21.870) (1.875 21.141 4.542) (1.085 2.5 Private Capital Flows to Korea.64 Corporate Governance and Finance in East Asia. Other investments include loans. II market value of all listed firms represented only 8 percent of GDP in 1985.546 (2. and 1993. However.571 2.433) (9. The aggregate market value of listed shares bottomed at 16.183 12.553 8.450 24.2 percent by 1989.126 (1. The relative size of the stock market diminished to 44 percent in 1990. currency and deposits.742 (3.852) (2. .800 (7.339) (9.239 19.953 10.287 (340) 73. Vol. Source: Balance of Payments. Bank of Korea.453 (2.440 1. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.944) 8.149 13.255 2.694) 2.910) 2.583 25 10.264) (3.942) 42.534) 1.924 (1.001 4. due to declining stock prices.338 4.737 (333) (297) (607) (2) 218 2. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.
2 percent in 1987. The contribution of the corporate sector to GDP was 73. Net private capital inflow. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. other net private capital inflows amounted to $130 billion during 1985-1998. The ratio is generally in the same range for Japan and Korea. Return on equity (ROE) and return on assets (ROA) showed similar patterns.6).7 billion and loans $42.5). but between 1988 and 1993. the growth rates of equity and sales dropped sharply in 1996 and 1997. and sales of the aggregate sector during this period were very high (Table 2. Of this. and (iii) chaebols.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. weak incentives for attracting FDI. Between 1986 and 1989.2. The dismal performance of the Korean corporate sector compared to the .China and the US. In addition to FDI. Korea had substantial current account surpluses and experienced net private capital outflow. but dropped in 1996 and were negative by 1997. Corporate sector net proft margins increased from 1993 to 1995. (ii) listed firms. This indicates that a substantial proportion of debt was denominated in dollars. excluding FDI. equity. Profit rates of Korean firms were relatively low compared to those of Taipei. Taipei.Chapter 2: Korea 65 Complicated government regulations. 2. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. and US. portfolio investments amounted to $73. following the sharp depreciation of the won. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2.China. Japan’s was consistently higher. Table 2. The growth rates of total assets. and high production costs were the main reasons for low FDI in Korea. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.6 percent in 1997. increasing to 76 percent in 1997.9 billion. However. This would lay the foundation for evaluating the effect of corporate governance on performance. The same categories will be analyzed in later sections.
4 10.1 6.8 22.1 8.1 2.5 1.9 2.4 2.2 18.0 7.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.6 4.0 13.9 5.2 13.4 4. Financial Statement Analysis Yearbook.3 14.4 1.9 2.7 15.7 1.9 4.1 — — — = not available.9 3.3 17.0 13.3) 5.9 5.2 1.7 3.3 6.2 9.9 16. Financial Statement Analysis Yearbook.5 3.6 1.3 11. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities). Source: Bank of Korea.Table 2.3 335.9 5. Net profit margin = ratio of net income to sales.8 1.8 2.9 2.0 8.8 8.3 1. ROA = return on assets (ratio of net income to total assets).3 21.6 13.0 3.8) 297.9 13.5 1.5 4.7 2. Source: Bank of Korea. .3 312.4 1.0 0.1 5.7 4.4 — 6.4 19.0 6.8 1.0 (0.3 3.7 3.2 19.7 325.2 1.4 2.0 4.3 — 3.2) (0.9 16.7 4.2 1.5 (0.4 1.6 3.5 1.6 424.5 2.9 8.6 (4.5 4.5 7.8 3.1 2.6 318.9 18.5 0.7 4.6 1.6 9. ROE = return on equity (ratio of net income to stockholders’ equity).China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.4 2. Table 2.9 18.9 3.3 308.8 21.0 10. 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 23.7 15.0 305.6 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).9) DER = debt-to-equity ratio.3 21.1 2.2 13.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.
A comparison of performance by firm size reveals some interesting results. 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. Profit rates of most industries are also quite low.4 percent.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits.5 percent while the aggregate sector recorded only 13. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. The manufacturing. However. but higher than that of small firms. and steam supply industry. sales of listed firms grew 18.10). This preference of Korean firms has its roots in the structure of corporate governance.8). trade. a year ahead of the other industries. while their average net profit margin was lower than that of medium firms. Small listed firms were hardest hit by the financial crisis. The other financial ratios follow the general pattern of the aggregate corporate sector. Performance followed similar patterns across different industries (Table 2. In 1997.9). gas. and transport sectors recorded negative profit rates in 1997. with equity in wholesale and retail trade even contracting. both ROA and ROE were lower for the listed firms compared to the latter.and small-scale firms (Table 2. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. with the wholesale and retail trade sector and the construction sector having the highest figures. followed by mediumsized firms and large ones. the exception being the electricity. 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. Again. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. ROEs. All sectors experienced a sharp decline in equity and sales growth in 1997. The growth performance of large firms for the 1988-1997 period was better than that of medium. In most years. Net profit margins. Growth rates of total assets are generally high. construction. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. the average ROE was lowest for large firms.6). Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. However. It is notable that the construction sector’s profit rate began its decline in 1995. .
1 0.8 22.8 16.8 2.6 14.5 1.9 340.0 1.1) (3.0 1.2 0.5 14.0 15.1 16.3 15.3 15.4 3.2) 6.4 15.6 0.4 291.7 (3.7 30.0 (4.2 2.9 (0.5 1.2 20.9 13.5 5.3 15.5 (0.5 286.0 37.5 483.1 (0.7 7.8 23.5 28.7 21.8 17.5 19.2 7.8 345.9 (0.0 3.3 25.6) (6.7) 2.1 27.4 458.7 520.0) 0.8 0.9 3.5 1.0 22.4 10.1 (0.8 7.4 17.8 14.3 285.1 17.8 14.4 740.4 .4 0.0 7.9 (0.2 315. Renting.3 15.2 0.1 22.0 9.8) 0.9 5.8 526.0 2.7 (0.0 24.8 22.4 1.4 10.5 5.8 2.4 5.5 13.6 14.0 16.9 16.8 12.6 2.2 5.5 3.3) (1.0 2.5 1.0 22.8 616.1) 3.2 5.5 432.2 16.0 22.7 16.6 1.0 5.4 14.7 5.3 13.4 1.0 23.2 0.3 18.3 10.4 12.1 396.7 514.9 16.0 1.8 24.5 270.8 562.8 461.0 2.2 20.3 8.4 0.5 4.1 0.6 17.4 2.1 296.7 17.3 14.9 2.4 10.2) 22.8 13.3 14.1 1.0 254.9 10.8 10.9 2.3 288.8 Real Estate.8 1.4 2.9 10.1 290.4 350.2 16.1 1.9 9.2 (1.1 21.2 6.2 423.6 12.7 1.3 11.5 6.3 2.5 569.9 0.8 16.4 10.0 1.8 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 13.4 2.2 24.7 317.4 4.7 0.4 2.1 1.9 31.3 1.4 5.8 3.8 302.2 25.0 1.1 2.3 8.5 (5.9 1.5) 0.6 3.9 19.0 (0.6 3.3 31.0) 1.6 655.3 8.2 241.1 20.7 9.1 28.6 1.1 7.1) 0. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.2 12.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.3 1.7 22.0 (0.6 12.2 18.6 24.8 2.1 2.7 4.9 538.6 6.0 19.0 12.9 14.8 32.9 16.0 245.Table 2.8 35.0 5.4 (0.1 0.1 1.7 228.6 318.1 10.5 473.5 27.4 9.8 24.6 375.5 1.2) 15.3 11.6 7.3 2.2 15.2 36.6) 3.8 0.0 1.3 10.2 5.9) 1.0 1.3 8.6 15.0 15.0) 4.0) 0.6 5.0 2.8 16.2) (0.4) 0.6 16.0 16.6 0.2 6.6 17.7 294.4 474.6 14.5 306.8 1.5 30.0 18.8 3.5 1.0 21.9 25.0 18.5 338.5 23.8 10.5 6.9 29.6 11.9 428.5 16.5 (1.8 34.7 10.4 2.4 348.0 24.4 5.8 12.5 239.
4 1.3 3.6 6.5 612.9 10.4 6.4 3.7 11.9 9.4 341.4 15.1 16.9 8.9 4.3) 11. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.4 (2.6 2.2 18.6 172.4 14.8) 1.2 18.6 8.4 11.3 1.1 12.9 17.4 7.0 13.0 21.5 13.5 4.0 (1.9 321.3 8.1 11.9 1.Table 2.8 14.4 1.9 18.062.3 4.2 15.0 2.5 12.9 17.5 14.5 (2.6 4.2 3.2 — — — — — 2.8 3.9 12.0 5.7 12.8 12.8 6.2 14. Source: Calculated using data from Bank of Korea.5 30.8 111.0 (15.3 0.1 (11.5 11.3 34.8 9.6 19.6 1.3) (1.6 — — — — — 0.0 14.4 12.4 16.2 143.7 11.1 (2.6 9.9 3.8 (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 — — — — — 31.6 4.2 7.8 0.3 1.4 633.4 2.5) 22.4 21.6 34.3 112.9 (10.3 12.6 8.1) (0.7 20.9 9.1 17.8 529.3 4.4 — — — — — 448.1 323.5 117.8 12.3 (2.6 12.1) (0.6 (2.6 (2.8 15.7 7.0) 1.0 Transport.4 3.3 8.4 9.1 1.2 10.8 11.4 0.7 2.8) (12.4 1.8 14.3 543.3 18.0 5.7 0.3 524.6 6.6 0. .8 7.1 6. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.9 6.6 20.5 14.2) 0.7 11.3 — — — — — 10.4 6.5 11.7 16.1 (0.1 2.5 482.2 10.3 125.7 14.7 2.3 23.7 0.1) 1.1 8.4 13.6 16.9) (8.7 187.6 6.5 16.9 8.6 1.2 14.0 106.4 30.5 15.2 18.9 4.7 116.6 19.3 4.0 14.6 9.6 — — — — — 17.2 2.4) (1.5 462.0) (0.3) 15.4 7. b NPM denotes net profit margin. Financial Statement Analysis Yearbooks.1 3.5 0. Storage.3 740.0 1.5 344.9 332.2 122.6 512.1 21.2 1.6 8.9 12.0 89.2) 13.0 921.0 1.3 18.0 98.7) 0.1 15.0) 1.8 8.6 3.1 14.5 47. Gas.7 — — — — — 14.4 367.7 15.1 15.0 7.2) 9.5 539.9 18.8 0.6 15.8 3.1 11.6 9.4 0.4 (0.2 10.4 2.4 10.7 19.5 15.3 2.5 8.5 307.9 (11.9 10.7 — = not available.6 14.0 1.3 0.7 510.8 4.4 0.6 21.9 Electricity.3 19.6 18.5 26.5 14.1 15.8 6.5 2.2 698. a New equity does not include capital surplus.0 2.4 12.2 90.6 12.5 14.9 7.3 17.7 7.2 11.4 169.3 9.4 3.7) (4.9 456.1) 5.3) 4.1 4.
It should also be noted that when the financial crisis struck in 1997. Kis-Fas. of which 16 were publicly listed (Table 2.8 5. In 1995.1 1.5 ROE 3.7) 0. 1985-1997 (percent.9 percent).9 11.6 (1. 1998.6 and 2.70 Corporate Governance and Finance in East Asia. debts (47.0 0.4 1.2 9.0 3.9 2.3 2.9 1.4 1. had 46 member companies. and close to half of total assets (46.5 5. Chaebols have been the most important actors and engines of growth in the Korean economy.9 Source: Constructed using data from Korea Investors Service.5 19. The number of Hyundai member companies rose to 57 in 1997.11). The criteria for selection of largest chaebols have changed a few times.1) 4.6 22.7 Net Profit Margin 0.9 0. In 1997. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.1 percent of the economy’s total value added (excluding the financial sector).1 1.4) 1.4 0.12).3 4.9 2.5 19.3 percent). Between 1993 and 1997. Performance of Chaebols This section uses available data on the top 30 chaebols.4 2. the largest chaebol.1 6.6 0. the 30 largest chaebols accounted for 13.7 (5.4 1.4 22.2 0. Vol.2 2.8 24.9 21.9 Growth and Financial Performance of Listed Companies.5 0.2 9.2 6. The top five chaebols registered the highest growth rates. the top 11-30 chaebols experienced a decline of . of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. followed by the top 6-10 (Table 2.3 15. sales (45. II Table 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.8 0.3 (0.3 20.7 percent) of the corporate sector. but the number of designated groups has been fixed at 30 since 1993.6 2.6 1. and net profits (46.12). The smallest group had 16 members in 1995. Generally.0 18. Hyundai Group. it is the chaebols’ large firms that are listed.8 6.5 ROA 0.6 23. of which four were listed.7 1.6 3.9 6.9 26.9 percent).3 0.7 1.
6 3.3) 5.10 Growth and Financial Performance of Listed Companies by Size.1 2.2) (1.6 2.6 3.8) 1.7 (0.0 16.6 1.2) 0.7 2.4 2.6 2.1 1.0 19.5) 1.3 3.8 6.7 3.0 1.7 2.3 Medium 14.0) 1.5 0.3 11.8 17.0) 0.8 10.4 1.4) 1.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.9 2.2 12.1) 5.9 0. 1988-1997 (percent) ROE Large 9.7 1.3 (0.8 16.7 (1.9 22.5 3.7 (1.1 2.2 Small 13.4 5.3 1.9 6.3) 0.8 6.8 1.8 0.9 2.9 0.5 17.9 0.8 3.2 13.5 25.0 (4.9 14.3 6.4 3.8 (5.3 15.2 7. 1998.2 0.4 1.2 3.2 1.4 11.6 1.9 2.4 Medium Small Large Medium Small ROA Growth Performance Large 17.0 10.4 16.5 2.8 0.5 5.9 1.6 (1.6 9.6 7.5 1.0 1.2 10.9 3.6 13.8 0.0 17.2 2. .9 25.3 (0.6 5.1 8.8 0.0 1.9 6.6 8.5 (1.1 11.1 0. Kis-Fas.3 9.5) 1.0 15.9 (0.3 15.0 4.6 0.8) 6.6 0.8 7.6 2.2) (1.6 6.6) 0.2 13.6 (0.9 1. Others are medium firms.7 18.9) (6.Table 2.2 (0.7 4.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.4 6.9 5.5 5.2 2. Source: Korea Investors Service.0 6.0 1.6 1.4 3.
398 — 2.761 31. Source: Fair Trade Commission.090 6.651 38.147 5.798 — No.364 5.458 6.177 — 6.Table 2.766 3.640 4.129 2.445 4.990 2.180 2.11 Features of the 30 Largest Chaebols Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43.677 3.309 14.599 — 2.756 5.774 7.287 10.853 1997 53.743 40.433 3.427 9.910 3.873 2. of Listed Companies 1995 16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4 — = not available.246 11.117 4.574 3.158 7.995 2.303 3.951 3.597 351.967 7.158 1.423 5.956 3.395 31.475 2.501 13.346 3.996 1.927 16.929 12.131 3.924 2.690 3.376 35. .313 14. 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.457 14.486 6.370 6.935 2.455 22.
2 0.7) ROE 5.2 (16.1) (0.1 10.7 1.6 1.1) (1.4 (2.2) (2.1) (0.6 Financial Performance Net Profit Margin 1.7) Source: Bank of Korea.0 19.9 3.9 18.1 19.0 2.6 18.2 (2.5) (0.0 31.9 20.2 3.8 Assets 12.9 20.4 0.3 16.0) 12.2) 1.1 2.3 3.5 32.7 4.4 38.2 11.2) (0.3 0.3 11.7 15.3 9.3 15.5 27.8 27.1) 0.5 19.1) 0.3 1.6 (0.3 14.9 24.4) (14.2 0.4 30.5) (0.12 Growth and Financial Performance of the 30 Largest Chaebols.2 (5.7 15.6 19.8 18.7 0.8 0.7 10.3 19.6 4.5 (0.3 1.3 0.9 3.1 (1.5 5.0) 3.1 (2.4) 1.9 1.0 0.2 (2. . 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 12.0 0.0 6.4 26.3 27.Table 2.4 12.1 27.6 25.1 (3.0 1.7 10.5 2.2 1.0) ROA 1.2 20.0 2.0 17.5 20.9 17.2 0.5) (0.7 13.4) (0.0 2.3) 0.
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. . resulted in the chaebols’ excessive leverage.” This “identical person. However. coupled with weak corporate governance. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. and government intervention interacted through a set of laws and regulations to bring about the existing structure. There has been a wide range in DER among chaebols. Vol.” in Korea’s legal and regulatory framework. However. a pyramidal structure of corporate ownership is prevalent. except for 1995.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea.3. in this instance. weak corporate control.765 percent (Table 2. internal and external control mechanisms. his/her relatives.74 Corporate Governance and Finance in East Asia.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. Ownership patterns. 2. from 190 to 3.95 percent.7 percent growth in total assets. loopholes and inconsistent policies spawned strategic behavior and agency problems. chaebols had a higher average DER than the corporate sector as a whole.5 Founding families are mostly still the largest shareholders and. 2. II 2 percent in their sales and a very low 4. and vulnerable balance sheets. and the companies that are under the control of the largest shareholder. Their worst year was 1997 when ROE hit -15. the average DER of the 30 largest chaebols reached 519 percent. it refers to the degree of concentration and shareholdings in the hands of an “identical person. By the end of 1997. technology. The absence of a well-developed equity market and the provision of subsidized credit. 5 While “ownership concentration” can be defined and measured differently in different contexts. and led to a high concentration of ownership. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. Only the top five chaebols registered a positive net profit margin in 1997.13). The better showing of the top five chaebols was a direct result of their dominance in human resources. and access to credit. In general. includes the largest shareholder. more important. The Commercial Code stipulates the basic governance framework and applies to all corporations.
2 924. Ssangyong 7.7 621. Lotte 11.7 267. Hanjin 8. Kumho 12. Kumho 12.4 175.2 292. Sunkyung 6.244. Dongah 14. Kolon 21. Kukdong Construction 29. Daewoo 5.Table 2. Ssangyong 7. Hanbo 15.2 346. 1995-1997 (percent) Chaebols 1995 1. Tongyang 22.7 620.0 436.6 936.2 423.6 409.7 416.855.5 464.9 321.5 2. Hyosung 18. Hanjin 8.441.3 297.6 516.13 The Top 30 Chaebols’ Debt-to-Equity Ratio. LG 4.8 313. Jinro 20.2 2. Byucksan 1996 1.1 278.1 3. Hanil 28. Dongbu 24.4 192.2 328.6 2.1 190. Doosan 13.3 315.6 . Samsung 3. Sammi 27. Haitai 26.8 336.1 385.3 572. Newcore 30.2 471.5 3.4 622. Sunkyung 6.3 328. Lotte 11. Dongkuk Steel 19. Jinro Debt-to-Equity Ratio 376.4 556.5 343. Hyundai 2. Samsung 3. LG 4.9 751. Hyosung 18. Dongah Construction 16. Hanwha 10.7 688.0 486. Hansol 17. Daelim 16. Hansol 23.1 674. Kia 9.1 477.0 218. Dongkuk Steel 19. Hyundai 2. Halla 17.0 370. Kohap 25.4 205.5 337. Halla 13.764. Kia 9. Daewoo 5. Daelim 14.5 383. Hanwha 10.0 506.065.8 312.7 354. Doosan 15.
Financial Statement Analysis Yearbook.1 359. Hanil 28.13 (Cont’d) Chaebols 20.7 1.5 386.214.9 578. Keopyong 29.1 375. LG 5.8 658. Tongyang 24. Keopyong 29. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.9 1. Lotte 12.4) 513.6 Sources: aFair Trade Commission. Kolon 19. Daelim 14. Haitai 25.784. Anam 27.600. Kamgwon Industrial 30.6 424.0 505.5 (893.501. Daesang 27.7 944. Hansol 16.4 1.9 490. Tongyang 24. bBank of Korea. .3 676.0 305.8 590.1 472.3 399. Hyundai 2.5 261. Daewoo 4.1 433. Samsung 3. Doosan 15.1 438. Jinro 23. Ssangyong 8.9 216.0 419.0 907.5 (1.6 478.5 1.8 338.9 472.3 1.6 416.498. Haitai 25. Kolon 21. Hyosung 17.8 468. Newcore 28. Dongbu 23. Anam 22. Kohab 18. Kumho 10.5 519. SK 6. Miwon 30. Shinho 1997 1. Halla 13.8 399.5 576.225. Dongah 11.7 370. Dongkuk Steel 20. Dongbu 21. Shinho 26.8 647.5 323.6 335. Hanwha 9.8 347. Newcore 26.8 307.9 465.6 590. Hanjin 7. Kohab 22.5) 404.3 347.Table 2.
and state-owned companies and securities companies declined. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. and then steadily declined after 1993. including investment trust companies. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. Beyond that range. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. including banks and other financial firms. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. managerial entrenchment becomes more likely. the ownership structure can bring about an incentive effect. while those owned by banks. Among listed nonfinancial companies. the entrenchment effect outweighs the incentive effect. The holdings of financial institutions.6 percent by 1997. However.1 percent. the year the stock market was in a frenzy due to buying sprees.” followed by banks. Theoretically. the percentage of holdings by individuals slipped to 60. with a given range of managerial shareholdings (for instance. the extent of ownership by these individuals declined gradually after 1988. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. The next important group was “other corporations. the Government. fluctuated widely during the period. The pattern of distribution changed little through 1992-1997. that is. However. i. individuals were also the largest shareholder group.14). and insurance companies increased during the period. resorting to extensive use of pyramiding to maintain control.7 percent by 1997. but their shares declined to 21. the incentive effect once again dominates. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. The percentage of shares owned by “other corporations.” foreigners.e.. The reduction can be . large ownership can also bring about the entrenchment effect.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. Composition of Ownership Among listed companies. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2. From 69. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. Thus. 10 to 30 percent).
8 5.9 15.3 8.3 18.6 8.2 17. and finance companies.1 1.0 9.8 5.5 12.6 20.3 17.4 5.2 7.5 7.0 5. Listed Nonfinancial Companiesd 1988 406 0.5 1989 498 0.2 8.9 36.2 18.8 17.4 18. merchant banks.0 28.4 6.1 17. c Data from Korea Stock Exchange.0 4.0 8.1 8.6 9.” includes commercial banks.2 5.2 9. d Constructed from data files of the Korea Listed Companies Association.2 3.0 5.b A.2 B.7 6.1 10.3 1994 521 1.1 60.7 3.6 16.2 1993 511 2.8 4.2 2.14 Ownership Composition of Listed Companies.6 13.2 1. etc.3 17.5 4. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.1 11.3 5.8 69.5 16.4 13.2 5.6 16.6 Year No.4 1997 551 1.3 18.4 14.6 16.1 4. of Firms The Statea Banks.1 2.1 18.2 4.6 22.6 36.8 59.4 13.0 59.8 59.5 Note: Ownership is based on number of shares.6 19. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.4 34.7 4.6 12.6 1991 505 0.5 1.9 17.Table 2.5 18.5 1992 508 2.3 39. etc.3 1.7 1990 531 0.7 7.2 9. mutual savings.9 2.1 8.0 27.5 62.5 1.8 2.9 26.5 6.5 60.9 19.9 5. b “Banks.7 8.5 7.6 9.0 7.4 5.9 37.1 68.9 1.1 3.1 21.9 2.0 60.1 21.8 1995 548 2.7 9. investment trust companies.4 Insurance Firms Other Corporations Foreigners Individuals 39. a The State covers the Government and state-owned companies.7 59.8 17.7 18.2 8.7 14.3 1996 570 2. .8 2.3 26.9 4.9 1.3 5.3 2.7 9.3 1.5 6.6 2.1 18.
Compared with its holdings in all listed companies. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation.15). and small companies. indicating their increased investments particularly in the service industries with high growth rates. foreign holdings were derived from purchases through country funds and direct capital investments. as distinguished from individual and foreign investors. 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. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. The holdings of other corporations are mainly equity investments in affiliate companies. Before such liberalization. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. financial institutions had more shares in the manufacturing sector than in primary industries.8 percent of listed shares in 1997. held 26. Institutional investors. medium.18). 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. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. government ownership in nonfinancial companies was remarkably smaller and more concentrated. In most instances. This is low compared with those in Japan. other corporations’ holdings shifted toward service industries. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. did not vary significantly (Table 2. whether partial or absolute. UK.16). categorized into large. In 1998. and US (Table 2.17). of some banks. Corporate holdings averaged 16 percent throughout 1988-1997. The ownership distribution in listed nonfinancial firms. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. Over the years. Individuals held the majority of the shares in all industries except in telecommunications. However.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. This trend can be explained by government ownership. indicating their heavier reliance on inter-firm financing investments. In general. electricity. and service of motor vehicles (Table 2. However.
2 1.0 0.5 7.3 4.1 65. Gas..2 1.9 52.8 3.9 10.3 6.8 1.6 1.5 12.9 60.4 8.9 59.7 2.8 7.0 — 0. Paper.5 6.4 8.2 22.0 9.7 59.5 85.1 0.4 0.8 7.8 Individuals 83.3 57.3 10.5 17.8 5.2 0.3 1.3 2.3 1.9 1.0 1.6 11.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.9 42.5 — 0.3 0.0 9.9 4.0 2.4 56. Etc.7 14.15 Ownership Composition of Listed Nonfinancial Firms by Industry.5 0.7 63.5 — 1.9 23.0 20. and Printing Pulp.2 — 0.2 54.5 — — 0.1 88.4 62.6 3.3 0.1 4. Motor Vehicles Electricity.3 7.8 6.1 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 55.8 3.8 7.4 14.7 20. Paper.5 0.9 16.7 2.4 5.7 29.8 8.3 2.3 9.4 Banks.Table 2.4 1.0 8.9 1.1 19.1 0.2 7. Rubber.6 18.9 0. and App.4 8.2 9.6 8.1 27.5 4.2 0.1 8.5 19.7 22. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.8 7.9 19.7 2.6 24.0 7.8 73.3 13.4 2.7 6.4 — 0.3 38.1 8.0 10.2 0. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.2 — — 0. Elecl Mach.0 9.4 56.3 62.3 11.7 64.2 9.1 1.9 66.4 7.8 7.5 3.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.2 2.0 — 39.2 9.6 — — 2.1 0.0 9.5 0.6 5.2 17.1 10.2 64.7 22.9 15.1 7.5 0.7 17.4 1. and Printing Chemicals.7 14.7 1.3 0.9 8.7 20.2 0.
4 45.6 3.3 8. Source: Constructed from data files of the Korea Listed Companies Association.1 — 0. Note: Ownership is based on number of shares.6 0.5 0.6 5.6 2.6 2.7 19.8 2.9 20. b “Banks.6 — = not available. Elecl Mach.3 57.7 23.7 2.9 1.9 2. and Printing Chemicals.9 7. and finance companies.5 — 2.0 5.6 0.8 5.9 20.” includes commercial banks.7 5.4 2.3 15.4 20.6 1.2 8.1 3.8 2.3 31.5 12.4 76.4 — 1.0 3.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.9 5.3 0.9 5.5 7.2 1.2 1.5 1.2 49.5 63.0 4.0 60.4 3.1 4. Motor Vehicles Electricity.7 2.7 2.0 11. .4 16.8 5.8 4.4 58.6 20. Rubber.7 4.2 4.6 6.0 6.3 6. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.3 7.0 6.9 1.1 18.6 60.2 3.1 9.4 1.4 43.5 59.1 2.9 69.1 6.0 1.9 7.8 57.6 14.1 25.2 0.3 2.2 7.3 1.0 43.6 18.9 6.8 12.9 2.5 4. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.5 3.6 2.8 11. Paper.4 2.2 5.4 2.1 54.4 6.9 2.2 6.0 7.9 0.2 13. mutual savings. a The State covers the government and state-owned companies.9 18.6 75.7 17.8 2.8 3.6 59.5 4.4 9.5 6.6 7. and App.9 6. investment trust companies.1 2. and Printing Pulp.0 8. merchant banks.4 0.2 23.8 0.8 54.7 6.4 4.2 4.2 0.7 1.4 1.9 2.2 4.9 57.1 1.9 1.1 1. Paper.9 78.3 1.1 — 1.2 4.3 6.78 81.7 2.5 5.3 60.1 3.5 3. etc.1 9.5 3.8 27.8 0.4 58.4 1. Gas.5 3.3 65.4 4.8 6.2 5.4 68.6 6.
17 Ownership Composition of Listed Nonfinancial Firms by Control Type. Others are medium firms. .4 1.4 2.5 6.4 21.8 3. 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.9 2. 1997 (percent) The State 1.5 8.5 4.7 Control Type No.3 6. etc.8 4.5 18.5 62.0 6. mutual savings.0 Other Corporations 16.8 4. and finance companies.8 6.Table 2.8 1.0 1. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.6 60.1 6.7 0. b Table 2.9 5.7 8.2 1.4 5.7 6.4 17. c “Banks.4 5. Securities Firms Insurance Firms 2.3 Banks.4 4.” includes commercial banks.5 Individuals 60.8 60.4 61.16 Ownership Composition of Listed Nonfinancial Firms by Size.1 8.1 2.9 4. Source: Constructed from data files of the Korea Listed Companies Association.5 19.7 1.4 61.c Securities Firms Insurance Firms Other Corporations Individuals 58.5 16.4 Firm Sizea No. etc. etc.8 2.4 2. The State covers the government and state-owned companies.7 Foreigners 4. merchant banks.7 4.6 16. 1997 (percent) The Stateb Foreigners 4.5 2. investment trust companies.1 Banks.
Generally.4 26. investors (Table 2. defined as those holding less than 1 percent of shares. corporations held 70 percent of the controlling blocks of shares. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. Institutional Investors 42. the majority shareholder group in all listed companies consists of the corporate.18 Ownership Composition of Listed Firms in Selected Countries. including those of the largest shareholder.7 16. minority shareholders.6 Foreigners 9.China United Kingdom United States Source: Stock Exchange of Korea.20).8 9. In 1997. only closed-end investment companies and traditional investment trust companies are allowed.1 financial institutions’ establishment of corporate pension fund accounts. But these may .3 47. Among nonfinancial listed firms. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.3 54. 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. At the moment.5 20.Chapter 2: Korea 83 Table 2.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.1 8. while family members accounted for only 30 percent.8 10. for example.6 39.8 56. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. rather than the individual.5 45. and the companies under the control of the largest shareholder. his/her family members.3 6.6 Individuals 23. Foreign holdings of Korean shares were 9. 1997 (percent) Country Japan Korea Taipei.19). This has had profound implications for corporate governance and the market for corporate control in Korea.
9 7.8 8.1 28.9 33.1 4.2 2.0 1.3 Subtotal 5.9 6.3 18.7 44.1 21.1 37.8 Individual Subtotal Other Shareholders Corporation 3.8 72. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.7 7.4 3.0 69.0 66.7 6.2 26.2 2.Table 2.1 32.1 5.4 5. and the companies under the control of the largest shareholder. .19 Ownership Concentration of All Listed Firms.6 46. Source: Stock Exchange of Korea.3 30.0 29. 1992-1997 (percent) Majority Shareholders Corporation 15.0 4. his/her family members.0 22.1 14.1 15.6 2.7 16.6 22.9 2.5 43.6 5.8 73.4 7.1 23.6 26.9 32.1 5.2 Minority Shareholders Subtotal 71.0 25.6 73.7 18. Minority shareholders are those holding less than 1 percent of shares.9 Individual 2.0 2.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.9 3.3 2.7 Note: The majority shareholder includes the largest shareholder.
20 Ownership Concentration of Listed Nonfinancial Firms. which held less than 1 percent of a company’s outstanding shares as of 1997. In most industries. rubber and plastics. ownership was relatively diffused due to government regulation. in the small firms. The practice of hidden shares seems to have been less prevalent in recent years.1 50.5 12.Chapter 2: Korea 85 Table 2. Ownership concentration tended to be lower in large compared to medium and small listed firms. In such cases.9 29.8 54. and mining categories. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.3 62. Across industry.0 58.4 Source: Constructed from data files of the Korea Listed Companies Association.9 25.8 Majority Shareholders 27.6 57.5 60. 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 2.6 58.5 13. hiding shares offers no additional tax or other benefits.7 18. Meanwhile.9 Other Shareholders 18.2 15.8 12. 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 2.21]).8 25. have been underestimated because it was widely believed that the largest shareholder often had hidden shares registered in the names of relatives and subordinates of the company.22). thereafter.0 22. . Besides. minority shareholders.9 48. collectively owned less than 50 percent of an average firm.9 27.5 23.8 57. In telecommunications. the Government has retained a large number of shares.4 23.3 25. It was highest in medium-sized firms before 1993 and.8 28. Majority ownership is also high in the chemicals. the majority owner held more than 20 percent of an average firm.9 12.4 28.0 20.6 11.
2 23.9 26.7 29. Elecl Mach. Paper.3 19.1 49.4 11.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.0 54.6 19. and Printing Pulp.8 25. Rubber. Paper.8 31.5 41.7 24.5 23.2 34.2 26.8 51. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.8 41.2 46. .5 44. and Printing Chemicals.8 24.6 50.7 36.5 20.0 51.2 22.9 Minority Shareholders Majority Shareholders Other Shareholders 12.0 39.1 17.6 53.6 38.9 10. Gas.2 19.4 16.3 26.8 55.0 21.5 21.6 34.8 21.5 52.5 47. Motor Vehicles Electricity.7 26.8 44.Table 2.0 30.5 16. and App.2 48.7 17.2 20.3 39.1 43.7 27.1 19.8 29..4 53. 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 36.2 37.5 19.7 21.21 Ownership Concentration of Listed Nonfinancial Firms by Industry. 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.9 44.6 25.
2 52.8 17.5 12.2 26.2 50.7 28.0 55.5 51.9 17.5 28.4 30.8 52.9 12.9 23.3 55.5 10.2 12.1 27.2 11.2 32.3 25.9 55.2 55.7 16.0 24.5 19.7 57.5 19.5 12.8 28.4 30.6 24.0 59.7 31.6 55.8 11.2 21.9 16.7 15.4 30.8 27.1 20.9 60.6 65.8 62.0 66.5 26. .4 51.5 21.9 28.9 21.3 26.1 58.6 11.5 33.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.1 15.4 29.7 14.2 21.8 52.9 22.9 53.7 22.7 17.0 26.1 16.2 21. 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 53.2 56.6 31. 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 26.8 56.5 49.6 59.2 18.1 48.Table 2.6 27.5 Other Shareholders 19.3 27.4 47.8 50.3 19.4 21.5 27.6 62.2 Source: Korea Listed Companies Association.2 Majority Shareholders 26.7 57.9 56.3 21.6 15.
Where direct cross-shareholding is not allowed. The study by Kim. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. If SCS is below the range of 20-25 percent. II Ownership Concentration and Financial Performance J. TQ is above 1. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. and Vishny. is effective control of a certain group of companies even with a smaller investment. J. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. thus a firm creates value. Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. If SCS reaches 10 percent. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. Kim (1992) and Kim. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding.88 Corporate Governance and Finance in East Asia. H. 1988). The Code prohibits a subsidiary company from owning shares of its parent company. They analyzed firms in which controlling shareholders participate as managers. Shleifer. The relationship between TQ and SCS shows a similar pattern. For example. from the standpoint of the controlling shareholder. TQ has a maximum value. if TQ is lower than 1. thus a firm destroys value. which can then pass the equity capital to a third. One of the merits of pyramiding. This type of inter-firm investment. TQ is below 1. Hong. Kim (1992) found the relation between TQ and SCS to be nonlinear. although turning points in the value of firms are different. If SCS is below 10 percent. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. Hong. which is the company holding more than 40 percent of outstanding shares of its subsidiary. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. In Korea. If TQ is higher than 1. one company from a chaebol group could obtain debt payment . often at terms unfair to one of the transacting parties. the firm destroys value. and Kim (1995) reached a similar conclusion. If SCS is above 20-25 percent. it means the firm creates value. Vol. one company can still place equity investments in another. H. TQ increases as the SCS increases. affiliated companies have been able to conduct inter-firm transactions.
5 corporations and two individuals.9 percent of shares. Until recently. and about 11 percent were domestic financial institutions.5 percent of shares. In Table 2. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. For the whole sample. 53 percent were domestic nonfinancial firms. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. or about five subsidiaries each. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. the top 30 chaebols’ shareholding by subsidiaries was 34. Thus. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. together owning an average of 38. Among the subsidiaries or firms receiving investments. for example.5 percent. or an average of 13 firms per company. 62 percent (16 out of 26) had a corporation as the largest shareholder.4 corporations. Among chaebol affiliated firms. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms.Chapter 2: Korea 89 guarantees from other members of the group at no cost. Of the 81 respondents.23. If we define the internal shareholdings of a . 59 were parent firms with one or more subsidiaries. Thus. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. Twenty-two of the 81 respondents were independent. 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. 59 parent companies collectively had investments in 759 firms. not individuals. 34 percent were foreign companies.14. standalone setups. The fact that corporations. or about four firms each. although they are likely to be insignificant. In the case of the 30 largest chaebols. Partial results are shown in Table 2. For the same year. there are instances of direct cross-shareholding in Korean firms. together owning an average of 37. In many instances. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. The extent of pyramiding can be seen in some of the previous tables. together having a total of 292 domestic subsidiaries. the average shareholding of the controlling owners and their families was 8. the top five shareholders consisted of 2. and 319 foreign subsidiaries. Among the 81 listed firms in the ADB survey. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms.5 percent as of 1997.
5 2.1 1.2 37.Table 2.6 3.0 21.4 38. 1999 Five Largest Shareholders No.0 17.5 1.6 3.5 24.8 38.7 19.9 5.7 37.6 16. A few companies reported less than five largest shareholders.4 21.4 2.9 21. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.8 8. .5 31.9 29.1 22. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.0 3.4 18.4 11.6 3.6 34.0 1.2 25.4 1.0 13.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.8 31.1 3. a Number of shareholders.3 26.0 3.0 2.8 18.7 0.7 5.5 4.5 18.5 2.5 4.5 2.9 34.0 1.5 38.4 25.5 2.7 39.4 42.8 37.3 12.
Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. Ungki Lim.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group.” In Korean Managerial Dynamics. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family.4 13.8 40. Lee. Tamio. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.” Paper presented at the Annual Conference of Financial Management Association.24 shows the average internal shareholdings in the 30 largest chaebols.2 12. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. The family and member companies’ shareholdings have been declining over time. New York: Praeger. the controlling families owned 8.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns.6 33. Chicago.7 31. Hattori (1989) identified three patterns based on data in the early 1980s. 1997. H.0 8. 1998.7 1992 46. Lee.5 percent.2 1994 42.5 34.4 1990 45. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.2 15.24 Internal Shareholdings of the 30 Largest Chaebols. it appears that the chaebol families have had a strong desire to expand their business bases. 34. As of 1997.4 1993 43. C. edited by K.8 33.1 1997 43.5 percent and member companies.7 9.5 Judging from the historical record. 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. 79-95. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. 1987 56. 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. Chung and H. 1989. 6 7 Hattori. pp. Table 2. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. the ownership patterns can be described as follows. Based on these studies. 15 October 1998. Table 2. . “Japanese Zaibatsu and Korean Chaebols.2 33. Jae Woo.4 10.
A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. The third (Type C) is “indirect control via complex shareholding. and subsidiaries’ equity participation. consisting of eight listed and 16 privately held firms as of 1997. The two base companies have investments in three other base companies. II The first (Type A) is called “direct family ownership. holdings of the nonprofit foundation.” Under this type of ownership pattern. financial. The Hanjin Group. subsidiaries have extensive investments in other subsidiaries. which then make investments in the subsidiaries. As of 1997. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. The Kia Group was about the only management-controlled group but was out of existence by 1999.92 Corporate Governance and Finance in East Asia. it had 18 listed and 39 private companies. Also. Thus. It consists of seven listed and 24 privately held firms. The family itself holds shares in some subsidiaries.” shows a simple pyramidal structure.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. or merged into. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. and business activities. the family controls the group’s member companies by its own shareholdings. Most of its member firms were acquired by. is an example of this type. investments made by the base companies. The Hyundai Group exemplifies this. The controlling family has sizable investments in two base companies and smaller investments in many others. Sun Hong Kim. The Hanwha Group can be classified as such a company. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. Hyundai Motors acquired Kia Motors via an international auction. and his management team exercised full control over the group without much interference from major investors. there is no controlling shareholder. But the former chief executive officer (CEO). Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. called the “indirect control via base company. For example. other firms. which in turn hold shares in some of the other subsidiaries. The second (Type B). One of the . Vol. completely dissolved under financial distress.” Here the family directly controls a base company and a nonprofit foundation. The fourth type (Type D) is “management control. Investments between the lower level subsidiaries are rare.
The prohibition of holding companies was also abolished in 1999. Also. At this early stage. only operating holding companies were allowed to be established. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations.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 Fair Trade Act). These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. These amendments prohibited holding companies and direct cross-shareholding. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. 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. Until the end of 1998. The Government is also considering whether to allow consolidated taxation for pure holding companies. and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets. This limit was also applicable to banks and insurance companies. 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. thus hurting the shareholders of stronger firms. One condition requires that the DER of the holding company should not exceed 100 percent. Existing guarantees had to be resolved by March 2000. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. It remains to be seen whether they will adopt the holding company structure in the future. bankruptcy reorganization. . They hindered early exits (liquidation. A third disallows multiple layering of holding companies. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. 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. However. Initially. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol.
) 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. Their operating costs were borne by the member companies rather than by the controlling shareholder. until urgent restructuring is complete. The staff of these organizations were employees of member firms. there have been no significant changes. Vol. The office established strategies for the group as a whole. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson.3. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. Chaebols maintain that the restructuring headquarters will exist only for a limited period. Since the economic crisis. and transferred funds generated by one firm to another. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. who is universally called the “group chairman. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. 2. Despite chaebols’ decision to dismantle the chairman’s offices. In 1998.2 Internal Management and Control Monitoring of corporate management by shareholders. usually in the rank of a company president. boards of directors.94 Corporate Governance and Finance in East Asia. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. These offices were legally informal and functioned as the headquarters of chaebols.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. The Fair Trade Commission has been deeply involved in promoting managerial transparency by exercising its power to investigate and levy penalties on “unfair internal transactions” among member firms of chaebols. The chairman’s office had its own chief executive officer. planned for capital raising and allocation on a groupwide basis. and the capital market was almost nonexistent until the recent reform . Some chaebols have disintegrated or shrunk in size. The 30 largest chaebols are now required to publish “combined” financial statements. which put together the accounts of all members of a chaebol. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. II etc. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members.
Chapter 2: Korea 95 efforts. in most Korean firms. Thus. the representative director was also the chairperson of the board. . or at least acts as the de facto CEO. This policy managed to hamper any monitoring initiatives from the capital market. except for banks. only the Government could play an effective role in monitoring corporations. Under such circumstances. As of 1997. but some large ones have two or more. Legal provisions to protect investors were limited. With few exceptions. Even when the covenants were violated. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. The board elects one or more representative directors from among the board members. In most listed companies. Banks. this was complicated by the prevailing attitude that large companies. creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. and takeover codes were not accommodative to active monitoring. the creditors did not declare defaults. corporations should have a board of directors consisting of at least three members. the controlling shareholder is officially the representative director and the CEO. Even where the largest shareholder is not the 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. had their own governance problems. Board of Directors General Characteristics of the Boards Under the Commercial Code. especially chaebols. Most companies have one representative director. There are many reasons for this. Directors are elected at the general shareholders meeting for a term not exceeding three years. Loan agreements and debt indentures did not include strict covenants. Meanwhile. were too big to fail. the concept of fiduciary duty of managers was not well established. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. he or she generally approves major decisions made by the management. as the major creditors. control is not separate from ownership. However. 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. and their positions (accept or reject) on matters voted on in board meetings. 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 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. II When the Commercial Code first introduced the corporate board system in the 1960s. A few large companies had more than 50 directors. Vol. almost all companies succeeded in adopting cumulative voting. Further. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. Despite the qualification requirements. . Recent Reform Efforts on the Board System In 1997.96 Corporate Governance and Finance in East Asia. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. Moreover. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. were supposed to be outside directors. the listing rules restrict the eligibility of independent outside directors to those who have no family ties with the managers and no significant business transactions with the company. the attendance rate of outside directors. However. all of whom were managers. With the boards consisting only of insiders. In order to address this concern. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. other than the representative director(s). 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. The exchange is also expected to recommend company charters to have provisions that allow for information demanded by outside directors to be promptly supplied to them. The 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. they were virtually under the full control of the CEOs and in practice functioned only as management councils without any decision-making power—at least until 1998. companies have to disclose in their annual reports the frequency of board meetings. members of the board. In the 1999 annual shareholders meetings.
The average board had 8. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. which had extended financial support in their recent recapitalization efforts. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). having no controlling shareholders. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. In 78 percent of the responding firms. In March 1999.9 percent on average.1 percent and outside directors 1. the chairperson of the board was also the CEO and on average held 10. the Korean Code recommends that large listed firms should have at least three independent directors. Meanwhile. are required to have a majority of outside directors. the Corporate Governance Reform Committee.2 percent and the CEO 14. an audit committee. These results are in accordance with the new listing rules introduced in 1998. Among others. a blue-ribbon committee.1 percent of outstanding shares of a listed company. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. On average. In September of the same year. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. they had a parent/child relationship in 20 percent of the cases. Where the chairperson was not the CEO. who would comprise at least 50 percent of the boards. This is because most banks. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis.4 directors. inside directors owned 16.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. this committee adopted the Code of Best Practice in Corporate Governance. The controlling shareholder of some banks is the Government. 88 percent had plans to hold elections in the near future. Where the two were separate.5 percent of the shares. although some banks recently have established board committees. Among the firms with no outside directors. and a nominating committee. Directors were also chosen on the basis of their relationship with the controlling . he or she held 6.
the management determines the remuneration. Most frequently. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). a total of 562 directors were sitting on two or more corporate boards. In some instances. The board or the management then determines compensation packages for individual directors. About five directors per firm have been in office for more than one term. Less frequently. II shareholder (30 percent). The current chairperson has been in office for 6. founders of the company acted as the chairperson (22 percent). the management nominated director candidates (64 percent of the directors). in 23 percent.2 years on average. . As discussed earlier. the board had a nomination and an audit committee. the board had no committees.98 Corporate Governance and Finance in East Asia. However. In 13 percent. among the 81 sample firms. one person was sitting on nine boards and this person was the CEO of a chaebol firm. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). In 91 percent of the sample firms. According to the Commercial Code. relationship with controlling shareholders (21 percent). including stock options. In one case. In a very small number of firms. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. the term of appointment of directors and board chairpersons is three years. Vol. In 1997. 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). In most firms. These were established only recently. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. and fixed fees plus performance-related pay. This rather long tenure must be due to their status as controlling shareholders in most firms. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. 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 survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. in some firms. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. compensation for directors must be approved by the annual shareholders meeting for each fiscal year.
the payment is about five times the CEO’s annual salary. and in another 21 percent CEO bought shares in the market. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. 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. CEO was given shares by the family. he or she was selected on the basis of professional expertise in 15 firms. he or she does not enjoy much power. in which there is no controlling shareholder. In 4 percent of the cases. fixed salary plus net profit-related bonus in 9 percent. CEOs have been in their positions for an average of 9. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. it was proposed by CEO and approved by the board. In less than 20 percent of the firms. shareholding in three firms. The firms in the survey consider steady growth of a company and maximization of the shareholder value as the most important responsibilities of CEO.Chapter 2: Korea 99 Management CEO In the survey sample. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. decides on important matters on his/her own in 13 out of the 44 firms. In such cases. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration. In cases where CEO is not the largest shareholder and chairperson. It indicates that CEO. In 20 percent. CEO simply follows the orders of the chairperson. In a handful of sample firms. In the survey. 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. . and fixed salary plus performance-related pay including stock options in 13 percent. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. CEO is also the founder in 52 percent of the firms.2 years. In 21 percent of cases. When CEO is not the chairperson. compensation is by fixed salary in 74 percent of the firms. However. In the 25 firms where CEO was not the chairperson of the board. the survey tells a slightly different story than is generally believed in Korea. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. According to the survey. CEO generally has the ultimate power to decide on corporate affairs. who is not the chairperson.
However. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. The bonus is supposed to be linked to company performance. II Senior Executives In the past. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. Penalties for fraudulent financial reports were increased. 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. 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. and . disclosure. 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. Senior managers were even often called directors although they were not official members of the board. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. (ii) establishment of accounting standards for financial institutions. but in practice is fixed and understood as part of a fixed salary.100 Corporate Governance and Finance in East Asia. The commission has played an active role in introducing new rules on corporate governance. in particular. 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. Korean firms have rarely used shares for executive compensation. This action was in response to calls by international investors and. and accounting standards. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. it was common for all senior executives to be elected as directors at the shareholders meeting. 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. Vol. from IMF and the World Bank. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards.
The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. Only 10 percent of the respondents have followed all international accounting standards. In practice. but 49 percent confessed that they have not followed international standards at all. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. Under the Commercial Code. 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. they also have the power and duty to monitor the activities of executive directors. 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. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. the internal auditor is considered to be a subordinate of the . 41 percent of the companies believed that they have followed some international accounting standards. The 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. In the ADB survey.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. 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. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. 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. however. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Thus. Consolidated reporting was introduced before the outbreak of the crisis.
Vol. But this problem can be mitigated if auditors function under the umbrella of the board. but since 1998 a committee consisting of internal auditors. If the company changes its external auditor for reasons that are not listed in the relevant regulation. This is because the auditor. outside directors. The current external auditors have been associated with the surveyed companies for an average of 4. . however. underdeveloped market discipline for accounting firms. About 100 listed firms will be subject to this requirement. the Korean Code of Best Practice also recommends that large firms adopt the audit committee structure with two thirds of its members consisting of independent directors. In the ADB survey. In the past.6 years. Big Korean accounting firms are affiliated with US accounting firms. Accepting these arguments. then the Securities and Futures Commission can appoint a new one. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors.102 Corporate Governance and Finance in East Asia. If the status of internal auditors is elevated to that of independent board members. and creditors selects it. 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. and lack of strong professional ethics in the accounting profession. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. almost all firms affirmed that the external auditor is independent from the company. as a monitor of management in the Korean (and also the Japanese) system. the board of directors had the power to appoint an external auditing firm. The internal auditor in the Korean corporate system can be argued to be inferior to the Anglo-American audit committee and the German supervisory board. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. In order to increase independence. 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. does not have the power to hire and fire the managers. Listed and registered corporations must publish financial statements audited by external accounting firms. II controlling shareholder/CEO. External auditors are selected for a term of three years. 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. Previously. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. this problem will largely disappear.
the Depository is subject to “shadow voting. and dismissal of directors and internal auditors require a “special resolution. Internet. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. These voters represented only 5. amendments of the articles of incorporation require a “special resolution. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). respectively. The Depository represented 20 percent of the shares attending the meetings. Approval of mergers and major divestitures. attended the last annual general meeting. corporations cannot issue common shares without voting rights. However. The management is the most important proxy. small shareholders do not attend the annual meeting and that. The Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally. the Depository is instrumental in getting resolutions passed. for some firms. or 10.” The survey shows that the Korea Securities Depository holds 69.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code.” Companies can increase the number . A total of 326 shareholders per firm. charter amendments. or telephone. However. The securities companies and banks are the second and third. 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. One common share should have one vote. in general.3. Thus. No companies have so far introduced voting by mail.53 percent of the total shareholdings.21 percent of total shares issued. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting.79 percent of the shareholders.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. The above results indicate that. Under the Commercial Code.Chapter 2: Korea 103 2. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding.77 percent of the shares. This shows that a relatively larger number of shareholders send in their proxies.93 percent of the shareholders but 26. representing 62. About one fifth of the listed firms issued nonvoting preferred shares. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares.
from 3 to 1. demand changes in business policy. laws and regulations were generally very loose in protecting the rights of minority shareholders. Shareholders have preemptive rights. and for access to unpublished accounting books and records.0 percent. Vol. Proposals put forward by management are rarely rejected at the general meetings. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. dividend proposals. In February 1998 and again in March. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. Various measures have since been taken to improve investor protection.01 percent. II of votes required for a resolution to amend the articles. Those that are most likely to be rejected relate to election of directors. and major investment projects (only five firms answered this question). Changes in the authorized capital require an amendment of the articles of incorporation. the board of directors decides on issues of shares within the limit of the authorized capital. the requirement was lowered from 1 to 0. mergers and acquisition plans.104 Corporate Governance and Finance in East Asia. but these can be waived by an amendment of the articles of incorporation. This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. In four out of 62 respondents. For recommendations for dismissal of directors and internal auditors. The amendment included a provision requiring the company management to get prior approval of shareholders to undertake major investments and raise capital in international markets. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. However. Only two out of 62 respondents to this question have had cases in which proposals were rejected. It also attended the shareholders meeting of several companies to present the views of outside shareholders. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. or block charter amendments considered harmful to minority shareholders. an institutional investor based in the US. The company also agreed to the right of the fund . Shareholder Protection Before the economic crisis. was able to force a change in the charter of SK Telecom.5 percent. the Tiger Fund. Due to the changes in rules for investor protection. As an example.
2. there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. simple. After the economic crisis. 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. managers were considered to be subject to the duty of care. Thus. and not strictly enforced. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws. .Chapter 2: Korea 105 to recommend two directors to the corporate board.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. 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. In 1974. This has strengthened the accountability of controlling shareholders as de facto CEOs. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. Before the amendment. affiliated lending or guarantees. but it was not entirely clear whether they had the duty of loyalty as well. and transactions with major shareholders. For further protection of investors. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. Banks have played some limited role in monitoring the investment activities of chaebols. The laws and regulations of the country protect shareholders from interested transactions. The covenants in loan agreements and bond indentures were very loose. mergers and acquisitions. In fact. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management. As for bond issues. This was one of the most significant developments with respect to shareholder activism in the Korean capital market. underwriting securities firms acted also as trustees.3. However. creditors did not interfere with the management of a debtor. loans to directors.
However. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. In 1996. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. Besides the setting up of an “External Auditors Committee” by firms. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. Purchase of real estate should be financed by equity capital and not by borrowed funds. on average. as discussed earlier. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. this proposal has only a slim chance of being accepted by the Government or legislature. In turn. 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. II acquisitions. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. Under the system. Vol.106 Corporate Governance and Finance in East Asia. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. the main bank system was introduced and has been applied to the 51 largest business groups to which banks extended more than W250 billion in loans and payment guarantees. On the other hand. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. 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 . However. including. 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. 11 banks. In 1994 the approval requirement was abolished. creditors now have a bigger say in court proceedings for receivership and composition. there have been concerns that the Government might use the system to intervene in the management of the business groups.
holding companies. penalty was involved in rescheduling. NBFIs infrequently ask for collateral. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. 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. Among the creditors. For a small number of firms. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. With respect to the types of loans. Creditors usually exercise their influence through covenants relating to the use of loans. The assistance came from. 16 percent . The typical company has also maintained its relationship with five of the 10 NBFIs for more than five years. More than half of the firms think that creditors have no influence on their management and decision making.Chapter 2: Korea 107 financial institutions (NBFIs). collateral is more likely to be required of loans for working capital than for fixed investments. collateral was taken away. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). while a third think that creditors have weak influence. Most firms feel that requirements for collateral have been tightened since the crisis started. in order of importance: affiliated companies. subsidiaries. Most of the financial institutions are not affiliates of the borrowing company. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. When loans could not be repaid on time. renegotiation took place after the crisis. One tenth of the firms received assistance from the Government in loan applications. payments were usually rescheduled through negotiation without any penalty. For more than half of such firms. banks are most likely to require collateral. holding shares of another company by both the borrower and the guarantor. Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. and other financial institutions. Only a few feel that creditors have very strong influence. and 17 nonfinancial corporations. or creditors filed for receivership. The borrower’s relationship with most banks has lasted for more than five years. or through their shareholdings. whereas seven of the 17 nonfinancial corporations are. controlling shareholders. A few creditors exercise influence through covenants relating to major decisions by the company. mutual guarantee agreements. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees.
Behind these new strengthened roles of creditors is the newly set-up FSC. Separate from but emulating the CRA.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. are summarized below. 2. Third.3. 2 percent by holding companies. 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. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. have been the driving forces for restructuring activities of the largest 64 chaebols. First. including commercial and merchant banks.108 Corporate Governance and Finance in East Asia. Under a contract signed between the creditors and the debtor. This committee was set up in accordance with the provisions of the CRA. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. and 1 percent by the Government. 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. Second. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. major creditors. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. especially banks. II by other affiliated companies. Vol. will get involved in the restructuring and workout processes. the Korean Government maintained a policy of protecting the incumbent management of listed companies. The new ways through which creditors. 4 percent by subsidiaries. In this connection. In cases where the creditors are unable to reach an agreement on a workout plan. Representative of the policy was the stipulation under the Securities and Exchange Act that no one can accumulate more than 10 percent of the voting shares of a listed company . the delegation has the right to approve wide-ranging financial activities of the firm. and in continued monitoring of debtors. banks and other institutional lenders are playing more important roles than ever before. The leading creditor banks will continuously monitor the progress in implementing the signed Plans.
Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998. more than half of these attempts failed. hostile takeovers by tender offers began to appear in the capital market. and announcing competitive tender offers by the controlling shareholder. 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. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. Publicly issued CBs require three months before their owners can convert them to shares. corporations cannot limit the voting rights of large shareholders to a given maximum. turning to white knights. Takeover Activity As soon as the Act was amended. Companies have also utilized share repurchases. Unlike the UK. 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. For takeover defense. Between 1994 and 1997. 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. The reasons for failure are diverse. Privately placed CBs cannot be converted into shares in one year. However. 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. 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). Unlike Germany. A company cannot issue new shares to a third party without first amending the corporate charter. listed firms rely mainly on shareholdings by the largest shareholder. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. .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. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. In one case. Stock purchases by tender offer were also exempted. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. but were completely eliminated in 1998.
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. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. Firms affiliated with a large group are generally regarded as difficult targets as the other members of the group will come to the rescue or act as white knights. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. For the steel company. the limit will be eliminated when it is fully privatized in two years. Korea Telecom. a steel company. and a bank had government ownership. In their charters. In 1999. As of February 1999. 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. are designated as public companies. Currently the limit is 3 percent. Many of the takeover targets in the past did not have a controlling shareholder (group). . 2. In 1998. 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. For the others.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. except for the banks. in which the Government still holds the largest ownership. 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. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. Some had two or more large shareholders who had joint control of the firm but could not cooperate. The Government-owned listed companies.110 Corporate Governance and Finance in East Asia.3. It is harder now to find such firms. an electric power company. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. Hostile takeovers in Korea will be rare in the future. Vol. was newly listed.7 percent on average as of the end of 1997 for nonfinancial listed firms). Another reason is that many listed firms belong to chaebols.
The nonexecutive directors are now recommended by a committee. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. the Government.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. Meanwhile. It was abolished before the economic crisis but another regulation. which limits the total amount of bonds issued by the five largest chaebols.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. especially those belonging to chaebols. which was introduced in 1996. 2.1).3. There were also limits on the amount raised and the number of issues per year.3. 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. only qualified firms could issue new shares. There is no active debate or discussion going on about this potentially difficult issue. The Government’s right to send public officials to the boards was eliminated. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. nominated by the minister in charge of the company in question. But this rule. the main bank system. Labor is not represented in corporate boards. as applied to four large corporations. Further. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. 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. Beginning in 1999. For example. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. Even where employees hold . administering through a self-regulatory committee of the securities industry. In addition. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. 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. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. more state-owned corporations became subject to this new board structure.
This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. Under the Labor Management Council Law. and 66 percent manual workers. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. and 2.1 in 1997. In 70 percent of the firms with organized unions. The percentage of shares held by the employee stock ownership plans in listed companies was 1. The relevant regulation was amended recently in order to facilitate voting by individual employees. In 1987. 32 percent technicians and professional staff. The typical collective bargaining agreement has a one-year duration.112 Corporate Governance and Finance in East Asia. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Local unions in the same industry have established industrial labor federations. In these firms. The respondents of the ADB survey had 2. 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. of which 2 percent were senior managers. Under the Capital Market Development Act of 1968. which were generally much lower than estimated values. Trade unions are organized on an enterprise basis. union members account for 54 percent of the employees.9 in 1980. Two thirds of the respondents had an organized union. the management usually consults the union on major issues relating to the management. operation. The union had no influence on the management in 17 percent of the firms. In actuality. employers are required to meet with representatives of labor unions at least once every three months. in principle. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. Under another law enacted in 1972 to induce private companies to go public. At the national level. the council meetings have been superficial. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. II shares of their companies through employee stock ownership plans. 2. . they delegate their voting rights to plans’ representatives. but 27 percent of them felt that it was strong. About half of these firms considered the influence of the union on the management of the company to be weak. Collective bargaining is.5 in 1990. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. there are two federations of labor unions. carried out at the enterprise level. and development of the company. Vol.654 employees per firm on average.
Chapter 2: Korea 113
Corporate Financing7 Overview of the Financial System
The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7
The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.
114 Corporate Governance and Finance in East Asia, Vol. II
counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.
Chapter 2: Korea 115
Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump
116 Corporate Governance and Finance in East Asia, Vol. II
after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the
Chapter 2: Korea 117
total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage
The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. listed companies. . Meanwhile. budget. and liberalization of foreign and capital transactions.2 Patterns of Corporate Financing Corporate Financing Practices In this section. etc. the Korean Government announced its Financial Liberalization and Market Opening Plan. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. Since 1985. especially the domestic bond market. development of the money market. depreciation. On the basis of flows of funds. It included such important issues as interest rate deregulation. Some policy loans were also abolished. Also.4. Moreover.1). the business scope of financial institutions was greatly widened from the early 1980s. which resulted in the establishment of a number of new banks. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. In addition. the Government simplified various directives and instructions regulating personnel management. II Interest Rate Deregulation Plan. The Government adopted a cautious approach. Internal funds include retained earnings.2. In June 1993. as a first step toward liberalization of capital account transactions. and organization of commercial banks. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. implementing the first stage in November 1991. was liberalized drastically in 1998 after the financial crisis. Vol. finance companies. revision of the credit control system. With the privatization of nationwide commercial banks. The capital market.5 percent in November 1981. short-term finance companies. mutual savings.118 Corporate Governance and Finance in East Asia. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. 2. and the 30 largest chaebols. Korean firms have been allowed to issue CBs in international financial markets. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983.
Equity capital represents the shareholders’ commitment to the business. except in 1991. The share of external financing. Before 1988.Chapter 2: Korea 119 and net capital transfers from the Government. Table 2. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). was 71 percent during the period.4 percent in the precrisis period 1988-1997. 1994. The SFR averaged 28. particularly in the 1990s in response to the liberalization of the capital market. Securities finance became a more important source from 1988 onwards. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. and government transfers. Meanwhile. and 1997. In securities finance. on average.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. It measures the degree of financing growth in total assets by additional equity. but it remained less than 10 percent of total financing. This means that internal funds after dividend payment were insufficient to finance growth in total assets. except for the stock market boom of 19871988. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. financing by corporate bonds and CPs was more significant than by new equity. capital surplus. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. the corporate sector’s most important source of external finance was bank borrowings. 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.26 shows the four measures of corporate financing calculated from Table 2.25. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. Financing Patterns of the Aggregate Corporate Sector Table 2. depreciation. particularly in the short term. including all sources other than retained earnings. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. the proportion of foreign borrowings in total finance rose steadily. and allowances) and new equity capital. depreciation. It measures the degree of financing growth in total assets by additional debts. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. comprising internally generated capital (retained earnings. The corporate sector used . In 1988 when the stock market boomed.
3) 11.3) 15.0 1.6 5.7 71. and Public Bonds Commercial Paper Corporate Bonds Stock Issuesb Equity Other than Stock Foreign Loans Foreign Current Bonds Trade Credit Direct Investment Others Others Government Loans Business Credit Other Financial Debts — = not available.6 4.0 22.7 8.8 — 26.1 17. Source: Understanding Flow of Fund Accounts.8 1.4 2.9 28.6 10.2 13.7 4.0 0.5 0.5 2.7 4.3 3.0 — — — — 8.8 56.7 1.6 11.1 — 27.1 2.3 72.3 30.9 0.1 2.6 25.3 6.7 32.6 14.4 11.6 3.7 11.8 (0.8 4.0 2.0 0.6 1.2 5.2 1.7 7.4 27.2 15.7 2.1 0.6 0.8 0.5 13.3 1.5 0.8 30.6 9.0 1997 26.3 6.7 73.1) 6.8 1.0 3. 1994.3 27.8 8.1 0.2 13.7 12.1 1.1 3.1) 4.4 2. and net capital transfers from the Government.5 2.1 — — — — 12.5 0.4 — 28.25 Flow of Funds of the Nonfinancial Corporate Sector.4 27.4 1.2 6.3 — — — — 8.5 16. b Includes capital surplus.3 16.2 26.3 1.9 2.0) 12.5 2.4 10.6 8.3 1.4 0.9 73.7 1989 1990 1991 1992 1993 1994 1995 1996 22.3 — 30.0 3.7 2.8 17.5 2.0 9.1 23.1 3.8 1.1 8.9 9. .6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.7) 11.0 9.6 0.3 25.7 10.5 9.1 1.4 15.1 27.6) 5.4 3.1) 4.4 71.9 10.2 6.9 72.6 9.0 3.3 2. a Includes retained earnings.2 10.6 9.7 (0.6 (0.9 6.9 34.6 0.7 8.0 11.2 — 28.1 12. which is the excess of current value over issue value of stock.9 38.7 10.7 1.1 10.1 36. and Flow of Funds.0 10.7 — — — — 9.3 10.5 29.1 (1.1 72.2 34.4 (0.7 2.6 77.4 27.8 27.4 1. Bank of Korea.9 10.7 14. 1988-1997 (percent) 1988 43.3 6.7 13.0 17.1 (0.7 6.6 11. Bank of Korea.6 2.0 16.7 14.2 (0.1 1.5 16.Table 2.1 3.4 2. depreciation.4 8.3 3.2 — — — — 9.4) 13.0 5.3 5.0 (0.7 10.4 21.0 70.4 (2.4 9.4 2.2 2.8 1.8 -2.6 3.8 1.4 0.7 15.6 0.8 15.6 4.2 0.2 14.6 4.
2 IDFR 36. declining to 26. IDFR reached 73.0 11. It dropped to 28 percent the following year.26 Financing Patterns of the Nonfinancial Corporate Sector.4 27. additional equity to finance 12.3 11.1 39. was financed by additional debts. 1994. indicating a high financial risk position.3 60. in the manufacturing sector. Incremental financing from equity was 40.3 59.6 Excludes capital surplus.0 57. respectively.9 60.4 percent (Table 2. average SFR was 37. higher than the aggregate 40.5 68.7 40. While SFRs. and IEFRs were declining.4 12. 45.7 26.Chapter 2: Korea 121 Table 2.2 percent of incremental asset growth was financed by equity.3 12.1 percent in 1988 during the stock market boom.8 10. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.6 percent and 1. an average of 59. NEFR registered 20. higher than the aggregate 28.4 NEFRa 20. and Flow of Funds.1 26. On average.9 22. SFR peaked at 44 percent.9 46. There were significant time trends.7 40. Bank of Korea.0 42.5 percent in 1997.8 percent of its total asset growth through debts.5 12. the corporate sector relied heavily on external financing for its expansion.7 percent in 1997.6 26.5 31.3 59. but also continuously fell.6 62.8 28. .5 percent.27). IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.7 9. Across industry.6 percent over the 10-year period. but plunged to 5.7 30.1 17. respectively.7 28.3 73.4 IEFR 63. Lower income diminished the industry’s equity position toward crisis year 1997. Its IEFR and NEFR dropped to 23. The balance. Bank of Korea. Source: Calculations from Understanding Flow of Fund Accounts.0 5.6 percent. Manufacturing financed 54. and the total debt ratio was much higher in 1996 and 1997 at 62.0 27.6 percent. dropping to 26.4 percent.2 37.3 27.1 12.1 53.9 28.5 and 76.4 percent.9 percent by 1997 when net profit margins were negative. In periods of high economic growth such as in 1988.7 40.3 percent in 1997.2 percent of the growth in total assets.8 62.4 37. NEFRs.
6 53.6 54.6 37.1 29.9 percent.6 37.9 IDFR 34.2 3.9 percent of asset growth. On the other hand.4 45.0 3. from 17. Vol.5 76.4 37. Categorized according to company size.5 7. and communication sector had relatively high incremental equity ratios. Equity financed an average 25.4 3.4 63.and medium-sized firms.7 37.2 percent in 1993. and hotels sector and realty/renting/business activities sector were similar.6 53. explaining partly the collapses of several construction companies in 1995.1 percent of total asset growth for the period.4 54. Total debt financed an average 74.0 42. It had the highest average SFR in 1988 at 31.8 percent in 1990. retail.6 3.7 37. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. large firms showed more cyclical patterns in these financing ratios than small.4 47.6 36.2 62. Table 2.9 6. this dropped further to 15.0 57.5 23.7 percent in 1996.7 47. their average SFR was higher. Financing patterns of the wholesale. the two sectors also had low equity financing ratios and high debt financing ratios.8 4. Since large firms were more profitable.8 IEFR 65.5 NEFRa 9. one year ahead of the other industries.5 1.2 21. In 1997. and steam) and the transportation.122 Corporate Governance and Finance in East Asia. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.3 28. II The construction industry showed the most cyclical pattern in annual asset growth.7 47.8 percent in crisis year 1997. and fell to about 10 percent in 1997. the utilities (electricity. and low total debt and short-term borrowing ratios. storage.6 4.6 62.2 5.2 .3 52. then increased to 20.8 50.0 30. which decreased to 8. the proportion of short-term borrowings in total financing has been high.4 46. Since 1992. gas.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent) Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.0 42.6 45.
1 84. Hotels 1988 33.0 17.1 19.7 41.6 73.1 4.3 21.9 15.2 4.8 81.4) 2.9 1989 63.9 1993 63.2 8.8 1994 15.6 14.0 65.0 0.5 23.2 46.0 1992 24.5 76.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.7 1989 26.7 78.7 1994 53.9 9.0 3.8 74.7 80.3 57.6 37.3 4.1 Trasport.1 69.8 2.3 8.2 1995 16.6 8.3 4.0 82.0 74.6 7.3 19.8 25.6 1997 29.9 2.5 29.7 Wholesale/Retail Trade.9 52.9 1.7 1997 8.0 1990 12.9 1.0 60.7 7.8 9.2 10.3 7.3 (9.9 Average 19.9 47.8 4.0 1.8 29.0 68.7 78.6 4.Table 2.7 6.8 76.2 5.5 12.5 1996 42.27 (Cont’d) Year SFRa NEFRa IDFR 53.8 54.1 70.8 1991 51.5 20.2 Average 53.4 IEFR 46.9 1.0 31.4 28.9 80.2 70.2 74.4 1995 53.9 29.3 84.1 66.6 37.2 23.5 62.7 15. Household Goods.6 2.3 1996 16.0 .9 1992 56.5 70.2 25. Storage.2 29.8 70.6 9.9 33.3 10.4 62.0 1990 50. and Communication 1988 64.2 3.7 53.5 87.0 40.0 10.1 25.9 20.7 42.5 1.6 8.0 4.7 15.5 1993 22.2 20.2 18.1 59.4 2.1 1991 14.9 16.0 34.3 47.9 30.5 21.6 9.4 26.6 71.
6 1991 18.9 Average 75.and short-term borrowings of these firms shot up in that period.4 5.1 34.1 0.8 135.6 IDFR = incremental debt financing ratio.3 92.1 1991 56.5 8.8) (35. NEFR = new equity financing ratio. SFR = self-financing ratio.6 52.1 1989 34.0 1992 51.8 1993 11. Vol.0 43.0 0.6 1997 23.4) 3.5 22.6 1995 17.0 33.3 207.0 1997 24.0 0.6 Real Estate. Source: Calculated using data from Bank of Korea.9 65. however.1 35.1 1993 55.0 53.0 21.3 3.8) 7.9 45. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.6 1989 118.7 18. .2 63.3 62.0 1.7 1996 18.27 (Cont’d) Year SFRa NEFRa 6.8 36.0 46.9 64.6 7.4 1996 45. when large firms had much lower equity financing ratios and higher debt financing ratios than small.7 37.3 7. The trend was reversed in 1996-1997.124 Corporate Governance and Finance in East Asia.5 77.0 67. Long.4 47.3 85.1 70.3 Electricity.6 1990 82.8 1990 19.9 IDFR 31.8 17.7 70. IEFR = incremental equity financing ratio.4 1.1 54.0 56. Financial Statement Analysis Yearbooks.4 IEFR 69. Their average IEFR was also higher and IDFR smaller.4 0. Gas. and Business 1988 51. II Table 2.9 57. The large firms had a higher proportion of external financing in 1996-1997.and mediumscale firms.7 1994 8.2 1992 18.3 29.6 1.0 (0.4 1994 72.3 81. Renting.4 7.4 (107.1 71.9 29.8 Average 22.1 42.0 79.4 1995 62.3 31. and Steam Supply 1988 118.4 0 0 0 0 1. a Excludes capital surplus.7 14.9 28.7 69.
8 percent of their total finance in 1997. Financing Patterns of Chaebols For chaebols. 153. and using cross-payment guarantees among affiliated companies. for listed companies. respectively. compared with the entire corporate sector’s 35 percent and 65. the IDFR of listed companies increased to 93. and higher than that of listed companies (Table 2.8 percent. In 1996-1997. the lowest ratio of 58. The debt financing ratio of listed companies was high since they relied more on external financing.28). 91.1 percent of their equity capital. Their shortterm borrowings accounted for 86.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. the average SFR was 28. Cross-payment guarantees have been declining since 1993 and reached 91. The average IEFR of the top 30 chaebols of 29. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. and the top five chaebols. The largest borrowers were the top 11-30 chaebols.7 percent. at an average 70. compared with 89.30). Group-member firms borrowed less. The average IEFR and IDFR were 10. about the same as that of the corporate sector as a whole.5 percent and their total external financing. and were large borrowers.9 percent. In 1997. the top 6-10 chaebols. The proportion of their short-term financing averaged 72.5 percent is lower than that of the corporate sector in general. .3 percent of their equity capital in 1997 (Table 2.3 and 89.4 percent.7 percent for all listed companies. In 1997. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.2 percent. The chaebols’ drive to expand their empires resulted in heavy borrowings. External financing reached 94. the top 11-30 chaebols had the highest guarantees commitments at 207. All of the top 30 chaebols relied heavily on short-term borrowings.7 percent.29).6 percent of total asset growth. They were able to borrow easily from banks by issuing corporate bonds and CP. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially.9 percent.6 percent. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. but higher than that of listed companies.
4 38.1 93.5 8.4 29.1 1.8 76.3 IDFR 57.4 12.5 91.29 Financing Patterns of the Top 30 Chaebols.7 13. Table 2.3 5. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.6 61.7 1.Table 2.8 22.7 12.6 11. Korea Federation of Industries.4 1.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus. .5 2.3 1.1 8.2 1.8 89.5 8.6 IEFR 42.9 6. 1994-1998 (percent) SFRa IDFR 85.9 NEFRa IEFR 14.28 Financing Patterns of Listed Companies.2 23.6 0.6 1.9 7.5 2.4 88. Source: Calculated using data of Seung No Choi.2 10.3 86.2 NEFRa 1.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.2 36.6 70.3 28. 1994-1997 (percent) SFRa 41. Largest Business Groups in Korea.
Chapter 2: Korea 127 Table 2. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. and loans from NBFIs. These are followed by loans from banks. and underdevelopment of the stock market. Interest payments on debts were considered a loss when calculating taxes. loans from banks. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. the Government applied high tax rates on net profits of corporations. so that the firms engaged in lobbying to gain access to them. bond issues. Further. There were several reasons for this.7 150. Source: Fair Trade Commission and the Federation of Korean Industries. and extended loans based on cross-payment guarantees. Fourth.30 Cross-Payment Guarantees of the Top 30 Chaebols. in order of ranking.0 1997 91. bond issues.3 200. Second. Third.0 207. Korean firms preferred debt financing (bank and nonbank borrowings).3 64.9 — — — 1996 105. more than half of bank loans were priority loans with low interest rates. First. Financial institutions did not strictly screen their loan projects and monitor their debtors. poor financial and corporate governance resulted in overlending by banks. Factors Influencing Corporate Financing Choices Until recently. inefficient investment and excessive diversification of corporations. the Government provided implicit guarantees on bank lending and large businesses.9 153. According to the ADB survey.1 — — — 1995 161. especially in the 1970s when real interest rates of bank loans were negative.1 — = not available. And fifth. Firms now prefer internal funds and new equity capital.9 — — — 1994 258. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. Few firms ranked loans from NBFIs as their first preference. company preferences in financing investment projects before the crisis were. the Korean economy was plagued with high inflation. rights issues. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. This change implies that firms now give more attention to financial risks.3 58. . and reserves and retained earnings.
The most important reasons why they chose to borrow foreign currency denominated loans were that terms of foreign loans were more favorable and/or these loans were considered cheaper. and futures and other financial derivatives. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). maintenance of the existing ownership structure.3 Financial Structure.5 percent at the end of 1997. the percentage of foreign currency denominated debt in the portfolio was 14.36 percent on average for these companies. Vol.128 Corporate Governance and Finance in East Asia. in order of importance. Among those that never hedged against exchange rate risks. A futures exchange launched in 1999 trades foreign exchange options. in selecting financing sources. 2. II In seeking external financing.4. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. some (36 percent) thought that a hedging facility was not available or not working properly. 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. more than half (53 percent) hedged against exchange rate fluctuations. For these firms. Only a few firms sought foreign loans because domestic loans were not available. firms give their first consideration to minimization of transaction and interest costs. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. According to the survey. they survived for two to three . and others (29 percent) expected the local currency to appreciate in value. ensuring the liquidity of the company. Diversification. Other factors include. many firms (or 42 percent) never considered hedging. Among the responding companies that had foreign currency denominated loans. even with a heavy debt burden. Nonetheless. and reduction in tax burden. Korea now provides a better environment for financial risk management. This preference has changed little after the crisis. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed.
. (ii) In terms of net income to total assets. (iv) In terms of EBITDA to total assets. except in 19931995 when semiconductor prices were extraordinarily high.3. However. But since 1992.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. the top five chaebols’ ratios were much higher. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. Among the main findings were the following. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. . In order to determine the relationship between financing patterns and corporate performance.2. but the ratios of independent firms were much lower. They were also higher than those of the top five chaebols until 1991. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. Table 2.13). (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. 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. 1999). the top five chaebols and the top 6-70 chaebols had similar ratios. as well as lax financial supervision (Nam et al. (i) In terms of total borrowings to total assets. They were also higher than those of the top five chaebols until 1992. Nam et al. except in 1991. These findings indicate that independent firms have had a lower leverage and performed better financially. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. 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.
or outright transfer of resources due to poor corporate governance practices. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. Their subsidiaries. The diversification of chaebols under workout was much lower than that of the top 6-30. debt guarantees for free. The differences in the degrees of diversification among the three groups are substantial. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. During 1985-1997. except in the recession years of 1996-1997. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. court receivership. its profit rate declined. 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 6-30.31). 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. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. and easier access to cheap credit. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. Government intervention. second highest in the top 6-30. In terms of the net profit margin (the ratio of net profits to sales revenue). the degree of diversification was highest in the top five chaebols. rising nonperforming loans (NPLs) and falling . Indicators such as increasing debt-to-equity ratios. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. The degree of diversification of chaebols that fell into default. too.130 Corporate Governance and Finance in East Asia. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. had a significant role. however. The diversification of the top five chaebols remained at about the same level within the period. and lowest in the top 3172 chaebols. Meanwhile. Vol. 2. larger research and development expenditure.
0) 0.1 1.3 1.6 1989 1.3 1.8 1990 0.1 (3. 1998.3 1.1 1.5) (0.2) (4.9 0.1) 0.3 1.9 1.1) (1.8) 2.2 1.2 0.0) 0.0) (3.8) 0.2 1.4 1996 0.2) 0.3 1.6 1.7) 0.3 (0.7 (0.1 (1.9 1.7 0. p.6 (0.0 (0.8) (20.8 (0.1) (6.0 4.3 (0.9 0.6 5.4 (0. Source: Whan Whang.2 1.3) 0.1 1.1 0.0) (4.2) 1.4 0.0 6.7 0.5 4.5) (2.2 1995 3.7 (1.6 0.7 1.8 (0.3) 1.6 1.4) (6.8 1.9) 0.6) (0.8) (3.2 (0.31 Net Profit Margins of Chaebols.6) (0.2 (0.6 1.4) (0.2) 2.0 1992 1994 1.1 4.0 (2.2) (4.2 1.3 0.4 0.4 0.3 (3.7 1.1 1.1 0.6 0.0) (0.1 1.3) 0.2) (4.8) (4.9 0.6) (20.5) (7.8) 1997 0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default. Chung Ang University.5 1.3) 12.5 (4.8) 1.9 1.7) (1. Background and Task of Structural Adjustment.9 1.1 (9.4 1. .4 1.8) (0.4 (1.8) 0.2 1.9 0.6) (12.7 0.4 (1.1 (0.0 0.6 1.7 3.8 0.2) 1.6 3.2) (13.2) 1.0 1987 1.3 1.7 (0.5 1.3) 0.5 (0.2 1.7 — (0.3 1.4 (1.3 1.6) 0.3 0.3 3.8) 0.0 1.8) (37. Court Receivership.1) 1.7) 0.3 (0.9) 2.1 0.2 4.1 0.2) (13.2) (3.4 0.6 7.1) 2.0) 0. Management Research Institute.5 (0.1) (5.8 3.0 1.4) (1.4 (0.8 3.3 0.9) (1.5 2.5 (0.9) (8.1 0.8 0.5) (1.4 1.3) (0.4) (2.Table 2.5 1.7 0.3) 0.2 (1.3 1.8) (11.3) (1.9) 2.6 0.5 (6.3) 0.3 1.1) 1.4) (1.0 (7.8) (1.3) (0.6 1.1 0.6) (12.3 0.7) (0.7 1.7 0.1 0.7 0.6) 0.3 1.2 (0.8) (1.1 2.11.4 (0.3) (12.5 0.7 2.3) 1.0 0.6 0.1) — = not available.2 (17.9) (9.6 (10.6 0.6 0.2 (0.4 (2.7 (4.1) (1.0) (0. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.5 (0.8 0.1 (4.2) 2.8) 0.8) 0.4 2.1 1.9 (0.1) 0.6 (0.5 1.4) (1.8 (0.8 0.7) (0.6) 0.2) (0.1) 2.3 0.5) (2.7 1.5) 0.6) 0.6 0.4) (4.8 1. Beyond the Limit.4 1.1 1.8 0.6 0.1 0.9 8.1 0.3 (0.2) (0.5 1.3) 0.1 (4.3) 0.1) (2.9) 2.
Until 1997. after the crisis. Now. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. Along with government policies to protect the status quo.132 Corporate Governance and Finance in East Asia. Ownership concentration also had ramifications on corporate transparency. They were then almost automatically elected at the general shareholders meeting.5. a committee composed of internal auditors. Vol. The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. Until 1997. Thus. A remote trigger in the Thai crisis was all that took to push the economy over the edge. But in 1998. Moreover. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system.1 Weaknesses in Corporate Governance Concentration of Ownership and Entrenched Management Concentration of ownership has been the root cause of many problems related to corporate governance. the 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. 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. 2. . 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. this has led to entrenched management. Thus. outside directors. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. the boards of all listed companies were composed of insiders only. the independence and objectivity of the external auditor were often questioned. internal auditors cannot be expected to perform their function independently of management. and to the development of the market for corporate control. and creditors should select (recommend) the external auditor. a firm’s board of directors had the power to appoint an external auditor. Meanwhile.
However. Meanwhile. Many changes were introduced to promote M&A in the 1990s. individuals. when a large diversified chaebol. a large issuance of preferred stocks with no voting rights. however. as well as institutions. One reason is that the percentage of inside shareholdings for an average listed firm is very high. corporate accounting information was not reliable due to the lack of independence of external auditors. prevalent window dressing practices. Diversification can reduce chaebols’ risks through the portfolio effect. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. restrictions of voting rights of shares of institutional investors. participated in the stock market as short-term traders rather than long-term investors. usually a member of the founding family. profitable firms within a chaebol tended to subsidize unprofitable firms. In this situation. There were no effective monitoring mechanisms for its management. 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. Many of the takeover targets in the past did not have a controlling shareholder. These internal dealings made strong firms weak and helped marginal firms survive. as a whole. regulatory and practical difficulty in implementing proxy voting. Under the direction of the controlling shareholder. and restrictions on hostile takeovers. 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. has an unsound capital structure and . These included restrictions of shareholdings of institutional investors. 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. the Government maintained a policy of protecting the incumbent management of a listed company.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. hostile takeovers in Korea will likely be rare in the future. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. Traditionally. and some differences in Korea’s generally accepted accounting principles from international standards.
the typical chaebol firm had an extremely high DER. while (non-chaebol) independent firms had much lower borrowing ratios. The Government’s supervision and regulation of financial institutions were poor.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.134 Corporate Governance and Finance in East Asia. 2. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. capital. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. 2. As mentioned earlier. II strong financial links among its member firms through investments and cross-guarantees. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. and internal funds. The new preference ordering is as .5. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. bond issues. and a high degree of inefficiency in the economy.5. share issues. financing choices of listed firms in order of preference were bank loans. Financing preferences changed drastically after the crisis. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. Such problems may eventually cause ripples through the entire economy. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. as the latter are well established in most business areas. and other individual markets. Further. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. Vol.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. However.
5 billion. the top 30 chaebols showed a DER of 519 percent. Bank loans. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. 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. However. At the end of 1996. The lending practices of banks. Nonpolicy loans were also considered to be cheap because of interest rate regulations. The ratio of external debts to GDP reached 48 percent at the end of 1998. The preference for debt finance also led to a relatively large foreign debt. which were the most important financing source until 1987. 63 percent of which was short-term. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. as evidenced by occasional. 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. As of the end of 1997. bank loans. In the international financial market.Chapter 2: Korea 135 follows: internal funds. the Government and the Bank of Korea defended the currency. large-scale bailouts of financially distressed firms. Other factors also contributed to this preference. After the financial crisis erupted in Indonesia and Thailand. consisted of high proportions of policy loans. Implicit guarantees by the Government on bank loans to large businesses. won/dollar nondeliverable forward rates increased rapidly. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. obviously contributed to overlending and aggravated the situation. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. and bond issues. 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. In November 1997. share issues. which generally required guarantees or collateral. 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. total foreign debt amounted to $157. signaling a bearish speculative move on the won. reducing foreign exchange reserves to a dangerous level. .
and the pursuit of growth through excessive diversification and inefficient investment. starting 1 July 1998. In 1997 they became negative. It jumped to 17. and there is collateral. However. excluding the financial sector.000 in September 1998 (Table 2. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. decelerated from March 1998. were low in 1996 and 1997.7 percent in 1997. Further. The banks and merchant banks lent to large businesses. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. The inevitable result of inefficient investment was a fall in corporate profits. reaching highs of 6 percent in 1997 and 8. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. nine out of the 30 top chaebols failed. The monthly number reached more than 3. Before the crisis.000 per year starting 1992.000 from December 1997 to February 1998. especially chaebols. they are defined as loans for which interest payments are overdue by three months or more. without strictly evaluating the creditworthiness of businesses and the profitability of projects. the ratios of net profits to sales. Following the “three months” definition. the NPL ratio8 of banks and other financial institutions began to increase. has given rise to various types of self-dealings by the controlling shareholder. and shareholders’ equity of all industries.1 percent in 1996. the NPL ratio of commercial banks increased rapidly from 4. Fixed loans are those for which interest is not received for six months or longer. Meanwhile. then 20. According to the “six months” definition. These were the definitions until 30 June 1998. Financial Sector Vulnerability Because of financial losses in the corporate sector. . Moreover.200 in 1997. and returned to about 1. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding.6 percent in June 1998. The Government could hardly help them because of the number and magnitude of business failures.136 Corporate Governance and Finance in East Asia. total assets. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. and there is no collateral.000 during January-September of 1998. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. Vol. the NPL ratio reached 7.32). legal and other barriers prevented the exit of financially nonviable firms. and estimated losses. Doubtful loans are those for which interest is not received for six months or longer.
417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.553 3. and large government-directed loans.472 2.107 6.133 3.259 2.China.573 3.859 3.890 4.457 2.Chapter 2: Korea 137 Table 2.979 8. 2.647 8.027 Manufacturing 1. Source: Bank of Korea.32 Number of Firms with Dishonored Checks.053 5.855 6.250 2.502 11. the ratio reached 7-8 percent. This was mainly due to the high ratios of NPLs.114 811 706 696 866 1.850 3.992 11.159 10.210 1.856 7. and Taipei. As a result they had largely overvalued currencies.131 1. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.33). This speculation was said to be one of the causes of the financial crisis in Korea. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.386 5.754 3.637 6. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries. those of domestic banks were lower in the 1990s. 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. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action. and declined to 4-6 percent in 1994-1996 (Table 2.255 13. Meanwhile.69 20.657 3. European countries. In 1990-1993. low efficiency.265 6.135 1.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.5.759 6.238 4. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.589 171.769 9.544 2.517 2.244 3. Compared to ROAs and ROEs of domestic branches of foreign banks.751 1. The current account deficits in terms .985 Services 3. and continuous and large current account deficits.673 Construction 380 354 242 195 294 585 1.
Related to this.520 194.190 9. The main result of the rigid labor market was a “high-cost and lowefficiency” economy. Businesses served as a social safety net.929 11.China. the ratio of short-term debt to foreign reserves was very high.874 22.649 375. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. which led to large corporate losses.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7. In addition to the overvaluation of the won. Vol.537 10.33 Nonperforming Loans of General Banks.832 337. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.221 8.6 percent (1995).705 160. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable. Mass layoffs became legally possible only after the economic crisis.584 Fixed (A)a 5. Source: Bank of Korea.0 7. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.652 29.484 11.8 5. and 30 percent in 1996. although per capita income in Korea was much lower. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.997 9. because of the rigid labor market. In 1997.475 143.600 10. of percentage of GDP were as follows: Malaysia -8.2 4.310 6.138 Corporate Governance and Finance in East Asia.China.266 10.176 7.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.0 8.954 9. . Meanwhile large businesses could not legally lay off workers.556 118. Korea -4.562 18.910 1. and Indonesia -3.827 289.1 percent (1995).739 241.639 1.8 percent (1996).170 1.1 7. even in times of economic slowdown. Land prices and real estate rents were also high compared to trading partners.160 11. Thailand -8.390 12.4 5.430 12.116 1.584 2.736 8.077 NPL Ratio (%) 8. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.1 6.192 Doubtful (B)b 952 1.0 7. II Table 2.6 percent (1995).
6.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. Downsizing by curtailing employment has been prevalent. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions.Chapter 2: Korea 139 2.6 2. However. Nonviable firms and financial institutions. had been forced into bankruptcy proceedings or merged into healthier entities. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. They have been pressured to stop such practices as providing loan guarantees. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. To achieve this. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. 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. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. which were laden with huge amounts of debt and were on the verge of bankruptcy. including banks. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. .1 Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness. Corporations. 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. and subsidizing money-losing units. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed.
Locally. banks and other creditors were reluctant to absorb losses realized by debt compositions.281 in April to 2. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. Noticing this disincentive. 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. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks.140 Corporate Governance and Finance in East Asia. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. A debtor whose liquidation value was estimated to be greater than its going concern value was subject to “exit”—meaning the creditors would altogether stop lending and not allow renewal of the existing debt. potential foreign buyers waited for the price of acquisition targets to come down further. On the other hand.138 by the end of October. the number of potential sellers decreased somewhat from 2. Banks did not have the incentive to force financially nonviable firms to liquidate. The reasons are manifold. 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. More important. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. In many cases. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. 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. the creditor . 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. This number was at 779 firms in April and grew to 1. In their first review. Internationally. Vol. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio.045 in October. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery.
11 were merged into other group members. interest reductions. The workout plans were completed for most firms by early 1999. three filed for courtsupervised bankruptcy reorganization. but viable. workouts are being applied to non-chaebol firms identified as financially weak. and 16 non-chaebol corporations that had been selected as possible workout candidates. Upon completion of the evaluation. the results thus far have not entirely been as desired. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. two were acquired by newly organized employee stock ownership plans. FSC has been monitoring the processes from a prudential regulation standpoint. 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. These chaebols submitted plans for restructuring to improve their respective capital structures. Based on these plans. Corporate Workouts Workouts in the forms of debt rescheduling. was allocated to the six largest banks for them to employ outside experts as advisors. Also. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. By the end of 1998. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. Among the sell-offs. Among the 55 firms selected. 24 were liquidated. write-offs. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. not only for the design of corporate workout programs but also their implementation. A portion of the Technical Assistance Loan of $33 million. . 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. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. The plans were put into action immediately following finalization. by their creditors. and 12 were sold off to other firms. provided by the World Bank.
Big deals would. In one case. inducement of foreign direct investments was considered to be the most effective means of achieving that end. Big deals have been elevated to the status of the most important means of effective corporate restructuring. In another. power plant facilities. First. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. aircraft. Korea adopted and implemented policies to open its capital market completely. However.142 Corporate Governance and Finance in East Asia. some of the acquisition agreements have been discarded for various reasons. purchase of divested assets. Foreign investment—in the form of acquisition of controlling interests. As of April 1999. enable chaebols to streamline their overly diversified operations and focus on several core business areas. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Thus. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. railroad cars. In the early days after the outbreak of the crisis. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. vessel engines. This figure contrasts sharply with the total of $700 million for all of 1997. automobiles. In the case of automobiles. and petrochemicals. labor union demands of the seller were not acceptable to the transacting parties. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. the foreign buyer demanded specific protections against adverse developments in the business environment. Vol. On 3 September 1998. it is hoped. and equity participation—reached about $8. uncertainty over the future . Restrictions on foreign ownership of land were also abolished. Big Deals Ever since the outbreak of the economic crisis.5 billion on agreement basis during the 10-month period after December 1997. oil refineries. most of the big deals have entered their final stages of negotiation. These deals could eliminate excess capacity in such industries as semiconductors.
(iii) to reduce financial leverage. Seventh. foreign buyers were concerned with the inflexibility of the labor market. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. Third. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. (iv) to focus on a small number of core businesses. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. 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. (ii) to remove cross-guarantees of loans among group members. As set forth in the agreement. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. 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. In effect. With this in mind. Fourth. Overhaul of Bankruptcy Procedures In February 1998. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. 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.Chapter 2: Korea 143 course of the Korean economy remains high.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. Sixth. and (v) to improve the accountability of controlling shareholders and the board. Second. 2.6. The presence of . these goals were: (i) to enhance managerial transparency. Fifth. but it also has important implications with respect to corporate workouts. local creditor banks were reluctant to absorb losses arising from debt compositions and debt-equity swaps that were necessary in deals involving insolvent sellers. Not only does this represent progress in terms of an improved institutional framework for market competition.
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.144 Corporate Governance and Finance in East Asia. Third. October 1998. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. the court may annul its previous decision and force the firm into immediate liquidation. a “Management Committee. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets. and economics professions should be organized to provide for expeditious proceedings in court. Second. II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. Fourth. etc. The changes in the reorganization procedures can be summarized as follows. Also. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. number of creditors. the right to revoke court receivership is allowed to the creditors. accounting. 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. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. .” comprised of experts in the legal. Korea’s Economic Progress Report. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. Vol. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. (ii) legal changes have been made so that domestic accounting practices conform to international standards. Also. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0. (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. First. In the past this stage usually extended for as long as two to three years. The purpose of this rule is to shorten the reorganization planning period.01 percent in May 1998. Fifth.
which was passed in August 1998. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. 514 listed companies had appointed 677 outside directors). beginning on 1 April 1999. (vii) by the end of March 1998.148 industries remain closed. A recent case in point is the penalty imposed by the Fair Trade Commission on chaebol subsidiaries found to be involved in unfair transactions among group members. including financial subsidization. administrative procedures for FDI will be dramatically simplified and made transparent. Korea has rapidly liberalized the capital market by adopting the following measures: (i) the ceiling on foreign equity ownership was completely eliminated in May 1998.Chapter 2: Korea 145 (as of the end of May 1998. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. either partially or fully. According to the law. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. (iv) during April and May 1998. an additional nine industries will be opened or further liberalized. These new standards are and will continue to be strictly enforced. have been instituted for FDI: . 21 industries were further liberalized or newly opened to FDI (now. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. to FDI). (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. only 31 out of 1. various supporting measures. Capital Market Liberalization Since 1998. and (viii) as of 1 April 1998. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. (v) by the end of May 1999. As for promotion. 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. In addition. financial institutions could no longer require cross-debt guarantees. including tax exemptions and reductions.
Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. Also. however.146 Corporate Governance and Finance in East Asia. 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. the Korean Government is strengthening prudent regulations and market monitoring. It aims to establish a benchmark by consolidating various government bonds. These liberalization measures. such as the high-tech industry. The location of the FIZ will be determined at the request of foreign investors. including infrastructure and tax support. are not risk-free. the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. These bonds will be issued . Various support measures. Vol. The law allows rental cost exemptions and reductions for FDI. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. will be provided to foreign firms in the FIZ. 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. Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. To minimize potential risks. Three-year government bonds will be used to establish a benchmark. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments.
6 trillion for the debt restructuring fund. a primary dealers system will be introduced for healthy financial institutions.Chapter 2: Korea 147 monthly. The Government established specific qualification criteria and selected the primary dealers in 1999.6 trillion in these funds: W0. According to the law. Prior to the introduction of this system. Moody’s signed a joint venture contract with Korea Investors Service. Twenty-five domestic financial institutions. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. and is promoting joint ventures between foreign and domestic agencies. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. It also opened the credit rating service market to foreign competition. and the demand for longerterm bonds increases in the future. but it will also help improve financial institutions’ risk management. It is now easy for private investors. To ensure transparency and efficiency of the fund operations. but may be extended as required. they will be managed by foreign investment management companies. and W1 trillion divided equally between the three balanced funds. invested a total of W1. financial institutions . In order to promote a greater market demand for government bonds. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. including the Korea Development Bank. These are expected to operate for the next three years. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. This law will not only provide an effective institutional environment for the disposal of NPLs. If interest rates stabilize at a low level. to establish closed-end investment companies. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. In August 1998. both domestic and foreign. As a pilot program. Mutual funds (or open-end investment companies) will be allowed starting 2001. Investment Companies Korea has developed an institutional framework for closed-end investment companies so that they function as a key instrument for long-term financing. Related legislation was put into effect in September 1998. with only minor standard exceptions.
Vol. 2. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. More important. However. As markets become more efficient. when the limit is binding. etc. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. foreign business corporations with good credit standing are now also permitted to issue ABS. can utilize ABS. unless the limit is tight and binding. A good governance system is essential for the healthy growth of corporations and financial institutions. 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.g. A investing in B. However. There must be stronger rules to control agency problems. as stipulated by the government measure.6. 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.148 Corporate Governance and Finance in East Asia. Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. the role of the board of directors as the internal control mechanism must loom large in corporate governance. there is another view that placing a maximum limit on interfirm investments. greater efforts to improve corporate governance are preferable to regulation of interfirm investment.. For instance. In principle.) and the level of interfirm investments is very high. is inevitable. II and qualified public corporations. considering that there is no other effective way to limit circular investments among chaebol affiliates (e. B investing in C. However. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. 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. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional . which is the case for many chaebols. and C investing in D. this regulation may not be effective in curtailing pyramidal structures. Selfdealings. On the other hand. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. such as the Korea Asset Management Corporation (KAMCO). this can only be a temporary measure. cross-subsidization.
One action that has yet to be taken is the introduction of an act to facilitate class action suits against corporate directors and internal and external auditors for their wrongdoings. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. One way of motivating institutions to do this is to 10 M. Companies could also invite nominations from such organizations as the Korea Listed Companies Association or citizens’ coalitions that have been active in monitoring corporate management through proxy solicitations. and other committees. . Latham. The Corporate Board. 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. governance. 1997. Since the economic crisis. September/ October 1997. Listing rules may recommend that all or large listed companies adopt an audit committee. 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. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. it will have to include making self-dealings by directors and officers.Chapter 2: Korea 149 investors or their trade associations. 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. If and when the law is introduced. Further. 1997). pp. various measures have been implemented to promote investors’ rights. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. using audit. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. 23-26. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. and also negligence of external (independent) auditors actionable. Class action suits are an efficient means for corporate monitoring. Institutional investors will play an increasingly important role in corporate governance.
insurance companies. an audit committee. II provide comprehensive guidelines for their actions in matters related to corporate governance. In the coming years. 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. 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. possibly. more drastic in nature. securities companies. the Government will have to come up with appropriate policy measures to solve these problems. objecting to certain defensive measures proposed by the management. Many of the larger investment trust companies. Another measure. such as the Korea Investment Trust Association. and impose stronger penalties on violations of the rules on portfolio investments. by all nonfinancial companies (or “industrial capital”). 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. etc. and thus cannot be expected to be actively involved in monitoring portfolio firms. strengthening incentive compensation schemes for executives. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. strengthen its supervisory activities. 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. and other NBFIs are subsidiaries of chaebols— especially the five largest ones. The Government can also lower the limits on investments in affiliated companies. 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. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. Also. . reviewing independence and expertise of candidates for outside directors. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. Rights of minority shareholders should also be strengthened for these institutions. The Government recently proposed the revision of bankruptcy-related laws.150 Corporate Governance and Finance in East Asia. The institutions’ respective trade associations. could prepare such guidelines. and compliance officers. Vol.
lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). the elimination of implicit guarantees for financial support to chaebols. excessively diversified into nonrelated business areas. which could provide alternative sources of long-term corporate finance. the limit on ownership of bank shares will have to be eased so that strategic investors (shareholders) can act as true effective monitors of bank management. Banks should adopt strong incentive compensation schemes for management. To facilitate the development of the Korean stock market. and introducing disincentive schemes for excessive borrowings. Bank boards also need to be made more independent from management. through them. and financial institutions. (ii) provision of reliable accounting information. and (iii) a good corporate governance system to protect investors. For this. such as application of higher interest rates by banks to chaebols with higher DERs.Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. reduction of protection of domestic markets and entry barriers. Chaebols are overly indebted. the important issues to be addressed are: (i) improvement of the corporate disclosure system. private firms. and thus full-scale education programs should be developed. and stop unfair internal transactions. to concentrate instead on a small number of core businesses. large firms. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date. The Government should substantially reduce the proportion of policy loans from bank loans. This means that the Government can control the banks and. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. Such measures include providing an effective corporate governance system. In order to minimize government intervention in bank and corporate management. The current obligatory system of disclosure that emphasizes “hard” . bank managers should be made accountable to shareholders but not to the Government. The Government should put more efforts into developing the capital market. therefore are vulnerable to economic shocks. The public and corporations should be taught or fully informed of the best practices in corporate governance. In turn. Many corporations are burdened with excessive debt and. and consistently show low profit rates. the banks have great leverage over the management of debtor firms.
Prevalent corruption. . is considered to be one of the major causes of the economic crisis. especially among business people.152 Corporate Governance and Finance in East Asia. and bureaucrats. The network should cover not only the exchange market but also OTC transactions of investors and dealers. on a real time basis. These should be lengthened to make them a source of stable long-term funds. and measures to reduce corruption. Vol. reasons for different degrees of corruption in various countries. At the same time. the information system of the bond market should be better organized to transmit. wage rates. Policies are needed to help develop more reliable services by bond rating agencies. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects. no economic reforms will be effective. Currently. The function of securities companies as dealers of bonds should be improved. 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. In determining optimal exchange rates. The establishment of a Corruption Prevention Institute will be helpful in this regard. politicians. The development of the OTC bond market requires a well-developed dealer system. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. penalties on violations of disclosure rules are not effective enough to have a significant impact. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts. and labor productivity should be considered. Without successfully addressing this problem. data on quotations and trading volumes. Future research could include causes of corruption.
pp.). A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. Bank of Korea. S. 79-95. Financial Studies. Understanding Flow of Fund Accounts. C. W. and J. Hong. Latham. Proposed: A Governance Monitor. Chung and H. S. Kang. D. Financial Studies. various issues. M. Chung. H. 1997. K. Bibong Publishing Co. H. Economic Statistics Yearbook. T. 1996. and H. Korean Managerial Dynamics. various issues. 23-26. Y. 1999. 1992. Survey of Facility Investment Plan. various issues. S. W. 1998. KERI. S. 1994. Lee. K. September 1998. H.. S. Evolutionary Chaebol. Kim. Kim. Korea Development Bank. An Empirical Evidence on Value of a Firm and Ownership Structure. 7995. 1996. Ju Hyun. Lee. C. September/October 1997. Determinants of Diversification of Korean Business Groups. Korea Economic Research Institute. 1989. September 1998. Korea’s Financial System. and 1998 issues. Maeil Daily Economic Newspapers. Kim. S.. 1995. Lee. Jae Woo.. Korea Economic Research Institute. KERI. New York: Praeger. 1996. Market Concentration and Diversification of Business Groups. Korea’s Chaebol. in Korean Managerial Dynamics. H. 1997. and K. Japanese Zaibatsu and Korean Chaebols. New York: Praeger. 1995. Bank of Korea. Bank of Korea. Financial Statement Analysis Yearbook. Hattori. 1993. I.Chapter 2: Korea 153 References Bank of Korea. W. 1998. C. International Monetary Fund. KERI. W. various issues. Korea’s Large Conglomerates. International Financial Statistics. Hong Moon Sa. Lee (eds. The Corporate Board. 1997. Tomio. . Corporate Restructuring. Kwon. edited by K. Center for Free Enterprise. I. Choi. pp. N. Jua. pp. 1997. Chon. 1989. Cho. Chon. Cho. D. Is the Fair Trade Policy Fair? Korea Economic Research Institute. September 1997. H.
J. H. Korea Institute for International Economics and Trade. K. Beyond the Limit. Wang. U.. 1999. October 1998. . 23. January 1995. Background and Task of Structural Adjustment.154 Corporate Governance and Finance in East Asia. S. Y. March 1999. Korea Institute for Industrial Economics and Trade. Ungki. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. 1995. Korea’s Economic Progress Report.. September 1998. Real Exchange Rate and Policy Measures. and J. Yim. Corporate Governance in Korea. W. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Chicago. K. H. Lee. Lim. Yonsei University. Kang. Annual Conference of Financial Management Association.. Nam. S. C. 1996. I. Seoul. Korea’s Trade and Industrial Policies: 1948-1998. Whan. Sohn. II Lee. Management Research Institute. Whang. J. Ungki. Chung Ang University. 2nd Sangnam Forum. 1998. Capital Liberalization. Korea Finance Institute. KIEP Working Paper 98-05. Joh. C. K. Conference on Corporate Governance in Asia: A Comparative Perspective. Lim. Kim. October 1998. Yang. and J. S. I. 1998. A New Trade and Industrial Policy in the Globalization of Korea. Y. Business Groups in Korea: Characteristics and Government Policy. November 1996. Lee. Korea Development Institute and World Bank. 1999. Y. Korea Institute for International Economic Policy. and H. 1998. Ministry of Finance and Economy. Kim. 1996. Vol. J. KIET Occasional Paper No. 1998. S.
The author wishes to thank Juzhong Zhuang. When the Asian crisis erupted in 1997. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. state-sanctioned monopolies. about a decade before the recent Asian crisis. Roble. overall. The lifting of the debt moratorium in 1991. 1 Principal. and government subsidies were tackled during that period. in particular Francisco C.3 The Philippines Cesar G. the Philippines. This has come about following a political and economic upheaval from 1983 to 1987. Inc. David Edwards. the Philippine economy and corporate sector were in a relatively sound financial position. From 1993 to 1996. The Asian financial crisis revealed that. Saldaña1 3. and Lea Sumulong and Graham Dwyer for their editorial assistance. Companies of other Asian countries were already using these markets to finance investment and growth. 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. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. for their research assistance. the PSR Consulting. Issues such as State ownership of businesses. Inc. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. The Government pursued the privatization of various state-owned corporations as part of its financial rehabilitation programs sponsored by the World Bank and the International Monetary Fund (IMF).. the Philippine Stock Exchange for its help and support in conducting company surveys. staff. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity.1 Introduction In recent years. Pineda. . both of ADB. and Liza V. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. Denise B. after the completion of debt negotiations with the IMF and Paris Club. PSR Consulting. Serrana.
156 Corporate Governance and Finance in East Asia. emerged to influence industrial policies. usually with the acquiescence of bank creditors. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. These early industrialists naturally opposed any initiative to reduce tariffs. on family-based and controlled conglomerates. Vol. control by internal and external governance agents. composed mostly of families previously in trading businesses. which leads to their easing of due diligence and monitoring standards when lending to group members. The policy was crafted by the martial law regime at that time. II Still. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. Companies finance long-term investments with short-term debt. their growth could not be sustained. Companies were profitable because of protection from foreign competition. It analyzes the impact of corporate governance on company financial performance and financing. patterns of ownership. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. 3. An industrial elite.2 3. Banks have significant presence as members of affiliated business groups. This study reviews the Philippine corporate sector in terms of its historical development. The Board of Investments (BOI) was created to draw up an investment priorities . Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. the Government overvalued the local currency and imposed high import tariffs.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. regulatory framework. and responses to the financial crisis. Corporate financing relies excessively on bank loans.2. and on the financial crisis. To implement these policies. patterns of financing. companies were necessarily large and capital-intensive. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. While new manufacturing industries were successfully established. But protectionist policies made labor relatively more expensive and. therefore.
It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. the “pioneer” industries identified in the IPP. the legislative body passed the Foreign Investment Act (FIA). Foreign ownership was allowed only in industries with high technological and market barriers. the Government continuously revised the enabling law of BOI so that incentives were reduced in number.. i. quantitative restrictions. made less associated with capital investments. 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 . Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration. Nevertheless. and initiated the development of alternative energy sources in response to the oil crises.e. and orientation toward domestic markets. In 1991. Exports were not competitive because of the high costs of imported materials. and oriented toward exports. Starting in 1981. The 1980s were marked by a peaceful transition of political power. Quantitative restrictions and tariff protection of preferred industries remained firmly in place.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives.” No strategic industry could take off without the Government’s participation in its management and operations. and import licensing requirements. dominance by large companies. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. the top three companies accounted for a disproportionately large share of total sales and assets. advance notice of areas where the country disallowed or restricted foreign investment. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. In many industries. Reforms in policies. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. The Government signaled through the IPP its intent to shape the future industrial landscape. assumed ownership of the largest petroleum refining company. In the early 1990s. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. including the reduction of tariffs. organizing industries into sectors and picking “winners. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. Following government initiatives in the control of the infrastructure and utilities sectors. the State took over the generation and distribution of electricity.
1 8. Its growth rate began to catch up with others in 1996.6) 0. II market.1 4.8 5.8 8. Vol.2 7.6 7. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.3 9.4 Philippines 3.5) 3.0 (0. which was taken as a representation of the Philippine corporate sector.1). 3.3 2.9 7.9 (1.9 6.2 9.2 During 1988-1997.0 8.2 Source: ADB.3 9. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.2) 4.0 (6. only to be unsettled by the crisis of 1997.1 GDP Growth of Southeast Asian Countries.2 Korea. This rate of growth was sustained by a comparable 18.3 8.000 Philippine companies grew 17.5 (7.8 4.9 5.7 (13. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.158 Corporate Governance and Finance in East Asia. net sales of the top 1.1 5.5) 5. only nonfinancial companies were used.000 corporations. In this section. however.8 8. Rep. of 9. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context.0 8.7) 10.2 7.4 4.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.8 10.0 7.7) (10.1 5. With economic reforms introduced in the 1980s and 1990s.2 (0.2.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.2 Thailand 11.7 Malaysia 9. Table 3.8 5.2). Key Indicators of Developing Asian and Pacific Countries 2000.5 8.2) 0.3 7.2 8.5 9. .5 8.000 Corporations covers financial and nonfinancial companies.7 8.5 percent per year (Table 3.7 5.
2 Growth and Financial Performance of the Top 1. of Companies Sales per Company (P billion) 899 0.3 382.160.7 1.1 881.2 4.8 22.000 Companies.978.7 443.1 95.9 1. turnover = net sales/total assets.5 1.6 290.5 192.3 121 12.6 954.0 900 1.0 148.6 5.9 78 6.697.2 900.4 898 1.394.2 2.1 4.9 149 6.3 46.6 102 16.561.1 714.5 Leverage = total liabilities/stockholders’ equity.3 898 1.9 898 1.225. .781.3 68 7.1 468.9 896 2.2 Average 146 12.2 136.7 218.3 862.6 18.2 707.6 35.4 776.4 1.8 411.8 77 7.6 1990 1991 1992 1993 1994 1995 1996 1997 1.4 8.4 63.9 480.512.8 741.1 181 11.6 75 6.7 28.5 14.2 27.5 4.5 72 7.8 618.8 6.6 896 0. 1988-1997 1989 519.3 107 13.341.9 2.6 144.191.9 629.1 197 14.332.7 20.4 555.9 96.5 51 4.1 6.1 615.177.1 Other Indicators No.4 188.4 411.2 Compound Growth (%) 17.9 617.0 1.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.131.2 338.6 900 1.8 5.000 Corporations in the Philippines.5 1.5 64.4 861.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.7 903 0.5 508.3 60 10.317. net profit margin = net income/net sales.4 3.1 73 5.5 1.1 33.4 602.1 1.4 260.3 941.1 54 11.209.5 887 0.5 570.8 902 1.Table 3.1 5.2 1.1 1.6 426. return on assets (ROA) = net income/total assets.0 1.1 72.5 446. return on equity (ROE) = net income/ stockholders’ equity.7 238.5 193.9 3.8 26.893.6 149 12.7 73 6.5 119 12.8 4.2 378.7 1.6 1.2 2. Source: SEC-BusinessWorld Annual Survey of Top 1.647.123.6 109 12.3 306.9 952.1 66 12.1 51.
5 17. Further.693 1.8 percent per year.474 1.8 17.979 17. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. 1988-1997 Top 1. Vol.178 1.3 percent.7 percent.5 Value-added is assumed to be 30 percent of net sales. Sources: ADB. and the SEC-BusinessWorld Annual Survey of Top 1.427 13.4 24. for the 10-year period. Net profit margins for the top 1.394 1. respectively. These rates of return are high compared with other Asian countries. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. . Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997. Asset growth was funded by debt that grew at an average of 20.697 1.9 21.000 Corporations in the Philippines.9 percent for the period.1 19. leverage increased from 109 percent in 1996 to 149 percent in 1997.9 23. This is high compared with developed countries but compares favorably with other Asian countries.8 19.172 2.5 16.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1. and by equity that grew at a higher average annual rate of 26.352 1. Assuming Table 3.3). Total assets grew at an average annual rate of 22.160 Corporate Governance and Finance in East Asia.000 companies averaged 7.6 percent and 5.4 20.906 2. Return on equity (ROE) and return on assets (ROA) averaged 12.248 1.5 Ratio of Estimated Value Addeda to GDP (%) 17. but the extent of the increase was not as dramatic as in other Asian countries.3 The Corporate Sector and Gross Domestic Product. Key Indicators of Developing Asian and Pacific Countries 1999. II assets.1 Net Sales (P billion) 465 519 630 741 862 954 1. various years.2 percent. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.077 1.
5 Source: SEC-BusinessWorld Annual Survey of the Top 1.8 No. 1988-1997 Indicators Publicly Listed Privately Owned Rate.5 GovernmentOwned 4.4 Total Liabilities 26. these figures suggest a significant and increasing contribution of the corporate sector to GDP. (ii) foreign-owned.5 Retained Earnings 30. of Companies 73 Sales per Company (P billion) 2.8 22.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.3 22.8 3.9 158 13.5 Other Indicators Share of Sales (%) 17. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.3 146 6.Chapter 3: Philippines 161 a constant ratio of value added to sales.3 42.9 17.1 ROA 8. various years.4 190 5.3 22.2 9.4 Stockholders’ Equity 32.0 Turnover 53 Net Profit Margin 15.0 28.1 22 10.5 23 4.8 Growth Indicators (Compound Annual Growth Net Sales 20.5 27.8 ForeignOwned 21.3 11. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. The foreign-owned companies were the Table 3. privately owned companies constituted the largest group (Table 3. A study of company performance by ownership type.9 26. size.2 103 5.0 5.0 31. %) 17.8 2. corporate control structure.0 5.3 27.1 12.7 22. Averaging 42.8 14.8 percent of the corporate sector’s total sales between 1988 and 1997.0 4.000 Corporations in the Philippines. and (iv) privately owned.4 Fixed Assets 19.7 2.1 Financial Ratios (%) Leverage 89 ROE 15.9 22. The premise is that these variables have a direct bearing on corporate performance and growth. (iii) Government-owned. .3 9.6 Total Assets 29.0 Net Income 19.8 606 0.4).0 142 22.4 28.9 196 1.
they generated the highest return on investments. or 38 percent.000 list. . a level high by Western standards but at par with those of other Asian countries.75 billion per company for foreign-owned companies. Publicly listed companies had a minor though steadily increasing share in total sales.162 Corporate Governance and Finance in East Asia. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. foreign-owned companies borrowed more than publicly listed ones. The privately-owned companies had a high average leverage ratio of 158 percent. selling an average of P4. II second largest at about 27. But by being most efficient in employing assets.1 billion per company in 1997. the highest net profit margin of 15. Bases Conversion Development Authority.2 percent and ROA of 9.5 percent.3 percent. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. these companies were comparatively large. Privately-owned and Government-owned companies grew at slower rates. registered the largest per company sales at about P9 billion in 1997. and low return on investment is the norm. exceeding the 17. Publicly listed companies had the lowest leverage at 89 percent. These were mostly large public utilities.000 companies in 1997. Vol. Their ROA and ROE were both more than twice as high as those of government-owned companies.9 percent. the asset base is large.5 percent average growth rate of the entire corporate sector. With an average leverage ratio of 142 percent. followed by publicly listed ones. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. but lower than those of foreignowned and publicly listed companies. 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. although small in number. compared with P2. and the second lowest asset turnover. Governmentowned companies in the top 1.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. were among the top 1. meaning that the remaining 62 percent were relatively small in sales and assets. while there were few of them. with an average ROE of 22. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). However. The government-owned companies had the highest leverage at 190 percent but lowest ROA and ROE because these are primarily public utilities and companies in the energy sector where turnover is low. the second best ROE and ROA. The compound annual sales growth rate was 21.
5 Growth and Financial Performance of the Corporate Sector by Control Structure. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997. of Company 159 Sales per Company (P billion) 2. grew faster.1 Source: SEC-BusinessWorld Annual Survey of Top 1.3 percent for the conglomerates.7 Stockholders’ Equity 34.1 Retained Earnings 32. and achieved higher returns on invested assets than independent companies (Table 3. had a lower leverage ratio.0 22.8 6. compared with 32.0 166 15. Table 3. the corporate sector is divided into large.0 25.2 Net Income 21.8 ROA 8.0 55. Performance by Firm Size By firm size. Sales and resources of the . depending on assets and sales.7 Total Assets 32.000 Corporations in the Philippines. various years.Chapter 3: Philippines 163 Performance by Control Structure By control structure.3 No.1 124 5. a company can be a member of a conglomerate or independent.3 Financial Ratios (%) Leverage 98 ROE 15.0 Turnover 67 Net Profit Margin 12. 1988-1997 Indicators Group Member Independent 18.5). medium.6 715 0.8 Growth Indicators (Compound Annual Growth Rate.2 23.6 26. But the conglomerates were larger measured in sales per company.3 Other Indicators Share in Sales (%) 32.4 24.2 Fixed Assets 25. %) Net Sales 20. and small companies.3 Total Liabilities 30.7 2.
0 156 16.000 list.7 44.0 32.5 12. which.9 Financial Ratios (%) Leverage 158 ROE 13. indicating that they deployed resources more efficiently than large and small companies. 1988-1997 Indicators Large Medium 19.000 list. Medium-sized companies also performed better in terms of ROE. averaged only P920 million in per company sales during the same year.8 percent of the total number of companies in the list (Table 3.6 Growth and Financial Performance of the Corporate Sector by Firm Size.000 Corporations in the Philippines.0 730 0.9 26.4 28.7 Net Income 1. while small companies. are defined as the largest 100 companies in the top 1.6).2 25.9 Retained Earnings 13.2 Other Indicators Share in Sales (%) 56. although they comprised only 8. referring to the remaining companies in the list.0 7. %) Net Sales 15.6 36.6 31.3 Fixed Assets 15.6 47.1 percent of the total sales of the corporate sector. various years.1 ROA 5. sales of mediumsized companies grew faster than large companies. Medium-sized companies.164 Corporate Governance and Finance in East Asia.9 89 1.1 25.9 32. .2 Stockholders’ Equity 18.3 Turnover 65 Net Profit Margin 8.5 128 10.6 49. of Companies 79 Sales per Company (P billion) 7. averaging 16 percent.1 4. Sales per company in this group averaged P13.5 73 6.6 Small 19. However. for this study.2 29. defined in this study as the next 200 largest companies in the top 1. averaged a far less P3 billion in per company sales. Vol.4 Total Liabilities 18.4 billion in 1997. Table 3. Large companies accounted for 56.5 Growth Indicators (Compound Annual Growth Rate.5 Total Assets 18.3 Source: SEC-BusinessWorld Annual Survey of Top 1.1 No.1 81 9.5 25. II Philippine corporate sector are highly concentrated among the large companies.
Large.6 percent. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. and utilities and services sectors. The sector showed consistent growth in sales.e. Leverage was the highest for large companies. of net income. and construction. ROE dropped from 10. and the construction sectors than for the manufacturing. But small companies’ leverage was significantly lower. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. net income.8 percent. net income. unlike their counterparts in other Asian countries. The growth and financial performance of selected industries. manufacturing. averaging 10.8 the previous year. Performance by Industry This study also looked at corporate performance by industry.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. i. and assets was much higher for the real estate and property. ROE dropped to 7. assets. and utilities and services sectors. Growth of sales. from 14.Chapter 3: Philippines 165 Small companies. and equity up to 1996. Poor returns appear to have been caused by the low profit margin at 6.8 billion in . as indicated by the negative annual growth. The Asian financial crisis affected large companies most severely. The real estate and property sector also suffered significantly in sales. reflecting to some extent a “bubble” phenomena in the former two sectors.1 billion in 1996 to P4.8 percent in 1997. compared with 9.7 percent in 1996 to 8. although the largest in number. profits. showed the lowest ROE. but suffered its largest decline in net profits in 1997..7 percent a year earlier. are shown in Table 3.1 percent. and profitability in 1997 when the crisis started.4 percent in 1997 from 11.2 percent for large ones. at 158 percent on average during 1988-1997. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales.7 billion and P35. at -12. at 128 percent for the period.5 percent for medium-sized companies and 8. but lower than that of construction.2 billion in 1997 for this sector. For small companies. Net income declined from P54.7 percent in 1997 for medium-sized companies. especially during the period 1994-1996. utilities. specifically those industries least and most affected by the financial crisis.7. Sales revenue and net income declined from P76. at 156 percent. with their ROE dropping to 3. real estate. Mediumsized companies’ leverage level was slightly lower.
9 billion and P24.7 percent to 10. and was also much more limited compared with the property sectors in other Asian countries.2 28 0.2 8.3 Retained Earnings 17.8) 17. 1996 to P56.7 ROA 5.2 37.7 Growth and Financial Performance of the Corporate Sector by Industry.0 25.4 Total Assets 19.000 Corporations in the Philippines. it does not appear to have been excessively exposed to foreign currency-denominated loans. As a result.3 20.0 21. respectively.2 12.9 17.4 16. %) Net Sales 16.5 12. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.8 48.0 31 0.7 19.8 41.4 3.7 28. 1988-1997 Utilities Real Estate and and Services Property 39.5 Other Indicators Share in Sales (%) 82.1 24 42.4 percent.9 5.0 23.6 Total Liabilities 18.7 83 2. . Vol. the sector’s ROE dropped from 15.6 Growth Indicators (Compound Annual Growth Rate.6 69 16.7 192 9.2 45.3 55.6 Financial Ratios (%) Leverage 142 181 ROE 13. various years.9 23.3 Fixed Assets 20.7 Indicators Manufacturing Construction 27. of Company 454 17 Sales per Company (P billion) 1. II Table 3.3 5.6 No. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.9 2.7 52.0 Turnover 112 24 Net Profit Margin 5.166 Corporate Governance and Finance in East Asia.7 10. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.000 companies’ total sales on average during 19881997.9 2.7 billion in 1997.4 Source: SEC-BusinessWorld Annual Survey of Top 1.1 2.1 10.7 Net Income (12.8 Stockholders’ Equity 21.4 19. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.
(vi) names. The articles of incorporation may also include other matters such as waiver of preemptive right and classes of shares such as founders’ or redeemable shares describing their rights. and recognized rules on corporate practices. and residences of original subscribers. (iv) term of existence. (ii) purpose of the corporation. and (viii) names. (iii) principal office. Under the Code. It specifies the minimum information to be indicated in the articles of incorporation.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. 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. For publicly listed companies. (vii) number. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. nationalities. Overall. nationalities. the leverage of all four industries was low. (v) number of directors (not less than five nor more than 15). the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. reaching up to 313 percent in 1997. privileges. operation. unlike in neighboring countries hit by the Asian crisis.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. par value. and the Insolvency Law. and residences of incorporators and directors. which is also the organic law governing the operations of SEC. and amount of authorized capital stock.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. administrative regulations. Two other pertinent laws are Presidential Decree (PD) 902-A.2. and amount subscribed and paid by each. which was based on American corporate law. The General Banking Law. 3. . The currency devaluation bloated the foreign currency-denominated loans of these companies. the Corporation Code of 1980 is a compilation of important juridical rulings. contains some provisions affecting corporations’ dealings with banks. which regulates banks and nonbank financial institutions except insurance companies. and dissolution of corporations. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. and restrictions. One month after registration.
It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. and control (adjudicative) of all corporations. among shareholders. To be valid. manner of voting. or officers. (ii) required quorum in shareholders’ meetings. and reasonable. between the shareholders and the corporation. In 1976. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. 4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. (vi) penalties for violation of the bylaws. uniform. However.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. duties. (iii) controversies in the election or appointments of directors and officers of corporations. and forms of proxies and manner of voting them. the corporation’s articles of incorporation. and (vii) manner of issuing certificates in the case of stock corporations. Vol. officers. (iv) time for holding annual election of directors and manner of giving the election notice. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. In addition. and should not impair vested rights. place. and public policy. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock.168 Corporate Governance and Finance in East Asia. and employees. directors. (v) manner of election or appointment and term of office of all officers other than directors. (iii) qualifications. II to adopt a code of bylaws or rules for its internal governance. and between the corporation and the State concerning its franchise or right to exist. Its mandate is to supervise corporations in order to encourage investments and protect investors. 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. must be general. (ii) controversies arising out of intra-corporate relations. supervision (regulatory). . the bylaws must be consistent with the law. and (iv) petition of corporations to be declared in a state of suspension of payments in cases when their assets cover all debts but they cannot pay these debts when they fall due. and manner of calling and conducting regular or special meetings of the directors and shareholders. and compensation of directors.
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The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for “suspension of payments” to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors’ properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the country’s facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a “self-regulated” organization. Thus, PSE now
170 Corporate Governance and Finance in East Asia, Vol. II
has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchange’s rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks’ voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks’ voting shares.
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Regulations on the single borrower limit (SBL) put a ceiling on the maximum amount that a bank can lend to a debtor. SBL rules limit the total liabilities of any borrower of a commercial bank to 15 percent of the bank’s unimpaired capital and surplus, and an additional 15 percent for “adequately secured loans,” to a maximum 30 percent (“unimpaired capital and surplus” refers to the total paid-in capital, surplus, and undivided profits, net of valuation reserves of a bank). SBL limits exclude risk-free loans such as Government-guaranteed loans and loans secured by cash deposits. Total corporate liabilities include all liabilities of the debtors and their majorityowned subsidiaries. The Monetary Board may prescribe the consolidation of the liabilities of subsidiaries with the parent corporation under certain conditions. Central Bank (Bangko Sentral ng Pilipinas [BSP]) regulations do not prohibit loans by the bank to its directors, officers, shareholders, and other related interests, known as DOSRI. However, they are subject to certain prudential requirements under banking laws, as follows: (i) a director or officer of a bank can only borrow or become a guarantor, endorser, or surety for loans from the bank with the written approval of all other directors of the bank (i.e., excluding the director concerned); (ii) the amount of outstanding credit accommodations that a bank extends to its shareholders shall be limited to an amount equal to the sum of their unencumbered deposits and book value of their paid-in capital contributions; and (iii) loans and advances given to officers in the form of fringe benefits shall not form part of liabilities under DOSRI.
Corporate Ownership and Control Patterns of Corporate Ownership
The historical development of Philippine corporate ownership is rooted in the country’s colonial past, the industrial policies of the Government, and the recent emergence of industrialists and an entrepreneurial class. During the Spanish and American period up to World War II, a small number of families acquired land and owned large businesses. These families built and preserved their businesses over several generations. Many of them became controlling shareholders of family-based corporations and business groups that are major players in the present-day Philippine corporate sector. Ownership is a key element in corporate control and governance. Public listing rules of PSE require that a minimum of 10 to 20 percent of
172 Corporate Governance and Finance in East Asia, Vol. II
outstanding shares, depending on the size of the company, be available for trading in the stock exchange. As companies usually only issue the minimum required number of shares, large blocs of controlling shareholders often dominate corporate decision making in publicly listed companies. Public investors and minority shareholders are not in a position to influence management. Moreover, the presence of large controlling shareholders makes takeovers by other companies difficult. For these reasons, the resolution of conflicts between the interests of controlling shareholders, minority shareholders, public investors, and creditors in Philippine companies depends very much on the effectiveness of internal control systems. Ownership Concentration of Listed Companies This study measures ownership concentration in terms of shareholdings by the top one, five, and 20 shareholders.5 Table 3.8 shows that the top shareholder owned 40.8 percent of the market value of an average nonfinancial company. The shareholding of the top shareholder varied across sectors. It was highest for the property sector at 54.8 percent, followed by holding companies (as a sector) at 53 percent. One shareholder held majority control of an average company in these two sectors. The average shareholding of the largest shareholder was less than 25 percent only in sectors with large market capitalization, such as power and energy, and transportation, and in sectors with high risks, such as oil exploration and mining. These figures suggest that for publicly listed companies, a single shareholder often has substantial or even dominant control. Combined, the holding of the top five shareholders in an average company was about 65.3 percent for the nonfinancial sector and 59.2 percent for the financial sector. The five largest shareholders held majority control over an average Philippine publicly listed company, except in three sectors—transportation; food, beverage, and tobacco; and oil exploration. Ownership by the five largest shareholders was on average most concentrated among holding companies (78.4 percent), and in construction (74 percent), property (69.8 percent), manufacturing and trading (68.4 percent), and communications (67.3 percent).
The study derived ownership data for 194 (169 nonfinancial) companies out of 221 (190 nonfinancial) listed on the Philippine Stock Exchange as of 1997. Shareholdings by the top one, five, and 20 shareholders were estimated for each company and averaged by using the market capitalization of each company as a weight.
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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
Through these. or 78 percent of the total. the top five controlling shareholders were classified into eight groups. In 111 companies. the top five shareholders held more than two-thirds majority control of a company. In 21 companies. large and family-based shareholders pool the family’s ownership over many . controlling an average of 52.1 percent of publicly listed companies in the Philippines in 1997. In four companies. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market.9 shows that in 44 companies. or 80 percent (only nominally publicly listed) of outstanding shares. a single shareholder held two-thirds majority control. five. which are mostly privately owned and controlled by family-based shareholder blocs. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. II analysis of the number of companies in which the top one. The largest group is nonfinancial corporations. In four of 11 nonfinancial sectors. 66 percent (signifying strategic control). Who are the top one. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. There are advantages to establishing pure holding companies. or 3 percent of the total.174 Corporate Governance and Finance in East Asia. and share prices are sensitive to movements of foreign funds. In 76 companies.10. The shares of publicly listed companies are thinly traded and illiquid. nonfinancial corporations held majority control. or almost 75 percent of the total. or 51 percent of the total. and 20 shareholders? In Table 3. or 14 percent of the total. In 116 companies.2 percent of outstanding shares of publicly listed companies. five. including pure holding companies. minority shareholders are unlikely to be able to influence the strategic and operating decisions of a company without the support of one or more large shareholders. With such high levels of ownership concentration. holding only an average of 2. or about 30 percent of the total. Individuals did not constitute a significant shareholder group among the top five shareholders. Table 3. or 20 shareholders owned more than 50 percent (signifying operating control). Nonfinancial corporations with controlling shareholdings are likely to be holding companies. Vol. a single shareholder held operating control of a company. the top 20 shareholders collectively owned a majority of a company’s shares. the top five shareholders owned more than 50 percent of the voting shares. a single owner owned more than 80 percent of outstanding shares.
a Data for top 20 shareholders were not available for five holding companies.Table 3. .9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. Distribution. and Tobacco Manufacturing. Source: PSE databank. and two companies in the property sector. 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. 10 manufacturing companies. Beverage. and Trading Holding Power Transportation Property Total — = not available.
3 0.3 1.6 0. Beverage.6 0.2 1.7 0.1 9.2 0.2 0.1 0.2 10.0 0.6 9.0 0.0 1. and Trading Hotel.5 0.6 5.2 3.2 3.8 11. Distribution. 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 0.0 0.3 0.0 0.3 5.6 0.5 4.7 0.5 12.3 0.0 1. and Other Services Property Mining Oil Average Shareholdinga 33.7 3.9 6.6 2.1 a Weighted by market capitalization.0 0.0 2.0 1.1 7.7 0.4 8.7 0.0 5.0 7.0 2.4 1.6 2.2 5.9 52.7 67.7 0.5 2.4 29.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.3 12.8 0.8 21.2 59. Recreation.0 4.2 3.0 0.6 1.1 1. .0 5.0 1.7 3.6 18.1 6.1 8.6 0.3 0.0 0.0 0.0 5.5 4.0 1.5 13.5 26.8 0.3 0.2 0.8 66.0 0.0 1.7 0.2 0.3 1.6 0.6 12.0 1.6 33.4 2. Source: PSE Databank.0 0.3 26.8 0.0 5.6 0.2 3.7 1.0 0.3 5.4 5.9 0.9 0.5 0.0 1.4 0. and Tobacco Holding Companies Manufacturing.9 36.0 0.0 0.3 37.3 2.Table 3.0 10.5 53.6 0.0 45.0 0.1 5.1 0.2 0.4 19.
respectively.6 percent of market capitalization in 1997. Such advantages have contributed to the popularity of holding companies among publicly listed companies. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. with an average of only 7. Because of limited ownership by institutional investors. The 7. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. accounting for P258.2 percent in 1997. and San Miguel Corporation (SMC) in food and beverages. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce.7 percent of market capitalization of the nonfinancial publicly listed companies.1 percent). . financial institutions did not have a significant ownership in nonfinancial corporations. Holding companies as a sector had the largest market capitalization in PSE in 1997.Chapter 3: Philippines 177 companies and share in the risks and profits of the group.3 percent). The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. Investment trust funds were the most important institutional investors. there was no real market for investment information. commercial banks (1. while still allowing the public to own minority shares. 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. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4.2 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.1 percent).7 percent of shareholdings). This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. and insurance companies (0. Holding companies were themselves 66 percent owned by other nonfinancial corporations.5 to 12. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS).6 billion or 26. securities brokers (1. The investment funds’ presence in these sectors ranged from 8. They can also better manage their income taxes because income from affiliated companies passes through a holding company. As a group. 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. Petron and MERALCO in power and energy.
Large shareholders and their families own these banks directly or through their controlled companies. Family-based groups have larger companies since their total sales were about 33. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. Still. and increased the capital requirements for all types of banks. suggesting that business groups are common in all major markets. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. This is significant considering that there were only 31 local commercial banks in the country in 1997. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Commercial banks hold the largest share. including SBL and DOSRI rules. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. the study put together a list of prominent business groups.7 6 7 The study used publicly available shareholder information and published reports. 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. Prudential regulations. so far limiting their involvement to selected products.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3.000 Corporations in the Philippines. including 16 commercial banks. A common feature of corporate ownership of a business group is the centrality of a commercial bank. For this reason. many companies in family-owned groups are not publicly listed. The Central Bank deregulated interest rates and foreign exchange. Corporate financing depends on intermediation by banks. Vol. and tracked the financial performance of each company from 1992 to 1997. about three fourths.178 Corporate Governance and Finance in East Asia. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. Some 20 financial institutions were affiliated with these groups. using data on the Philippines’ top 1. However.000 companies.11). but they comprised only 23. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. of the financial resources in the country. identified the companies belonging to each of these groups. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. remain in force to control excessive lending of banks to insiders.000 corporations’ sales. .4 percent of the top 1.8 percent of total companies in number. To understand the ownership and governance characteristics of family-owned business groups. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). All major industries were represented. 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. suggesting that most publicly listed companies are parts of business groups.
the largest was the Eduardo Cojuangco group. the principal owner of SMC. These corporate entities accounted for 53.1 percent). In terms of sales.8 percent). it was manufacturing (36. In terms of number of companies. the study used the four largest business groups—Ayala. the largest family-based business group was the Ayala Corporation Group. Lopez. the top 10 family-based business groups had only 119 companies in the top 1. Gokongwei. including business groups and independent companies. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. In 1997.Chapter 3: Philippines 179 Compared with other Asian countries. Foreign-owned companies mainly serve the export markets. broadcasting (49. Together. for the Lopez group. for the Gokongwei Group.000 corporations in 1997. for each of these groups. and banking. which was majority-owned by the Henry Sy group. For the Ayala group.4 percent of the group’s 1997 profits).12). the nonfinancial sector was real estate (60. construction. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. It is also noteworthy that. a substantial proportion of group profits came from its financial subsidiaries. as discussed in previous sections. namely. and more than 20 percent for the Lopez group and Henry Sy group. and Henry Sy—as examples. 25 out of the 50 top corporate entities were familybased groups. retail merchandising (69. an average group in the Philippines has fewer member companies. Cojuangco. Lopez. To show this. The main constraint may be the availability of family members that could be drawn for top management positions. with 27 affiliated companies in the top 1. In the meantime. Commercial banks are often affiliated to a particular business group. the biggest private company in the Philippines. in most . Also.000. Family-based business groups are most dominant in sectors such as manufacturing. and Ayala. the three largest entities were family-based groups. or an average of about 12 per group. real estate. ranged according to their sales (Table 3.6 percent of the total sales of the top 1. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups.2 percent). the two were closely related through their affiliations to business groups.000 companies. Significantly. and for the Henry Sy group. with the exception of Banco de Oro. 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.
of Affiliated Companies Total Sales (P billion) 123.1 4.4 .5 2.6 2.3 3. 17. telecom.3 15.0 13.3 2.5 49.4 48.8 84. and personal care prods Shipping. 15.5 13. Sector Orientation.0 26. beverages. 11. coconut oil.9 3.5 46.4 6.5 6.5 44.6 3. 2.5 26. Eduardo Cojuangco Lopez Family Group Ayala Corp. Consunji 4 3 Food and dairy products Construction and mining 10.5 17. 16.4 10. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines.2 1.1 4. and tourism Credit card 18. Beverages. and packaging Power distribution and mass communications Real estate. 8.0 5.11 Total and Per Company Sales.2 1.0 17.2 16. and dairy products Investments. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. Flagship Company. Real estate. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. 4. 3. 9. 5.Table 3. 6. power. 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. real estate.6 3.7 98. and mining Management. construction. 14.9 2. beverages. and food Food.3 11.1 2.6 7. 7. 13. 10.5 47. food. agriculture. food. and Affiliated Bank of Selected Business Groups.0 Average Sales Per Company (P billion) 6.
9 1.8 1.7 1.9 1. 20.6 5. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.3 2. 25.1 1.0 0. 36. 34. distribution. Ramos Gaisano Family Group Felipe Yap Felipe F. mining. 27. 29.9 1. .9 6.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.6 0.3 2.4 3. 37.5 2.6 3. 22.9 7.0 5.8 6.8 1. 21.4 3.3 7. 4 238 1.19. 26.4 5.1 2. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank. 28.2 1. 38.8 1. 35.1 805. and various company annual reports.2 6.7 4. 39. 31.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.7 3. 30.1 0. P.0 1.7 0.1 1.5 8. 32.4 1.9 0. 23. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. 33.0 2. SEC-BusinessWorld Annual Survey of Top 1.9 0. 24.7 0.2 4.000 Corporations (1997).7 0.6 2. 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.
3. 4. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go W. Alaska Milk Corporation DM Consunji. 9. 1. 12. 6. 11. 15. Flagship Company. 16. 5.Table 3. 2. 17. Sector Orientation. 13. 8. and Affiliated Bank of Selected Business Groups.11 (continuation) Total and Per Company Sales. Inc. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 14. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. Uytengsu/General Milling Group David M. 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. 10. Eduardo Cojuangco Lopez Family Group Ayala Corp. 21. 7. 18. 19. 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. 20.
48 billion. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Fil-Estate Development Inc. 31.. unless otherwise indicated. 35. 33. Kepphil Shipyard Inc. 29. and various company annual reports. small = less than P1. a b Size class is measured in terms of sales: Large = greater than P4.65 billion. 25. 24. Ramos Gaisano Family Group Felipe Yap Felipe F. 26. Cruz & Co. 22. 38. 36. 39. 32.000 Corporations (1997). 28. SEC-BusinessWorld Annual Survey of Top 1. 34. medium = P1. Sources: PSE Databank.65 billion to P4. F. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. PT&T Corp.48 billion. Inc. 30. 23. Refers to commercial banks. 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. 37. .East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. 27. P.
4. 9. 17. 14. banking. and dairy products Investments. 3. of the Phils.5 77.7 98.).5 15.8 84. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123.Table 3.5 44. coconut oil. 13.4 48. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. food.1 17. food. 18. 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. and real estate Banking. 15. 2. construction.0 37. and mining Gold and other precious metal refining .1 60. 19. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. and bank Real estate.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.). beverages. 6. 20.3 15. 16.2 16. 8. and packaging Power distribution. car manufacturing.5 17. power. beverages. Philippine National Bank Mercury Drug Corp. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. Fujitsu Computer Products Corp. 23. Inc.2 49. 5. 10. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 24.0 24.0 38. telecommunication.5 26.5 46.4 19. Inc.5 47. 22. food.12 Control Structure of the Top 50 Corporate Entities. and food Food.8 22. Texas Instruments (Phils. 11.8 53. 12.6 18. agriculture. bank. and telecommunications Department store and banking Airlines.6 26. mass communications. 7.2 Business Group Business Group Business Group Government. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. First Pacific/Metro Pacific Group 21. Beverages. and personal care products Shipping.
4 8. corn (unmilled).7 10. 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. 27.5 8.290 53. 14. 46. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.. Jollibee Foods Citibank N.0 5.A. 48. W.0 11. Uytengsu/General Milling Group David M. 28.9 6. 42. Consunji Uniden Philippines Laguna.5 8. EAC Distributors Inc. 26.0 12. 36. 9. 49. 35. . Corp. 40. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. 32.9 7.000 Corporations (1997).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 38.0 13. Philip Morris Philippines.3 8.6 1. 50.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management.8 9. 39.1 9. Philips Semiconductors Phils. 43. 31.9 7. 29.3 13.6 12. and various company annual reports. 34.2 7.5 10. 33. Inc.9 14.4 10.25. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 45. Amusement and Gaming Corporation Mitsubishi Motors Phils. 37.7 10.8 6.7 13. Inc.6 9. 41. 30. 47. National Steel Corporation National Food Authority Phil.6 Foreign-Owned Foreign-Owned Foreign-Owned Business Group Foreign-Owned Business Group Privately-Owned Government-Owned Business Group Business Group Business Group Business Group Business Group La Suerte Cigar and Cigarette Factory Land Bank of the Philippines Procter and Gamble Philippines Andres Soriano Family Group George Go Hitachi Computer Products (Asia) Corp. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. Inc. real estate. 44. PSE Databank.
such as amendments of the articles of incorporation. these were dispersed shareholdings. appointment and compensation of senior executives. voluntary dissolution. removal of directors. Actual control of the banks was still held by the groups. amendments in the bylaws. and declaration of cash dividends. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. However. the board of directors plays a crucial role in corporate governance. approval of management contracts.8 The Board of Directors As the representative of shareholders in a company. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. issuance of corporate bonds. issuance of stocks. determination of compensation to board members. corporate mergers or consolidations. II publicly listed commercial banks affiliated to these groups. accounting and auditing. 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.186 Corporate Governance and Finance in East Asia. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. Of course. jointly and individually. Vol. The Corporation Code holds members of the board of directors liable. and financial disclosure. They are likewise liable if they pursue financial interests that conflict with their duty as directors. 8 The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank.3. . shareholder voting in general meetings and legal protection of their rights. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). investments of corporate funds in other companies or purposes.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. business groups had only minority ownership. 3. although public investors held a majority of shares. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. sale or disposition of a substantial portion of corporate assets.
Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. protecting shareholder interests. appointing senior management. Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. . But professional expertise is also an important criterion (28. or representatives of creditors. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. with a maximum of 36 percent. The longest was 27 years for board chairpersons and 14 years for board directors. the average number of years of holding office was 6. and determining remuneration for board directors and senior management. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. or percentages of shareholdings (28. More than half of respondents indicated that board directors were elected during the shareholder general meetings. Making day-to-day management decisions was not regarded as an important board responsibility.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership. or a per diem for meetings (18 percent). But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management.7 percent). In a few cases. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents).6 for board chairpersons and 7. appointed by the Government. In practice. ensuring that a company follows legal and regulatory requirements. a fixed fee plus performance-related bonuses (30 percent). According to the ADB survey. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests.7 percent).5 for board members. in a descending order.9 percent). or the Government without approval by shareholder general meetings. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. board directors were the founder of a company.
9 In practice. This suggests that large shareholders control CEOs by means other than shareholdings. Companies may set up special board committees to strengthen due diligence procedures. In the ADB survey. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. large shareholder-dominated companies often view such committees as unnecessary formalities. But the independence of these outside directors is often doubtful. About half of the active committees were audit committees and the other half nomination committees. the CEO 9 The three most common board subcommittees are the compensation. The audit committee selects external auditors. Vol.188 Corporate Governance and Finance in East Asia. the parent company or company bylaws (21 percent). The nomination committee searches and reviews candidates for key management positions. or amount of shareholding (15 percent). The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. or management (15 percent). CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). relationship with controlling shareholders (35 percent). only 35 percent of responding companies have set up board committees. The ADB survey shows that in 41 percent of the responding companies. the chairperson of the board was also the chief executive officer (CEO). Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives. II Compensation for the chairperson was determined either by the board (54 percent of respondents). . Unlike in Western corporate models. 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. Ninetythree percent of the respondents had one or more outside directors. and reviews the findings of external audits. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. namely. however. by tenure and compensation. negotiates the audit fees and scope of audits. It is also not clear whether the outside directors were elected before or after the financial crisis. In some companies. When the CEO was not the chairperson. These committees were established only recently. audit. and nomination committees.
Fourth.e. Among others. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. Second. if the CEO’s contract was preterminated. But about 27 percent viewed it to be ensuring steady growth of the company. 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. to help ensure the representation of minority interests in the board. Shareholder Rights and Protection Under the Corporation Code. and prohibits the removal. of directors representing minority shareholders.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. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. shareholders may exercise appraisal rights.. . first. shareholders enjoy a number of rights and protection.2 years. or (iv) enters into a merger or consolidation with another corporate entity. i. 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. 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. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. equal to three years’ pay. the Corporation Code allows cumulative voting for directors. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. Fifth. (ii) contracts with companies linked through interlocking directorship. The average service length of CEOs was 5. and (iii) involvement of directors in businesses that compete with the company. including electronic means. (iii) invests in another company for a purpose different from that of the corporation. 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. Companies are not allowed to issue shares with different voting rights. without cause. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. They can vote through proxy. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus.
There was little chance that a proposal from minority shareholders could ever get approved. However. In the case of preemptive rights. because of poor compliance and enforcement as well as some loopholes in corporate laws. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares. Consequently. Last. The company was dissolved before indictment. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. board members are likely to be under pressure to approve transactions that benefit controlling shareholders to the detriment of minority shareholders. In practice. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. Being appointees of controlling shareholders. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. Vol. minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. there were often no real discussions of board proposals or actions. Few minority shareholders actually exercised their appraisal rights. potential buyers are required to make a tender offer to minority shareholders at a price equal to the offer it is making to controlling shareholders. Regardless of the amount of shares held. because of the dominance of large controlling shareholders. During annual general meetings where minority shareholders could exercise their rights. the Revised Securities Act has strict provisions designed to deter insider trading. Sixth. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. in the Philippines. that of Interport Resources Corporation. II shareholders are allowed to inspect a company’s stock and transfer books.190 Corporate Governance and Finance in East Asia. There was only one case. In cases of derivative suits against directors for wrongdoings or actions against insider trading. SEC proceedings were costly and time-consuming. hostile takeovers are not common because in most companies ownership is concentrated . there are no requirements for disclosing such transactions to shareholders under the Corporation Code. In the past. Those who did were usually offered below-market values for their shares. in cases of corporate takeovers. no one has been successfully prosecuted for insider trading. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. where SEC made substantial progress in investigation. a shareholder could file a derivative suit against a director to redress a wrongdoing.
demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. representing about 24 percent of outstanding shares.7 43.3 56.2 7.0 51. Nevertheless.4 No 0.2 43. representing 3.4 70.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.4 percent of shareholders but 58 percent of outstanding shares.8 56. the successful hostile takeover by First Pacific Group of PLDT. a company that is widely held but has a large shareholder.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. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. An average of about 4.6 30.8 92. protection. About 93 percent of the respondents contracted . 1999.522 shareholders each.0 63. Table 3. and their activism in the corporate sector. The ADB survey provides further evidence on shareholder rights. Table 3.13 summarizes rights that the shareholders of the responding companies enjoyed. The responding companies had on average 43.Chapter 3: Philippines 191 in a few controlling shareholders and families.0 48. Yes 100. followed by management and banks. The brokers or securities companies were the most important proxy voters. About 333 shareholders per company voted by proxy.8 30.900 shareholders per company did not vote during the last annual general meeting. Nominees held about 45 percent of the outstanding shares.0 36.2 69. appointed either by the board or shareholders during the annual general meetings.
although closely related. and consolidation policy. Most major international auditing firms operate in the Philippines. the local standard (i. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. revaluation of fixed assets.. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. and an analysis of financial statements. The Code grants a shareholder the right to inspect business records and minutes of board meetings. the agency also requires reports on important details about their operations and management. a management discussion of the business. intra-company receivables and payables. Nevertheless. there are many cases of poor financial reporting by large companies. or the accounting standard of a specific developed country (for example.e. Because of such long relationships. as practiced in the Philippines). These different versions of GAAP. Vol. the responding companies have been associated with their present auditors for 13 years. with the longest being 50 years. II their annual audit to an international auditing firm. the international accounting standard. Nevertheless. vary in their evaluation of some major accounts such as securities and other liquid assets. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. From publicly listed companies. financial reporting standards allow room for interpretation by independent auditors.192 Corporate Governance and Finance in East Asia. 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. independent audits do not guarantee the absence of questionable accounting practices. long-term leases. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. In two celebrated cases. In practice. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more.. a hostile takeover case). the information statement transmitted to every shareholder should contain the audited financial statements. foreign currency-denominated liabilities. investments in subsidiaries. . namely. imposing penalties on violators. Meanwhile. intangible assets. An auditor can choose among three alternative sets of GAAP. On average. the US GAAP).
and publicly listed. which are controlled by large shareholders with public investors in a minority position. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. 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. e. because of the highly concentrated ownership of Philippine corporations.. accounting for 27 percent of the total stock market capitalization that year.g. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. which are closely held by large shareholders and family members. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. sometimes did not penalize independent auditors for poorly prepared audited financial statements.Chapter 3: Philippines 193 Many small. Pure holding companies can be privately owned. they formed the largest group of corporate entities in the Philippine stock market in 1997.6 billion. Family-based controlling shareholders use them as vehicles for controlling business groups.and medium-sized businesses did not have quality financial statements. Publicly available financial information was often of low quality. which are usually controlled by holding companies. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA). from a minority-controlled to a majority-owned subsidiary. arguably. marketing. Even for widely held public companies. the authorities. However. Corporate Control by Controlling Shareholders As in many other Asian countries. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. and financing. They allow risk pooling and can achieve economies of scale in management. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management. “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. When control rights exceed cash flow rights. Controlling shareholders usually select member companies that require large .
an active minority share at 44. Ayala Corporation’s majority. Honda Cars (Philippines). Some holding companies are not pure holding companies. Ayala Land fully owns Makati Development Corporation and holds a minority stake. and customers.4 percent of Bank of the Philippine Islands. They are operating companies but at the same time have majority or minority share ownership in other operating companies. controlling shareholders of the parent company do not participate in management. active minority or passive minority holdings. Vol.1).6 percent of Globe Telecom. and a passive minority investment at 15 percent in Honda Cars (Philippines). namely. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. It has a majority control at 71.. the parent company plays an active role in management. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. Ayala Corporation is a publicly listed pure holding company. In a passive minority-owned operating company. as an example (Figure 3. of Cebu Holdings (a publicly listed government-owned company). These investments can be classified according to the role of the controlling shareholders in the management of the invested company. Depending on the performance of the company. In cases of minority ownership.and minority-controlled operating companies are also holding companies. Controlling shareholders gain additional leverage in management control over minority-owed companies. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. financing. 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. Public investors collectively hold a minority of 41 percent. a family-owned pure holding company. is privately owned.2 percent. II equity investment for public listing. Ayala Corporation. especially its management. Inc. at 47.1 percent of Ayala Land. . The first three companies are publicly listed while the fourth. They may have a representative in the board. controlling shareholders of the parent company may eventually increase their shares to a majority position. minority control at 42. It is majority-owned by Mermac.194 Corporate Governance and Finance in East Asia. with 59 percent of shares. Minority-owned companies may also need access to resources of the group. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. In an active minority-owned operating company.
(47. Inc. .04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. (58.2%) >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 (42.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.96%) Privately-Held Pure Holding Company Public Investors (41. Inc..44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.Figure 3.
3% x 5. and Larry H. Benpres Holdings. 1999b. The control of companies through indirect corporate shareholdings. Who Owns and Controls East Asian Corporations? 11 Ibid. is illustrated in the Lopez Group (Figure 3.5% x 14. Lang. Diversification and Efficiency of Investment by East Asian Corporations.3% x 1. P. First Philippine Holdings Corporation. Fan.14%] / [1. Being in the public utilities sector.44%] / [25%] = 1. The Separation of Ownership and Control in East Asian Corporations.7 times 12 . Rockwell Land. Expropriation of Minority Shareholders: Evidence from East Asia.8%] 5. and a minority-controlled holding company. Joseph P.98% x 42. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1. Vol. P. see the World Bank research papers by Stijn Claessens.44%] = [42. and Larry H.196 Corporate Governance and Finance in East Asia.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.64%) + (37.2).12 These examples show that even when large shareholder groups are minority shareholders.44%] / [58. Lang: 1999a. and 1999c. defined as control by large shareholders of an operating company through minority ownership by several companies. companies in the Lopez Group are large and minority-controlled. Generally. H. however.7 times Ibid. MERALCO.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. Simeon Djankov. a privately owned company. Simeon Djankov.10 The Ayala family’s control rights over BPI was 1.64% +37. See also Stijn Claessens. The situation offers large shareholders tremendous incentive to move resources 10 For details.11 The Lopez family’s control rights over MERALCO was 5. 1998. 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. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company.14%] / [6. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.5%] [39.5%] / [(88. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights.76%)] [39.
76% Operating Company MinorityControlled 24. Privately-Held Pure Holding Company 88.Figure 3.64% MinorityControlled 14. . Inc.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 24.7% 62.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.3% 11.
Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. Vol. 3. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. Suspension of Payments of Debts Under PD 902-A. The average company. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them.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. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. The survey results also revealed that creditors did not intervene in the management of borrowing companies and wanted to maintain business relationships with corporate borrowers even when they were in trouble.3. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. Control by Creditors According to the ADB survey. the data suggest.198 Corporate Governance and Finance in East Asia. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. whether for working capital or capital expenditure. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. However. and (ii) how the legal framework protects creditor interests and rights.
The corporation continued to be under rehabilitation receivership as of June 1999. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. SEC could intervene to avoid asset dissipation. Publicly listed companies do not represent a cross section of the Philippine corporate . a company’s assets are of sufficient value to cover all of its debts. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. The borrower will propose a rehabilitation plan to SEC. For example.4 3. a real estate-based business group.4. Consequently.. SEC and the court required that the creditors of BF Homes. under which. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. profitable companies from going public. Markets for equity and debt instruments are small and there are serious structural problems that discourage large.Chapter 3: Philippines 199 agreement. including the rehabilitation of the corporation. Commercial banks hold about three fourths of the resources of the financial system. wait for 14 years from the time the company petitioned for suspension of payments in 1984. In practice. Under this mode. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. The first mode is for simple suspension of payments. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. There are no legal or practical limits to the time period of suspension of payments. 3. Under such circumstances. bank credit is the main source of corporate financing. the litigation process. There are two modes of suspension of payments under PD 902A. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. An impending conflict between the two parties could result in dissipation of assets of the company due to creditors’ action to liquidate the company’s assets they hold as collateral.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. Inc. could take an indefinite period.
As a result. 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. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Vol. preferred stocks. Foreign portfolio investments also remained small. The Philippine stock market is not a liquid market. The corporate sector raised a substantial amount of . 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. and convertible securities. Equity financing through IPOs was active. From the 1970s up to the early 1990s. Even in the real estate sector.4 billion (or $59 million using the average exchange rate). especially short-term debt. The stock market was depressed up to the early 1990s. while interest rates were at high levels and volatile. inflation. and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. Rising stock prices during the Ramos administration reflected to some extent the business optimism. Table 3. However.000 companies. and Indonesia ($61. however. Korea and Thailand).200 Corporate Governance and Finance in East Asia. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. The market capitalization of the Philippine stock market in August 1997. compared with Malaysia ($186 billion). compared with other economies. Korea) ($143 billion).. was one of the smallest in the region at $47. II sector. Most publicly listed companies issue only up to 20 percent of total shares to the public. Philippine companies were less leveraged. companies expanded only at a moderate pace. Of the 221 companies listed in the Philippine Stock Exchange in 1997. is far ahead of the flock. the country experienced double-digit inflation. They invested in only a few large companies whose shares were relatively liquid. Malaysia. The crisis affected the Philippine corporate sector. the Republic of Korea (henceforth. this is because. but not to the same extent as it did in other Asian economies.5 billion). and less engaged in risky investments. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e. the minimum required to qualify as a public corporation. Interest rates. The period 1993-1997 was one of lower inflation and declining lending rates. less exposed to foreign debt. most listed companies are controlled by their five largest shareholders. Equity instruments include common stocks. In part. only 84 had sales large enough to be placed in the top 1. about the size of Thailand’s.7 billion.g.
2 925.5 16.7 2.1 0.4 Ratio of Market Capitalization to GDP 0.121.7 391.7 207.14 Philippine Stock Market Performance.0 1.2 59.2 1.445.9 114.2 3.0 0.686.2 0.3 2.7 41.8 1.906.3 4.3 — = not available.351.8 1.9 2.4 728.5 12.1 5.5 72.2 61.9 682.2 0. .1 524.1 0.2 297.421.5 571.692.8 1.9 2.248.077.474.1 0.251.545.6 1.8 102.0 0. Source: PSE databank.2 ($ million) — — — — 6.5 1.7 0.3 0. 1983-1997 Daily Trading Volume (P million) — — — — 129.4 9.5 Year 369.3 0.2 1.373.8 799. P billion) Gross Domestic Product (current prices.5 26.7 1.0 0.6 1.3 Market Capitalization (year end.3 59.8 0.1 88.0 2.Table 3.4 1.386.9 1.2 57.515. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.5 1.3 314.0 161.9 608. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.171.6 261.088.1 0.9 12.3 158.
are in a position to provide such discipline. Corporate bonds are another type of debt securities.6 billion. Debt securities include commercial papers and corporate bonds. The measures used in the analysis are: . However. corporate bond issuing was even more limited. the rights issue was a popular way of raising equity capital. discounting of receivables. The underwriter. and inventory financing. by virtue of their large stakes in the financial system. leases.. The corporate bond market was stunted. tight regulations. From 1988 to 1997. asset-backed credits. moreover.4. However. and debt as sources of corporate financing by using flow of funds analysis. Only the commercial banks. and high transaction costs. 3. sells these commercial papers through brokers.202 Corporate Governance and Finance in East Asia. which in most cases is an affiliate of the issuing company. new equity. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. Under SEC regulations. and the dominance of large commercial banks. lack of competition among financial institutions. Only a few large companies floated commercial papers because of the limited market. Negotiated credits. The largest buyers have been commercial banks.2 Patterns of Corporate Financing The study looked at retained earnings. which were the principal source of corporate financing in the Philippines. Vol. about 127 companies went public with a total value of offerings of about P134. Because existing shareholders wanted to retain their proportionate control over their companies. by volatile interest rates and the absence of a secondary market. a strong regulatory system for bank supervision is imperative. which ultimately influences the pricing of commercial paper issues. which buy commercial papers either for their own account or for their clients. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. because business groups often own large commercial banks. Debt instruments include negotiated credits and debt securities. include bank credits. Capital markets cannot provide the market discipline that corporate investors need. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. The picture of the financial system that emerges is thus one of limited capital markets. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. of which 85 percent was raised from 1993 to the first half of 1997.
On the other hand.5 2. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. As shown in Table 3.1 Average 1.1 0.000 Corporations in the Philippines.6 0.6 0.15 Financing Patterns of the Corporate Sector.5 0.2 0.9 0.5 0.4 0. It measures a company’s capacity to finance asset growth by internally generated funds. it is one minus IDFR.4 0.2 0.9 0.1 0.3 0.8 0.9 0.2 0.3 0.0 0.3 0.0 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.3 0.15.1 0.000 Corporations in the Philippines from 1988 to 1997. 1988-1997.4 0.5 0. By definition.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. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector. It measures a company’s reliance on borrowings in financing asset growth.4 1. It measures a company’s capacity to finance asset growth by equity capital. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.8 0.2 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.8 0. .5 0. the average SFRF was high at 109 percent.5 0.7 0.6 0. during this period.4 0.4 0.4 0.3 0.4 0.1 0.3 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.9 0.3 0. the SFRT was low at Table 3.1 0.2 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.5 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.5 0.5 0.5 0.
the SFRF was higher.204 Corporate Governance and Finance in East Asia. with debt providing 93 percent of the financing requirements.2 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. retained earnings declined and few new equity investments flowed into the corporate sector. implying that internal funds were far from sufficient to finance growth in total assets. debts were the most important source of financing.1 a Excludes negative balances. Retained earnings were the least important.16. reflecting the capital flight caused by political instability in the early 1990s.3 0.8 0.5 Foreign-Owned 1. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. internal funds were not a significant source of financing growth in total assets.6 0.5 0. Vol. the level of corporate leverage increased.16 Corporate Financing Patterns by Ownership Type. Companies financed fixed assets from internal sources in hard times. except in 1991.2 (0. . 1988-1997. privately. In periods of an economic crunch such as in 1989. for all three types of companies—publicly listed. In 1997.and foreign-owned. Total assets grew by 23 percent that year.9 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 Privately-Owned 0. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. Source: SEC-BusinessWorld Annual Survey of Top 1.7 0. In all the years. On Table 3. except for foreignowned companies that had a negative new equity financing ratio. II only 19 percent. There were significant year-to-year variations. As a result.000 Corporations in the Philippines. This was mainly caused by the declining contribution from retained earnings.3 0. 1991. Corporate Financing by Ownership Type As shown in Table 3. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.3 0.3 0. when it financed 45 percent of it. and 1997.0) 0.
4 2.0 Source: SEC-BusinessWorld Annual Survey of Top 1.8 16.0 8.4 100.1 49.9 38. contributing 90 percent of growth in total assets. especially bank loans.3 48.7 13.8 26.8 38.6 43.8 0. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.2 12.9 24.0 1995 1996 13.9 100.1 10.17.2 100.8 0. Foreign-owned companies relied more heavily on debt financing.9 12.and foreign-owned companies.2 51.1 50.8 46.5 16.1 9.2 42.9 16.0 1993 14.3 12.4 100.7 100. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.17 Composition of Assets and Financing of the Publicly Listed Sector.8 51.0 12.8 3.000 Corporations in the Philippines.2 100.3 10.0 9.9 16.7 4.3 13.8 17.8 4.9 16.6 26.4 3.3 12.0 38.4 100.3 51. .1 15.4 43. 1988-1997.7 2.6 37.5 12.6 48.0 13.2 3.Chapter 3: Philippines 205 average.3 11.6 0.7 13.8 100.3 10.3 4. It presents a composition analysis of assets and financing sources for the period 1992-1996.0 9.9 4.3 12.9 0.0 6.8 39.4 41.0 9.5 0.1 7.8 3.7 2.0 1994 19.5 41.7 7.4 100.5 9.4 12.1 13.6 48. publicly listed companies relied more on new equity financing than privately.0 10.0 10.4 10.0 9.4 2.9 3.2 3.0 100. significantly Table 3.5 27.0 53.7 23. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3. 1992-1996 (percent) 1992 Assets Cash and Temporary Investment Accounts Receivable Inventory Other Current Assets Total Current Assets Investment Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Debt Other Long-Term Debt Other Long-Term Liabilities Total Liabilities Stockholders’ Equity Total Liabilities and Stockholders’ Equity 14. The sector built up its short-term debts.
Further. for independent companies. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. Group companies were generally more profitable than independent companies. On average.3 0.3 0.206 Corporate Governance and Finance in East Asia. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. compared with an average of 54 percent for independent companies.3 0. II in 1996 and became more vulnerable to the financial crisis in 1997. the easier access to external credit. Table 3. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. As shown in Table 3. Group companies financed an average of 45 percent of growth in total assets by debt. the average SFRF of business groups was higher compared with that of independent companies.45 in 1996.6 Independent Company 0. their inherent ability to pool risks. 1988-1997.13 was at 1.18. The normal standard liquid position is a current ratio of 2 or higher. as opposed to 94 and 30 percent. respectively. Vol. 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. . indicating that many publicly listed companies were likely to be in a tight liquidity position.5 0. and economies of scale in fund raising.2 0. For these two reasons.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. The traditional measure of liquidity. group companies usually financed their investment in member companies by equity rather than debt.9 0.1 0.18 Financing Patterns by Control Structure.5 0.000 Corporations in the Philippines. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. the current ratio.
Table 3.55 was substantially higher than the small companies’ 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. 1988-1997. The corresponding ratio was 0. These years were 1991 with 110 percent.6 0.1 0.06.5 Excludes negative balances. equity financed 42 percent of incremental asset growth.19 Financing Patterns by Firm Size. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.8 0.2 0. On average.3 0.50 (Table 3.5 Medium 3.5 0.3 0. Large firms consistently increased their reliance on debts from 1994 to 1997. Excluding .20). and 1997 with 131 percent.88 for large companies (Table 3. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. Large companies’ IDFR of 0. compared with 55 percent for large companies and 47 percent for small ones.6 0.Chapter 3: Philippines 207 independent companies. averaging 61 percent of growth in total assets. With assets growing at a fast pace during this period.2 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1. Source: SEC-BusinessWorld Annual Survey of Top 1.76 for small companies and 0. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.08 and SFRT of 0.47.9 0.19). medium-sized companies used more debts. with an average of 3. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.3 0.4 Small 0. 1993 with 96 percent.000 Corporations in the Philippines.2 0. There was also increased reliance on debt financing.
1 0.6 0. Up to 1997. Since the real estate boom coincided with that of the stock market. The sector had the highest leverage among all industries that year. The situation improved beginning 1994. In the eight years preceding the crisis. The real estate industry financed its growth by substantial equity funds. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. while SFRT averaged only 0. During the crisis year.6 0.5 (0.58 and SFRT of 0.5 Utilities and Real Estate Services and Property 0. Excluding 1997 when fixed assets declined.000 Corporations in the Philippines.5 0.3 0.32.6 a Excludes negative balances. the total debt ratio was much higher in 1996 at 0.3 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year.2) 0. II 1991. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. many of the leading real estate companies successfully went public during that time.7 0. The construction sector was a heavy user of debt financing.29. increasing to 0. Equity financed an average of 62 percent of total asset growth. ranging from 41 to 118 percent.4 0. .6 0. Vol.04. While this level is considered prudent. the industry generated internal funds. Incremental equity financing amounted to an average of 44 percent of total asset growth. 1988-1997. The utilities sector showed weaknesses in internal fund generation in 1989-1994. SFRF for the sector averaged 0. the incremental equity ratios of the industry were high. with an SFRF as low as 0.91.208 Corporate Governance and Finance in East Asia. Table 3.4 0. Source: SEC-BusinessWorld Annual Survey of Top 1. when debts declined. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.79 and in 1997 at 0.3 0. The effects of the crisis of 1997 were adverse.4 3.47 two years later.27.20 Financing Patterns by Industry.4 0.5 0. debt financed about 78 percent of asset growth in real estate.3 0.4 Construction 0. achieving an average SFRF of 3. the manufacturing industry financed 57 percent of its total asset growth by debt.
the degree of ownership concentration. As shown in Table 3.860 Leverage = the ratio of total assets to total equity.21 Ownership Concentration. alternatively. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. Journal of Finance 48: 831-880. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. 14 See for example Michael Jensen (1993). the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant.008 5.421 0.3 Ownership Concentration. ROA. The Modern Industrial Revolution.769 0. ROE. measured by the percentage of shareholdings of the largest five shareholders. ROA = return on assets. Using the PSE database.00056 1. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.130 ROA 0.00036 2.Chapter 3: Philippines 209 3. ROE = return on equity. 1992-1996.00125 2.230 Leverage 0. ROE.009 5. was regressed against measures of profitability and of financial leverage. creditors bear the consequences. as the dependent variable. and leverage. and the Failure of Internal Control Systems.14 Large shareholders may borrow excessively to undertake risky projects. at the same time.287 0. ownership concentration = the total shareholdings of the top five shareholders. and financial leverage are all positively and significantly related to the degree of ownership concentration. knowing that if an investment turns out to be successful they could capture most of the gain. Source: Author’s estimates based on the PSE databank. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Profitability.21. more profitable.4. Table 3. Financial Leverage. . Exit.004 3. while if it fails.
but its share had been declining by 4 percent per year since 1995.210 Corporate Governance and Finance in East Asia.5 3. Although much lower than those of other Asian countries. Net trades in goods and services averaged a deficit of 4. and intermediate goods.1 The Corporate Sector in the Financial Crisis The Financial Crisis: Causes and Manifestations A devaluation of the local currency signaled the arrival of the financial crisis in 1997. The largest contributors to GDP were services at 43 percent. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. which averaged 4. their growth gathering momentum only beginning in 1992. After a . with a narrow exporting industry base. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. 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. industry at 34 percent. The export sector had a very narrow breadth. and agriculture at 21 percent. notably remittances of overseas workers. Net investment inflows were $3. Vol. an overexpansion of capacities. the economy still showed vestiges of its import-dependent and substituting character.” that is.5 percent per year from 1992 to 1997. foreign investments in the country have been low. The country experienced balance of payments surpluses but these were due to transfers. Commercial and industrial activities in the country were largely oriented to domestic markets. II 3. Because of limited local capital. Manufactures accounted for about 85 percent of exports. raw materials. with commodities accounting for the balance.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996.8 percent of GDP from 1995 to 1997. the country’s GDP growth pace indicated that it did not have a “bubble economy. In sum. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). Garments was the second largest export sector at about 9 percent. more than half (52 percent) of exports were semiconductors. the country was less dependent on foreign private capital. In 1997.5. Compared to other East Asian crisis-affected countries. Historically. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. Exports were growing at about 20 percent per year in the three years preceding the crisis.
the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998.8 percent. average ROE was 13. however. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. From 1993 to 1997. During this time. The corporate sector was in a relatively stable financial condition around the time of the crisis. Eventually. adjustments were focused on the quantity and quality of the banking system’s corporate loans.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991.1 percent. The lessons from debt restructuring became the basis for the Government’s economic policies. the Government sought stability and achieved this in 19921997. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Profitable operations since 1992 had allowed it to build equity. while sales grew by only 20 percent per year. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. . Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. 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. the Government restructured its debts into longer tenors with a maximum of 25 years.3 percent. assets grew at a compound annual rate of about 31 percent. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. depended on the quality of the corporate sector’s investments. From 1988 to 1996. the country and the corporate sector had no access to foreign currency debts from the international financial market. the discipline of the loan moratorium and the restructuring of the country’s loans to long-term maturity kept this ratio below 100 percent up to September 1997. which. and a relatively healthy banking system. After hovering in the range of 100 to 127 percent. an average inflation rate of 7. resulting in stability in the short-term debt to reserves ratio. unlike their counterparts in the region. fueled also by successful IPOs during the stock market boom of 1993-1996. Total debts were only 52 percent of assets or 108 percent of equity.5 percent. In the Philippines. in turn. a government fiscal surplus from 1994 to 1997. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. Closer analysis. a positive balance of payments from 1992 to 1996. an average Treasury bill rate of 13.6 billion as of March 1997.
101 92. Vol.7 Note: Peso-dollar exchange rates used are: 1995 = 25. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.” 3. But portfolio investment amounting to $406 million flew out of the Philippines.22).073 (406) 121.074 2. 1997 = 29. or 114 percent of net foreign direct investment (FDI). These patterns in investment and financing are similar to those of other countries in the region.22. Debts financed a large part of this expansion. growing by about 34 percent per year from 1994 to 1997. Sources: Bangko Sentral ng Pilipinas and SEC.71. . mitigated the effects of the pullout and liquidation of investments in the aftermath.650 32. In 1997.609 1.4 1997 762 1.485 145. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.300 1. Table 3. 1998 = 41.303 23.47. net FDI remained stable at more than $1 billion. the country’s economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive “contagion” effect of optimism by investors and creditors about the region.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.22 Foreign Investment Flows. 1996 = 26.0 1998 739 555 328 69.749 26. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. Most of this leverage happened during the boom years in the region.212 Corporate Governance and Finance in East Asia.101 billion or 196 percent of net FDI in 1996. precisely. In sum. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. 1995-1998 Item Net Foreign Investments ($ 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 1.06. Data for 1998 cover only January-August. but to a lesser degree.0 1996 3.5 billion in 1995. Net foreign portfolio investment amounted to $1. the other immediate impact of the crisis was that on foreign investment flows. It rose to $2.718 30. It financed 26 percent of corporate capital growth.517 1. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.5.
Loan calls. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. in turn. and leverage increased to 149 percent compared with 109 percent in 1996. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. meanwhile. The resources of the financial system that year totaled P3.2 percent in November 1997. then rose to a high of 22. ROE at 6. Net profit margins were at a 10-year low at 4. Companies deferred investments in new fixed assets. new borrowings financed asset growth. When the Treasury bill rates eased in March 1998.9 percent. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Loans outstanding of commercial banks declined by the first quarter of 1998.369 billion. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. The interest rates on Treasury bills. lending rates also came down. the sectors with the highest outstanding loans had reduced their credit exposures. the corporate sector became vulnerable to loan calls and high interest rates. ranged from 11 to 13 percent from 1993 to July 1997. Lending rates were well above the 20 percent level from July 1997 to March 1998. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position.2 to 28. which held about 75 percent of the assets of the financial system in 1997. Because commercial banks were strongly capitalized. depended on the liquidity and capital position of commercial banks. with commercial banks holding P2. and the wholesale and . The real problem of the corporate sector during the crisis was the rise in interest rates. they were willing to restructure and renegotiate existing loans by corporate borrowers. By October 1998. By March 1988.7 percent in January 1998. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. in varying degrees for each sector. With the increase in borrowings and reduced liquidity.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 17.513 billion. albeit at current market interest rates.3 percent of assets. Because of weak internal fund generation. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. sparking a rise in interest rates on corporate loans. Although corporate borrowers were not highly leveraged. Average bank lending rates climbed to their peak of 25.
Vol. These peaked at 14. The move retained the liquidity position of banks but lowered their cost of reserves. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986.5 percent by September 1998. But the Philippine banking system had gone through worse crises in the past. As for nonperforming loans (NPLs). real estate loans averaged 11. as with its counterparts in other Asian countries. and subsequently went down to 13. thereby reducing overall intermediation costs. and its experience of low.6 percent in June 1998. II retail trade sector. 3. by 12 percent.214 Corporate Governance and Finance in East Asia. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. The Central Bank also moved to control inflation and bring down domestic interest rates by reducing the statutory reserve requirement by 3 percentage points and raising the liquidity reserve ratio by the same amount. was a problem sector.3 percent in December 1997.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. and set up a hedging facility for borrowers with foreign currency-denominated loans. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. the fiscal position. and the financial system. the ratio increased to a high of 11. single-digit NPL ratios began only since 1989. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. This allowed the Central Bank to convince the banks. through the Bankers’ Association of the Philippines. However. These figures show that adjustment problems were industry-specific and that the real estate industry. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1.5-6 percent. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998.9 percent of bank loan portfolios. Still. In March 1997.5. The Central Bank adopted other measures to strengthen the financial system. set limits on overbought/oversold foreign exchange positions of banks. including (i) a regulatory limit of 20 percent on banks’ loans to the .
came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. 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 economy avoided a recession in 1998 and achieved 3. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. Large companies with heavy loan exposures such as Philippine Airlines Inc. consolidating business units.Chapter 3: Philippines 215 real estate sector. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. With its weakened financial position. Financially strong companies were able to survive the crisis by effecting such internal restructuring. (PAL). The acquiring company. the country’s flag carrier. In the case of PLDT. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. In response to calls for lower bank intermediation costs. was known to have a policy . First Pacific Corporation. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. changing technologies. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. Average Treasury bill rates have cooled since mid-1998. PAL. (v) improving disclosure requirements on the financial position of banks. The policy directions and actions taken by the Government appear to have ushered in recovery. the Government kept inflation below 10 percent. Responses of the Corporate Sector The corporate sector’s financial position. the largest telecommunications setup in the Philippines. and giving up noncore businesses. bank loan rates have also come down. the Asian crisis opened a unique opportunity for foreign investors.6 percent growth in 1999. took more action. its accessibility to foreign capital. (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. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. With prudent monetary management. subcontracting and outsourcing.
Although considered the prime industrial company in the Philippines. In a legal process that ended in his takeover of management. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. When companies are highly profitable. Its stock price and returns to shareholders had stagnated. By itself. eventually took over PLDT and announced a restructuring plan for the entire group of companies. Consequently.6. however. The question. Corporate governance is conditioned by the high ownership concentration of these large companies. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years.216 Corporate Governance and Finance in East Asia. SMC is another widely-held company managed by a minority shareholder. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. First Pacific. Ownership is highly concentrated and a few dominant players control major industries. Conclusions. the Cojuangcos. Vol. is whether there are sufficient safeguards to prevent controlling shareholders from . at a premium over the market price to reflect the value of management control. the stock price of PLDT was buoyant during the takeover period. II of investing to control companies that are dominant players in their industries. A second method was to purchase the shares of other large 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. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. When Cojuangco took over. concentrated ownership of companies is not equivalent to weakness in corporate governance. using some or all of these means. One mode was the outright purchase of shares in the open market.6 3. PLDT’s large minority shareholders such as the SSS and First Philippine Fund publicly announced their willingness to offer their entire holdings in a block sale at a premium. the Soriano family. controlling shareholders can capture these profits by excluding public investors from ownership. 3.1 Summary. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries.
the most numerous in the corporate sector. foreign companies were the most profitable but highly leveraged. The five largest shareholders have majority control of an average publicly listed company. Analysis of corporate financing by ownership . Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. With large shareholders in control. Privately-owned companies. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. ownership of banks by business groups. passive independent auditing. By ownership structure. an underdeveloped capital market. Leverage was within Asian norms but above developed country standards. were the least profitable. Returns to capital exceeded inflation rates. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. By control structure. to some extent. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. influenced by industry characteristics. an ineffective insolvency system. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. medium companies showed higher profitability than large and small ones. minority shareholders need to be protected by external control mechanisms. Ownership of publicly listed companies is highly concentrated. while the largest 20 shareholders control more than 75 percent of shares. The result is that corporate governance depends only on internal controls. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings. 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. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. By size. 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. Financial institutions are not significant shareholders. Performance was. oligopolistic market structures.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. and the lack of market for corporate control.
. Even in cases where the group owned only a minority share of a commercial bank. Large companies owned or controlled by business groups tend to dominate their industries. Large. After controlling for industry effects. superior profitability. The difference between management control and ownership rights is usually substantial. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. ROE. and centralized management and financing. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. as typified by the Ayala Group. 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. Ownership concentration was positively related to both returns and leverage. The extent of governance problems depends on internal control policies of the controlling shareholders. Vol. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. and sustained growth. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. selective public listing of companies in the group. A business group is an effective business organizational model for achieving leadership in industries. ROA. and leverage were all positively related to the degree of ownership concentration. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. and the extent of supervision of outside institutions such as independent auditors and SEC. II type gave similar results. Business groups with pyramiding structures heighten the issue of corporate governance. A commercial bank is an important part of most business groups. with the foreign-owned companies found to rely more on borrowed funds. family-based shareholders gain control by such means as the setting up of holding companies. 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 bank usually accounted for a large share of each group’s net profits.218 Corporate Governance and Finance in East Asia. The pyramid model is useful for centrally managing smaller companies. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group).
and sound overall creditworthiness.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. 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. Specific actions recommended are described below. a strong international reserves position. 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. Still. Under the new Securities Regulation Code enacted in 2000. low inflation. mostly by highly leveraged companies and speculative investors in real estate. This law is flawed in concept because it supplants a market-based credit agreement with a political process. SEC officials. there were sharp rises in the number of bankruptcies and petitions for debt relief. There are systemic risks involved in highly concentrated ownership. decisions by large sharehold- . SEC’s quasijudicial functions. For example. including suspension of payments. 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.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. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. 3. adversely affecting companies’ operations and financial position. As the crisis wore on in 1998. the government budget in surplus. strong capital position built on IPOs in a buoyant stock market. rather than the banks that lent millions of pesos. decide on the financial future of a troubled debtor. are to be removed and transferred to courts. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates.6. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years. The Central Bank imposed strict limits on real estate lending. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. That is. resulting in the banks’ accelerated restructuring of troubled debts in this sector. and a market-oriented policy environment.
Because independent directors tend to adopt the perspective of minority shareholders in board decisions. Vol. This may limit current practices of appointing prominent individuals and family members as directors. Strengthening Minority Shareholder Rights An issue that concerns minority shareholders is whether they have instruments—legal or ethical—that can prevent controlling shareholders from expropriating their wealth through risky investment and financing. inadequate disclosures. depending on the size of the company. Another measure would be to impose a statutory limit on the number of directorships that one can accept. and self-dealing. to 25 percent. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. It has suffi- . Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. To help ensure this. 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. insider information. II ers often cause wide volatility in stock prices and invite reaction from creditors. Clear legal accountability is a precondition for successful shareholder activism. 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. (ii) require disclosure of material changes in ownership. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards.220 Corporate Governance and Finance in East Asia. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. The adjustment should be made over a fixed period of time. To strengthen the board.
in particular. in areas of supervisory functions of the central bank. e. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines.. and disclosure standards. prudential measures and regulations. and related interests. Finally.g. directors. The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks. raising the current two-thirds majority to a three-fourths majority. reporting. For example. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards.Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements. 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. officers. Impose severe penalties for any attempt by banks to circumvent this regulation. Because ownership is generally concentrated in five shareholders. fit and . Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. and of banks in nonfinancial companies in order to avoid connected lending. (iv) require banks to follow international financial accounting. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. and (v) closely monitor. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. They need legal empowerment such as higher majority voting requirements. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. the board can easily muster the needed majority to approve the deal. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. limit. (ii) set strict limits on lending by banks to affiliated companies. or prohibit cross-guarantees by companies belonging to affiliated groups. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority.
The current law should expand class action suits to include management and . II proper rule. This way. If institutional investors are present. 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. and lending to DOSRI. 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. Promoting Shareholder Activism Promoting shareholder activism to encourage small shareholders to actively monitor management is an approach that has not been tried out in the Philippines. This investor profile has a “missing middle”—long-term investors who intend to participate in longterm growth of a company and who also trade shares depending on company performance. and external auditors. Presently. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. management. In developed capital markets. By supporting the establishment and operation of institutional investors. Investment and venture capital funds meet this description. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. Its priority is to protect prospective fund investors from unscrupulous fund managers. Vol. foreign ownership of banks. Two measures should be adopted to promote shareholder activism. Institutional investors impose market discipline by voting on strategic corporate decisions. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. institutional investors can be a driving force in providing market discipline to management.222 Corporate Governance and Finance in East Asia. institutional investors lead public investors in providing market signals to companies. an active financial analyst community can begin to form. transparency. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders.
Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. the Government could develop the market for future issues of corporate bonds. And by issuing Government Treasury securities in longer tenors. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. 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. leadership. information disclosures. Legal provisions for class action suits should cover self-dealing by directors. and Credit Information Bureau that can be the starting point of this effort. There are existing institutions such as Dun and Bradsreet. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. their directors and management. Securities market development efforts should coincide with strict regulation of the commercial banking sector. and dividend decisions. 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 broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. These groups have an incentive to gather technical expertise. 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. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management.Chapter 3: Philippines 223 auditors. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. SEC should allow minority shareholders to be represented by activist groups. and the external auditors. guarantees. compensation contracts. entry .
Current disclosure requirements of SEC are not rigorous enough for public investors. Lack of liquidity deters institutional investors. Penalties for poor conduct of auditing by independent . 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. PSE and SEC need to build a liquid and efficient market. and provide quality basic services should also be heightened. and various other forms of protection. Audited financial statements contain basic information about a company’s financial position and performance. The Government should also continue to improve infrastructure. Vol. II and exit barriers. and publicly listed companies trade barely the minimum number of shares required for public listing. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders.224 Corporate Governance and Finance in East Asia. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. improve enforcement of the rule of law. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. Efforts to reduce graft and corruption. Many large companies remain privately owned. The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. PSE should campaign for top-tier companies to go public and work with SEC in encouraging publicly listed companies to expand their share offerings to the public. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors.and medium-scale companies can become more competitive relative to large companies. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. so that small. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public.
SEC and PICPA need to formulate more specific disclosure standards. Improving the Legal Framework for Suspension of Payments. 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. review the system of penalties on professionals involved in a company’s violation of disclosure rules. it creates a moral hazard problem. and transferred these to courts. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. Reorganization. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. including the resolution of intracorporate disputes. and Liquidation. For that matter. and implement those standards and penalties rigorously. The law on suspension of payments replaces a market-oriented solution with a political process. violators were made to pay only nominal penalties. and liquidation of troubled companies should be made a priority of the Government. the new law needs to be effectively implemented and enforced. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. Instead. . reorganization. Reforming the legal framework for suspension of payments.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak.
Journal of Financial Economics 25: 371-395. P. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Joseph P. 1998. Emilio. Simeon Djankov. and Atulya Sarin. Large Shareholders. and Clifford Holderness. 1998a. Equity Ownership. The Separation of Ownership and Control in East Asian Corporations. Working Paper. Stijn Claessens. 1985. May. Joseph Fan. 1998b. P. Asian Development Bank. Joseph P. Claessens.. Pedro. Lang. and Larry H. Working Paper. World Bank. Simeon Djankov. Lang. 1994. 1989. H. 693-728. Burkart. Michael. and Larry H.226 Corporate Governance and Finance in East Asia. Harold. Joseph P. 1988. World Bank. David J. Simeon Djankov. Philippine Macroeconomic Prospects: The Next Ten Years. Antonio. 1998. World Bank. The Structure of Corporate Ownership: Causes and Consequences. Lang. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. Barclay. The Philippines: Onward to Recovery. and Corporate Diversification. Thailand: From Financial Crisis to Economic Renewal. and Larry H. and Fausto Panunzi. Private Benefits from Control of Public Corporations. and Kenneth Lehn. Ownership Structure and Corporate Performance in East Asia. Claessens. Claessens. II References Abonyi. Jr. Journal of Political Economy 93 (6). 1997. March. Diversification and Efficiency of Investment by East Asian Corporations. Claessens. 1998c. 1997.. H. Tokyo: Institute of Developing Economies. 1999. P. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. Stijn. Lang. Key Indicators of Developing Asian and Pacific Countries 1998. Diane K. Stijn. and Larry H. Fan. M. Stijn. Discussion Paper. 1999. edited by Toida Mitusuru and Daisuke Hiratsuka. P. July. 1999. Demsetz. XXIX. P. Institute of Southeast Asian Studies. George. . Dennis. Asian Industrializing Region in 2005. and Simeon Djankov. Dennis Gromb. Working Paper 2088. Vol. Claessens. Simeon Djankov. Manila: Asian Development Bank. World Bank. Fan. October. Agency Problems. Alba. Stijn. Expropriation of Minority Shareholders in East Asia. Fan. Simeon Djankov. H. Stijn. Vol. World Bank. Bangko Sentral ng Pilipinas. and Larry H. Lang. Monitoring and the Value of the Firm. Quarterly Journal of Economics. Journal of Finance 2 (1). Denis.
Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. Modigliani. The Cost of Capital. and Merton Miller. Michael. Douglas. Prowse. and John Moore. .). and the Failure of Internal Control Systems. Determinants of Corporate Borrowing. Corporate Structure. Michael. Philippine Stock Exchange Fact Book 1997. American Economic Review 76: 323-29. Quarterly Journal of Economics 106: 33-60. Anil Kashyap. Journal of Finance 48: 831-80. Agency Costs and Ownership Structure. Internal versus External Capital Markets. 1991. Milton. Liquidity and Investment: Evidence from Japanese Industrial Groups. 1994. Harris. and the Theory of Investment. Joseph C.. Takeo. 1977. 1990. Gestner. Journal of Finance 45: 321-350. 1998. F. Stephen. Stein. and Artur Raviv. Michael. 1976. World Bank. Hoshi. Oliver. Jensen. American Economic Review 85: 567-85. 1995. Agency Costs of Free Cash Flow. Journal of Financial Economics 5: 147-175. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. and William Meckling. David S. Michael. Prowse. Franco. Euromoney Books. International Corporate Governance. Capital Structure and the Information Role of Debt. 1984.. The Modern Industrial Revolution. Scharfstein. and David Scharfstein.Chapter 3: Philippines 227 Diamond. 1958. Journal of Financial Economics 11: 5-50. 1993. 1986. 1990. November. Journal of Financial Economics 3: 305-360. 1995. 1990. The Quarterly Journal of Economics. The Market for Corporate Control: A Scientific Evidence. Myers. Hart. Financial Intermediation and Delegated Monitoring. 1994 and Investment Guide 1997. Stuart. and Richard Ruback. Jensen. Lufkin. Journal of Financial Economics 27: 4366. Stephen. and Jeremy C. Robert H. Theory of the Firm: Managerial Behavior. and David Gallagher (eds. Exit. Review of Economic Studies 51: 393-414. American Economic Review 48 (3): 261297. Jensen. Corporate Governance: Emerging Issues and Lessons from East Asia. Corporate Finance and Takeovers. Corporation Finance. Jensen. 1983.
Vishny. Ajit. Shleifer. 1991. Some Conceptual Issues in Corporate Governance and Finance. No. Journal of Money. Journal of Finance LII. 1985. Stein. II Prowse. Asian Development Bank. David. Shleifer. 1998. 1992. March. Jeremy C. 1. 1. East Asia: The Road to Recovery. May. Vol. DC. Journal of Political Economy 94: 461-88. Washington. No. 1997. Internal Capital Markets and the Competition for Corporate Resources. 1997. Credit Markets and the Control of Capital. Large Shareholders and Corporate Control. and Robert W. and Robert W. Webb. 1996. 2. Technical paper No. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. Vishny. Stephen. . DC. Credit. A Survey of Corporate Governance. Andrei. The Structure of Ownership in Japan. November. Andrei. Journal of Finance 91: 1121-1139. Journal of Finance L11: 737-783. and Banking Lecture 17. Washington. World Bank. Singh.228 Corporate Governance and Finance in East Asia. Mimeograph. IFC/WB. 1998. Joseph E. Stiglitz.
Asian University of Science and Technology. poorly regulated and sheltered from competition. Faculty of Business. David Edwards. It was inefficient in financial intermediation. Republic of Korea (henceforth. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. Thailand. For the period 1994-1996. In the prelude to the 1997 crisis. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). the Thai Government conceded and adopted a floating exchange rate regime. The banking system. 1 Associate Professor. Malaysia. Korea). The majority of these debts were not properly hedged.” After mounting an aggressive defense of the currency. but also the stalling of East Asia’s “economic miracle. The fixed exchange rate policy. both of ADB. with the currencies of Indonesia.4 Thailand Piman Limpaphayom1 4. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. The corporate sector also contributed significantly to the crisis. Chonburi. As a result. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. the Thai baht came under pressure from speculative attacks. with Thai corporations overutilizing short-term foreign currency-denominated loans. . heralding not only a financial crisis in the country. and Philippines all depreciating significantly. and Lea Sumulong and Graham Dwyer for their editorial assistance. But it also laid bare weaknesses in both the financial and corporate sectors. the Stock Exchange of Thailand for its help and support in conducting company surveys.1 Introduction In May to July 1997. The author wishes to thank Juzhong Zhuang. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. the banking system merely validated the financial risks. short-term private debt obligations grew to about 60 percent of total private sector debts. Thai corporations were collectively overexposed to exchange rate risks. had been plagued with prudential problems for a long time. magnified the impact of these problems on the economy when the crisis hit. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies.
1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. Section 4. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).230 Corporate Governance and Finance in East Asia. with government policy providing support but avoiding direct interference. Section 4. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. The First and Second Plans (1961-1971) Under the first two plans. as well as its legal and regulatory framework. while new industries were encouraged to reduce the need for imports. Import tariffs on machinery and heavy equipment were removed.2 4.2. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. the Government increased tariffs on products that could be produced locally.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. lack of transparency and adequate disclosure. Vol. This study examines these and other factors that might have weakened corporate sector governance in Thailand. The study then considers policy recommendations with emphasis on corporate governance improvement. and a family-based corporate ownership structure. The National Economic and Social Development Board was created to plan the country’s economic and social development. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. The country initiated national economic development planning in 1961 when the economy was growing rapidly.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. Section 4. To protect domestic industries. 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. its growth and financial performance. 4.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans.
and increases in world food and oil prices. capital inflows. with the devaluation of the baht in 1984 a major step in this direction. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. including luxury goods. Thus. resulted in increases in the current account deficit. the value of the baht remained stable. textiles. especially foreign aid from the United States. an improved trade balance. gross national product grew by about 7 percent per year. averaging 1. The focus shifted to export promotion. Industrial sector growth was also rapid and many industries (tires. and reduced current account deficits. the industrial sector grew at a faster rate than the agricultural sector. To close the fiscal gap. including a weakening of the dollar.4 percent of GDP. Fourth.Chapter 4: Thailand 231 During this period.4 billion from overseas and increased taxes on numerous items. Inflation reached 15. canned foods. it proceeded with its development plan for the industrial sector. remaining high until 1981. Consequently. Inflation levels were low. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. however. however.6 percent per year. However. As a result. became a major problem as domestic investment declined. External factors. lower than anticipated due to a worldwide economic recession. At the same time. leaving the Government no choice but to resort to overseas borrowings. Average growth for the period was 4 percent per year. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. and automobile assembly) emerged. the Government borrowed $6. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. chemicals. The average budget deficit reached an all-time high of $2.15 billion per year or 4. Budget deficits remained a major problem during the Fifth Plan. The Third. Budget deficits also increased throughout the Fourth Plan. Unemployment. the government’s debt burden escalated. The decline in imports was steady. The Government had to shift emphasis to restoration of economic stability. helped offset these deficits. the current account registered a surplus in 1986. The results were increased exports. with the agricultural sector the major contributor. But the sustained importation of heavy machinery and equipment resulted in large trade deficits.3 percent in 1974. processed steel. .5 percent in 1973 and 24.
6 percent target of the Seventh Plan. compared with the 8. compared with the 14. invited a deluge of capital seeking profitable investments. an oversupply of housing emerged. . Growth rates during 1987-1991 ranged from 9. and Hong Kong. with private foreign debt reaching $92 billion by the end of 1996. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. the bulk of domestic investments went to speculative ventures such as real estate. rather than to productive activities. Inflation was 4.4 percent targets. respectively. property development.2 percent per year. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. increasing its share in total export value from 42 to 76 percent. The country also attracted a large amount of foreign direct investments (FDIs).7 and 11. From 1989.2 percent target. reaching an annual inflow of $2 billion in 1991. Growth of exports and imports averaged 14. while exports expanded considerably.6 percent. Europe. The manufacturing sector became a dominant force in the economy. and the stock market. United States.8 percent. Vol. The country’s high ratings in the international capital market. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. averaging 10.5 percent. better than the 5. Private sector investment grew at an average annual rate of 7 percent. lower than the target of 8. China—went to export-oriented manufacturing industries. Singapore.232 Corporate Governance and Finance in East Asia. On top of its predominantly “borrowed” nature. Average annual growth in real GDP was 8 percent. By 1995. The exchange rate was steady at around B25 to the dollar. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. Most of the FDIs—originating mainly from Japan. combined with its liberal financial policies. Thailand became a debtor’s market. from only $31 billion in 1992.8 percent.5 to 13.2 and 13. the property sector began to collapse in 1996. compounded by a slump in property sales.
And because the Government considered the banking system vital to the development of the economy. In his report. Robbins. its policy had always been to protect domestic banks. Before the capital market emerged. In 1972. The deficits caused the Government to rely on even more external borrowing. Under the 1962 Commercial Banking Act. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. with growth shrinking from 23. which was amended in 1979 and 1985. In May 1974. which raised the debt service ratio. a policy that held throughout the first six economic development plans. Sidney M.8 percent in 1995 to 1.3 percent in 1996. In 1978. many companies considered the Act too restrictive and a hindrance to growth. on account of an overvalued baht that weakened export competitiveness. the capital markets didn’t play a significant role until 1975. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. Foreign banks were barred from competing directly with domestic banks. Exports went into a tailspin. prepared a comprehensive report entitled “A Capital Market in Thailand. the corporate sector’s main source of funding was the banks.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. the signs of an economy about to falter were there. the Bank of Thailand and . a former Chief Economist from the US Securities and Exchange Commission. SET officially became “the Stock Exchange of Thailand” in 1991. In 1969.Chapter 4: Thailand 233 Toward the end of the Plan period. 4. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. placing all publicly listed companies under regulation. However.” which later became the master plan for the development of the Thai capital market. Robbins recommended an overhaul of the existing informal stock market established earlier by a group of local brokers in favor of a centrally regulated institution.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development.2. the Government passed the Public Limited Company Act. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. the Government amended the “Announcement of the Executive Council No.
Thailand’s capital market entered a new era with improved legislation and regulation. the financial and banking laws were generally ineffective. increased financial market activities. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. The regulatory measures were inadequately designed and poorly enforced. the World Bank had recommended such a move. Vol. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. Thai banks gained access to a variety of funding sources from around the world. to cater specifically to its . there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. While the Bank of Thailand had the regulatory power to influence business practices. At the end of the Sixth Plan. and new financial instruments. In the 1990s. However. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. Externally. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. it usually relied on “moral suasion. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision.234 Corporate Governance and Finance in East Asia. the Government was under international pressure to deregulate the financial sector. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. 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. Earlier. With the liberalization of financial markets. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. II the Ministry of Finance had full authority to supervise all commercial banks. Laws were enacted to stimulate growth of the corporate sector. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy.” The Government also granted financial institutions overly generous bailouts.
6 1. 4. and Fishing Mining and Quarrying Manufacturing Electricity. Insurance. Real Estate.9 1.0 Paid-up Capital (B billion) 1.5 111.9 34. The majority of the companies are in manufacturing. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.6 2.1). The Bangkok International Banking Facility (BIBF) was thus established to facilitate international borrowings and encourage capital flows as a means of financing the current account deficit. and Business Service Community. and Restaurants and Hotel Transport.3 trillion have been registered with the authority (Table 4. however. Storage. Financial deregulation and liberalization were key to realizing that vision.5 791. the financial sector is the largest. Gas.2 Type of Business Agriculture. in that order.Chapter 4: Thailand 235 fast-growing neighbors. and Communication Financing. the country became recognized as an economic development model for other emerging economies.1 Public Companies Registered. and Water Construction Wholesale and Retail Trade. Hunting.394. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.5 50.4 trillion in registered capital and B791 billion in paid-up capital. Thailand. In terms of capital.1 30. Source: Department of Commercial Registration.6 350.2 11.1 trillion and paid-up capital of B1. The result was a corresponding growth and development in Thailand’s capital markets.0 19.0 21. with B1.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. and wholesale/ retail trade and restaurant/hotel sectors.291. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. Worldwide.101.9 261. . Social and Personal Service Total Note: The data for 2000 is as of October 2000. Forestry.1 78. finance.3 83.0 110.9 16.2. Ministry of Commerce.6 23. about 661 companies with total registered capital of B2.
0 1994 82. the capital market became instrumental in the rapid growth and development of the corporate sector.2 Public Offerings of Securities.8 billion. from only B20. reaching a precrisis peak in 1996 (Table 4.1 599.7 5.5 1. The stock market also became an invaluable source of funds for corporations. Source: Key Capital Market Statistics.5 — — 56.6 39.2). Domestic and offshore debt issues reached B54.236 Corporate Governance and Finance in East Asia.3 31.6 7. The number of listed companies and securities steadily increased until 1996 (Table 4.2 12.9 1998 1999 15.7 7.3 22.4 34.4 51. II B261 billion.7 9. These peaked at B89. 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 1.8 151. Vol.6 — = not available. The signing of Article VIII with the IMF.7 billion and B27.3). While a rebound was apparent beginning in 1998. The preeminence of the financial sector is a direct result of financial deregulation and liberalization.5 billion and B1 billion the previous year. reducing the value of offerings to a little more than a quarter of the previous year’s level. After the passage of the SEA of 1992. respectively.8 1995 64. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.2 25. allowed Thai financial institutions and corporations to obtain funds overseas. the year before the crisis struck.7 27.1 — — — 6.8 — 26.3 6. The development of the corporate sector closely followed the development of capital markets.0 0.6 8.1 2.5 39. Market capitalization.5 1.0 20.9 37. The 1997 crisis battered the primary market for securities.9 31.2 40. moreover.8 201.4 277. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.6 174.2 5.3 1996 1997 65. Securities and Exchange Commission of Thailand. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. reached .1 286.3 194.7 136. meanwhile. Table 4.7 billion in 1996. the value of public offerings rose steadily.4 96.1 54.
325 3. 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. however.565 2.4 percent to 5.133 1. Throughout the 1990s.360 1. But instead of shifting to a low gear.114 1.301 3. The key financial ratios of all companies listed on SET bear this out (Table 4. the average times interest earned (TIE) was down to 5. the companies could not generate enough net returns from their assets and equity.268 2.8 percent. Source: Securities and Exchange Commission of Thailand. not all public companies are listed on the SET.303 930 855 1. as measured by return on assets (ROA). in the end.3 Statistical Highlights of the Stock Exchange of Thailand. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. The upward trends for ROE and ROA continued through 1989. return on equity (ROE). ROA dipped from 10.683 1. corporate profitability had been declining.1 by 1996. gross profit margin rose until 1991 before falling in 1992. From 10. their share rising from 17 percent in 1993 to 43 percent in 1997.6 trillion. the averages for all three profitability ratios took a downswing all the way until 1996. was the ominous deterioration in the key financial ratios of publicly listed companies. Corporate profitability. Meanwhile.535 1. had been on the rise throughout the 1980s. The trend reversed in 1995. its high point in 1995 at B3.5 at its peak in 1987. While the decline in gross profit margin was not as sharp.Chapter 4: Thailand 237 Table 4. then stalled in 1990.201 2. pulled down by active public offering activities.4).281 832 373 356 482 Due to listing requirements and other reasons. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments.4 percent in 1996. Side by side with this surge of financing for corporate growth. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the .610 1.193 2. however.3 percent in 1989 to 3. The financial leverage of all companies declined until 1994. By the early 1990s. resulting in their inability to fulfill debt obligations.560 1. Foreigners accounted for an increasing proportion of SET’s turnover value. ROE similarly fell from 21. and gross profit margin.
8 14. which fell from 16 percent in 1991 to just under 6 percent in 1996.6 7. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.6 27. which was particularly significant in the two years preceding the crisis.9 140.5 52.7 12.4 28.1 9. the textiles.6 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 26.4 7.238 Corporate Governance and Finance in East Asia.1 242.9 7.8 25.4 4.3 91.4 12.4 119.9 27.2 161.2 6.4 5.4 9. practice of heavy borrowing.1 16.1 52.8 151.7 80. and footwear had the lowest at 11 percent.8 8.8 51.1 120.7 15.4 34.6 138.0 145. 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 (%) (%) (%) 3.4 44.3 4.4 51.2 35. these companies opted for debt.2 27. was also distinct in the region. was felt across industries. resulting in higher collateral values for borrowers.9 14. clothing. The downtrend in corporate profitability.9 77.0 125. Thailand’s ROE. clothing.7 5.4 47.1 114. II Table 4.4 12.0 7.0 117.4 3.5).0 63. A major reason for this was the rapid rise in asset prices.8 5.3 10.7 4.9 8.6 41.9 66.9 144.2 64.8 88.7 21.0 3.4 18.2 10.9 7.0 29.7 5.9 51.2 10.5 50. and footwear industries also experienced losses.0 139.1 60. Severely affected by global competition throughout the decade.7 34. Despite the availability of the equity market.3 12.4 139.7 20.5 15.7 35.8 54. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.7 5.7 12.1 44.2 27.6 168. Hotels and travel showed the highest ROE of 15 percent while textiles.7 27.5 38. 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 11.4 Key Financial Ratios of Publicly Listed Companies.7 27. Among the crisis-hit countries. US.3 8. Overall.6 12. Korea and Thailand had the highest debt-to-equity ratios.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.7 12.7 12.4 24.7 54.8 5.5 9.5 30.6 36.5 51.2 10.2 49.2 215. They were generally more efficient in managing their assets and .4 7.9 39.7 59.1 16. Vol.5 63.6 125.
5 6. However. They also tended to use more financial leverage than small companies as their total DERs show.3 164.7 14. measured by total asset turnover.2 18.Chapter 4: Thailand 239 Table 4.3 23.6 12.0 20.3 49. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.8 6.6 61.5 7.2 10.6 5. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.3 135.0 83. For instance.6 30. .3 25.6 7.2 121.5 94. by the 1990s.1 25. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.8 142. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.5 87.6 31.3 52.4 116.1 5.7 6.8 26.3 43.4 Legal and Regulatory Framework Before 1992.0 48.8 10.8 6.6 30. Cumulative voting.7 10.3 176.2. Although stable in the 1980s.6 10.2 134.9 20. although the performance of listed companies in the late 1980s was strong.3 88. 4.1 13. capital despite the higher gross margins of small companies.3 15. 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 6.5 Average Key Financial Ratios by Company Size. total asset turnover declined after 1989. During the 1990s.2 12. the law disallowed cumulative voting. it was thought.6 6. also deteriorated.1 29.1 Small Medium Large 5.1 6.4 8. weaknesses became evident.3 49. In sum. could lead to a high turnover in the board.8 62. which would be disruptive to company management. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.8 47. the overall activities of listed companies.9 13. US.4 52.
. As it turned out. 4. Cumulative voting was made optional. II Another issue was the proportion of shareholding by top shareholders. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. and external monitoring and control of corporations were also weak. The provision discouraged original family owners from registering their companies. concentrated ownership. Fortysix companies responded. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. the exit of these provisions appears to have contributed to the 1997 financial crisis. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. played an important role in bringing about the financial crisis. that creditors had generally little influence on the management of corporations. adopted to promote the development of publicly listed companies. The protection of minority shareholders was inadequate under the Public Company Act of 1992. An Asian Development Bank (ADB) survey conducted for this study shows. for instance. However. This will be discussed in Section 4. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. The law prohibited the largest shareholders. and the punishment for management misconduct was also lightened considerably. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. As the succeeding sections point out. but not all questions were answered. Vol. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector.240 Corporate Governance and Finance in East Asia.5. The Public Company Act of 1992. coupled with weak corporate governance.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. relaxed the contentious provisions of the 1978 Public Limited Company Act. as a group.
7 7. and 28.7 6.6 27. Ownership was most concentrated in the packaging. .8 5.3 11.4 26. Thai. But with their increased reliance on new varieties of equity and debt instruments. Unfortunately.1 4.3 percent.4 percent of outstanding shares. Indonesian. Ownership Concentration Between 1990 and 1998.1 12.7 11.9 percent of shares of a company.0 5.3 percent and 18.0 7. Stock Exchange of Thailand.9 3.9 4. and minority shareholders to stake their claim in the control and regulation of these companies. China firms have the highest single shareholder ownership concentration at 35.0 56.5 28. with the top three shareholders accounting for almost 50 percent (Table 4.4 6. In contrast. 56. 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 28.1 5.6 4.Chapter 4: Thailand 241 4.4 4.8 32. 33.1 11. Most large Thai corporations listed on SET started out as family businesses.3 16. In the past.7 percent.9 11.2 4.9 52.4 6. these companies obtained funding solely from banks or from their own retained earnings.9 6.9 26. The Public Company Act of 1992 allowed ownership and control of these companies to remain with the founding families even as they became increasingly dependent on nonfamily resources.6).4 26.2 4. Across industries.2 11.3 28.4 10.4 26. and Hong Kong.2 4.6 68. on average. the top five shareholders of each of publicly listed Thai companies held.9 54. Table 4.6 28.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.3 5.1 percent of control rights. Source: Comprehensive Listed Company Information Database. respectively. with the largest shareholder on average controlling 10.1 3.5 9. this was not the case.China have the least concentrated ownership.0 3.9 3.1 5.0 53. creditors.8 11.6 57.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.3 7.5 Average for 1990-1998 period.3.0 3.9 52. there were only slight variations in the pattern. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.2 56.1 5.3 7.1 7.7 12.0 7.9 52.4 5. one would expect the public.9 55.
8).7 percent of outstanding shares on average (Table 4.080 6.003 0. *** at the 1 percent level. and building and furnishing industries.533)*** Debt-to-Assets (0. Company size is significantly related to ROE and leverage. Table 4. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. results show a significant positive relationship between ownership concentration and financial leverage.001*** 0. Ownership Concentration.001 0.647 Note: The regression included dummy variables for industry.072) (0.031 3. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. ** at the 5 percent level.034*** 0. US. and ownership types. 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.005** 0. founding families maintain effective control of entire groups.037 0.169*** 0.800 0. Leverage.029 3.022*** 0. * Denotes significance at the 10 percent level.7 Statistical Relationships between Corporate Profitability. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. II agribusiness. 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. owning 26.116) Debt-to-Equity (1. Based on a regression analysis.058* ROE (0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. as measured by debt-to-equity and debt-to-asset ratios.115 9.090 0. Vol.001) 0. including those that are publicly listed .7). with a top-five ownership concentration of at least 60 percent.242 Corporate Governance and Finance in East Asia. year. Through these holding companies.
9 15.9 7. In addition.7 1.8 28.5 5. Individual family members also hold a significant amount of outstanding shares. one of the founding members. Typically. operates five of the most successful shopping malls in Thailand.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. a NBFIs denotes nonbank financial institutions.3 — = not available.3 percent of outstanding shares.5 2. The largest shareholder is Central Holdings Company.5 1.2 5.0 18.5 percent.0 3. the company increased its registered capital and became a public company listed in SET.1 4.3 1.2 1.8 1.2 7.3 0.3 20.5 0. averaging about 18.9 18. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.4 22. Although holding companies set up affiliate firms.9 19.6 percent of outstanding shares.6 1.5 Government Other 0. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. a joint venture among three families.3 1. owned by the Chirathivat family.8 23.6 1. the affiliate firms rarely hold shares of their parent companies.4 1.9 0. the company.0 17. .2 18. including finance and investment companies.3 1. Established in 1980 with a registered capital of B300 million. with 29.5 26.7 — 1. Source: Comprehensive Listed Company Information Database.4 1.5 0.6 1.1 1.Chapter 4: Thailand 243 Table 4.3 27.8 0. In 1994.6 25.7 5.5 1.7 Bank 2.5 0. Stock Exchange of Thailand.6 28. The top 10 shareholders include a holding company owned by the Tejapaibul family.3 27. The ADB survey indicated that listed companies held shares in an average of 11 companies.1 0.4 1. a company listed in the real estate sector of SET.7 0. in SET.5 NBFIsa 6.6 5. individual members of the Chirathivat family aggregately hold 25.3 27.1 1.4 20. These individuals usually hold important management positions in concerned companies.2 1.5 Individuals 13.0 19.9 6. unlike in Japan where crossshareholding is common. This practice is illustrated by Central Pattana.
Except in the hotel and travel service sector.1 percent of total outstanding shares of listed companies. Nonbank financial institutions hold an aggregate 5. Moreover. has the Ministry of Finance as its only large shareholder with 92. 4.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. they account for 80 percent of total outstanding shares. qualification. commercial banks account for only 1. roles. Vol. On average. these shareholders are able to control the company.5 percent of total outstanding shares. By owning 62 percent of voting shares. 1. they exercise limited influence in operations because of the restricted size of their shareholdings. and responsibilities of directors of public companies.5 percent of total outstanding shares of listed companies. In effect. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. For example. . duties. the Government owns the majority of the shares. Thai Airways International Plc. the Petroleum Authority of Thailand. and a state bank. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. the predominance of individual family members and holding companies in the top shareholder list remains valid. the Government’s role in public companies is expected to decline.244 Corporate Governance and Finance in East Asia.3. Only a handful of companies have the Government among their large shareholders. Although the list of top shareholders of publicly listed companies includes financial institutions.. on average. Together. In such cases. Across industries. II another of the company’s founding members. 3 Discussions in this section are based on results of company surveys by SET and ADB. where the top three shareholders are the Ministry of Finance. Another example is Bangchak Petroleum Plc. the top 10 shareholders consist predominantly of members of founding families and their holding companies. both conducted in 1999. only one tenth of listed companies have commercial banks on their top-five shareholder list. with the envisioned privatization master plan. However.9 percent of outstanding shares. The Government holds. There was a trend of rising government shareholdings throughout the period 1990 to 1998.
the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. 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 shall be elected at the annual general shareholders’ meetings (AGSMs). In addition. directors may be imprisoned or fined. In their business conduct. selection was based on relationships with controlling shareholders. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. In five other companies. but not in 22 others. meanwhile. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. Some companies (36 percent) had five to six main board members holding seats in their executive boards. If found in violation of these provisions. the majority (71 percent) had board chairs who were also members of top management teams. The ADB survey indicated. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. Many companies have a formal policy on corporate governance and business ethics. Meanwhile. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. directors could be compelled to compensate the company for damages arising from their misconduct. Three companies indicated that the CEO and the chair were close relatives. while 30 percent of respondent companies held board meetings monthly. . and to comply with the laws and articles of association. Generally. directors are required to act with care and honesty for the company’s best interest. an executive board consists of senior management and some main board members. Unless stipulated in public companies’ articles of association.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. while 15 percent of respondents went beyond the requirement. Although 28 percent of the chairpersons came from the ranks of independent outside directors. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings. Nineteen companies stated that selection was based on professional qualifications.
not an independent assignment. These committees were mainly responsible for determining compensation for senior and regular staff. the work of this committee was often considered part of the executive board’s responsibilities. Companies already with audit committees did not have independent outside directors as audit committee members. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. while 19 companies observed only some of them. the auditor is not . and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. Three companies allowed their management to determine the chair’s compensation package. Where different. II Compensation of Directors.246 Corporate Governance and Finance in East Asia. SET’s attempts to bring accounting practices to international standards have included requiring listed companies to consolidate all liabilities— including those on off-balance sheets—in their financial statements beginning June 1998. however. Also. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. the remuneration packages had to be approved during AGSMs. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. Chair. However. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. with 41 firms admitting the use of services of international auditing firms. In 25 companies. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. Audit Committees and Accounting Standards Since January 1999. In one company. 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. All respondents confirmed the use of external auditors. Half of the companies in the SET survey had a separate remuneration committee. Vol.
shareholders have access to reliable information at no cost. there are also significant gaps in the system of shareholder protection. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. According to the ADB survey. most responding companies have rules and regulations intended to protect shareholders. or other financial instruments. For instance. (iii) Because the chair is frequently also part of the top management team. and the Bank of Thailand— are not clearly defined. debentures. While safeguards are in place. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. (i) No standards are enforced in the content and timing of notices for shareholder meetings. (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.Chapter 4: Thailand 247 independent from the company. Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. averaging about 14 years. remuneration. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. At least 28 responding companies had the following . SET. shareholders can claim compensation in cases of negligence or dishonesty by management. as well as the registration and holding of shares. stipulates the proper conduct of shareholder meetings. and executive committees. As a result. However. there is the danger that top management may be capable of unduly influencing the board’s decisions. SET’s rules and regulations closely follow this Act. Relationships between firms and external auditors are generally long-term. Forty-four companies indicated that they had proxy voting in place. SEC. The Act also holds directors liable for any damage to shareholders. with 13 companies allowing proxy voting through mail. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. The Act. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. likewise. In the majority of these companies (38 out of 46 respondents). Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. although recently. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce.
it would be difficult for minority shareholders to gather the shares needed to take action. Banks would be obvious candidates to implement these mechanisms. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights.3. While stimulating the growth of the sector. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. Vol.248 Corporate Governance and Finance in East Asia. takeover of the company. But with the ownership concentration of Thai companies. they comprised only 8 percent of total shareholders. and call an extraordinary session. representing only about 28 percent of shareholdings. In practice. the only group of shareholders that can exercise rights is the top five shareholders. 4. . minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. did not vote in previous AGSMs. and insider trading. Although the attendees held. 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. however.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. on average. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. Only a small number of shareholders attended the latest AGSMs. On paper. But the exercise of these rights requires even higher shareholding levels. and mandatory disclosure of related interests and significant shareholders’ transactions. 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. 66 percent of total outstanding shares. such protection has been insufficient. given their importance in providing finance and their stake in companies. minority shareholders are assured adequate legal protection. Almost 82 percent of shareholders.
which could cause a delay by at least a year. a company’s reputation and its long-term relationship with creditors sufficed in many instances. For 20 of the 46 responding companies. . such as that seen in Thailand before the crisis. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. Leverage allows the assets and operations of the company to grow without diluting corporate control. borrowers seldom lose control to creditors even when they default and become insolvent. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. creditors do not always require project feasibility studies or business plans in granting loans. 11 experienced rejection after the crisis started. Apparently. while loans for fixed investment were also more likely to be supported by collateral. Under a weak bankruptcy system. In the end. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. they resort to borrowing. including procedural disputes. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. Normally. when insiders want to expand their company’s operations without losing control. 17 indicated that only some of their creditors had such a requirement. other than losing control. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. However. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. There were many options. while 18 said none of their creditors required collateral. to solve debt repayment problems. creditors’ collateral requirements were tightened after the crisis. as the ADB survey confirmed. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. Actual bankruptcy proceedings took more than five years on average. Debtors had many handles to stall the bankruptcy process. Only three companies thought otherwise.Chapter 4: Thailand 249 Historically. Most companies reported that banks were more likely to require collateral. the majority believed that creditors had little influence on company management and decision making. however.
SEC has no authority to either approve or reject tender offers. its main role is to ensure transparency and fairness.9). In this case. if the purchase of shares implies a change in the directors or business activities. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. of shareholders: (i) all shareholders must receive tender offers. 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. and failed to provide managers with strong incentives to perform efficiently. with a significantly lower total tender offer value of B8. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. Although merger and acquisi- . Vol. only a limited number of successful mergers of public companies have taken place. In 1996. In 1994 and 1995. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. whether directly or indirectly. however. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. before the extent to which the bankruptcy framework has been strengthened becomes clear. Such efforts would serve to strengthen external discipline on controlling owners.3 billion (Table 4. Recently. According to the SEA of 1992. Since the introduction of the Public Limited Company Act of 1978. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. The first category is the acquisition of shares in the open market. there were only six tender offers. The second category is the tender offer. with a total tender offer value of B42. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. There are detailed requirements regarding such notification. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition.250 Corporate Governance and Finance in East Asia. It will take years. SEC was later made responsible for regulating corporate takeovers. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days.3 billion. The market for corporate control has not been active in Thailand. there were 41 cases of tender offers. there are two categories of merger and acquisition activities with associated regulatory measures.
9 Merger and Acquisition Activities. Twenty-nine firms indicated that employees held shares of their companies.8 81. The number of domestic institutional investors rose after the mutual fund industry was established in 1991.9 3. 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.Chapter 4: Thailand 251 Table 4. but the average shareholding is smaller than 1 percent of total outstanding shares.3 60. employees regard the plans as monetary incentives.0 B billion 4.1 75. Employee Participation in Corporate Governance There has been little.0 55. . Source: Securities and Exchange Commission of Thailand. but employees have never been represented in the board of directors since their shareholdings are minimal.1 84.2 6.7 Purchase Value Number of % of Tender Offer Value Companies 84.6 17. not with a view to becoming involved in actual management.2 6. it remains small. they have mostly been concerned with short-term gains. tion activities increased after 1997. Provident funds for government workers and workers in public enterprises have been established only recently.1 19. Because of the current crisis. employee participation in corporate governance in Thailand.4 23.2 8. Pension funds are perhaps even weaker in Thailand. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. if any. Eleven of the 46 responding companies in the ADB survey offer ESOPs.3 11. While the Thai mutual fund industry compares well to those in other developing countries in the region.1 58. Even when companies offer ESOPs.2 7.3 6. most of these were forced mergers or related to rescue packages.7 11. Few companies offer employee stock option plans (ESOPs). Since 1994. employees are even less willing to accept common shares as a form of compensation or benefit.5 6. But instead of opting for an active role in the market for corporate control.
4 4.2 262.230.252 Corporate Governance and Finance in East Asia.4 4. .037.4. accounted for 28 percent of the banking sector’s total assets.669.1 6. Thai Bond Dealing Centre.10 Size and Composition of the Thai Financial Sector..3 5.4 1.8 941. the banking sector was highly concentrated.979.10) shows that Thailand is a highly bank-dependent economy. 15 of which were domestic banks.1 3.5 6. although its role increased in the wake of the crisis.268. The bond market played only a marginal role in corporate financing. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.564.5 4. total assets of commercial banks amounted to B22.214.171.1240. and Bank of Thailand. The share of domestic banks in the banking system’s total assets was 80 percent.5 Outstanding Loans from Commercial Banks 2.663.360.6 1. Vol.430.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.1 126.96.36.199 4.6 2.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.0 339.9 2.1 7. The country’s largest bank. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.3 546.8 3. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.2 2.559. Table 4.1 5.485. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.4 519. In 1996.0 424.775. II 4.5 5.906.325.133.3 1.825. Bangkok Bank Ltd.4 3. the next four largest banks accounted for 63 percent.1 Domestic Debt Securities Outstanding 215.912.0 8.390.0 SET Market Capitalization 1.372.477. The Banking System Until recently.5 trillion.6 6.0 3. there were 29 commercial banks.
8 in 1998. was set up by 74 members with an initial capital of B500 million. In contrast. an over-the-counter market. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. Because borrowers carried the exchange rate risk. Through the years. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. Despite the worldwide market crash in 1987. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. owning 70 percent of the country’s second largest bank. also made it unattractive to raise capital from the equity market. Some 347 companies were listed in the same year with a total market capitalization of B3. After that. SET is organized into 32 major industries. and property have accounted for the bulk of trading volumes. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. Turnover value reached B2. SET immediately recovered due to the strength of the Thai economy. and almost all capital account transactions were deregulated. Banking activity peaked in the mid-1990s. due to their close ties. reaching 355. SET was not very active. In 1995. the Bangkok Stock Dealing Center (BSDC). self-regulatory organization under the . Easy access to commercial bank loans by family business groups. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. finance. the market rose steadily and reached a record high in the fourth quarter of 1993.3 trillion. The Equity Market During the first few years of its operations. BIBF banks also enjoyed tax incentives on their operations and profits. Licenses were granted to 15 Thai banks. the SET index declined. and 20 new foreign banks.2 trillion. The lack of supply of quality shares was a big problem for SET at that time. banking. The number of listed companies also quadrupled between 1981 and 1993.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. The Government removed controls on capital and dividend repatriation in 1991. BSDC is a nonprofit. In the following years. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. Benefiting from rapid economic and industrial growth. the stock market entered its first boom period in 1986. In 1993. 12 existing foreign banks.
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. According to the SEA of 1992. SET. financial projections. After initial public offerings.5 percent and collectively owning at least 30 percent of paidup capital. which consist of SET and BSDC. each holding no more than 0. Listed companies were those that had (i) paid-up capital of at least B20 million. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. securities can be traded in the secondary markets. but dropped the following year to B122 million. If approved by SEC and the SET Board of Governors. to assist in the public offering process. lottery drawing must be used to ensure fairness. the BSDC was dissolved in 1999. SET established new requirements for initial public offerings. In 1998. also acts as a clearinghouse.254 Corporate Governance and Finance in East Asia. . The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. Only one security was listed in BSDC in 1995 and two more in 1996. and securities registrar. In July 1990. and (ii) a minimum of 300 shareholders. The primary market is supervised by SEC. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. If the issue is oversubscribed. The company should then appoint a financial adviser. Vol. stock trading can commence within five days. Before 1993. 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. The allocation procedure is nondiscretionary. turnover value was negligible and the BSDC Index remained flat throughout 19961998. among other functions approved by SEC. It separated the primary and secondary markets to promote more flexible and effective supervision of both. Turnover value was B1. II jurisdiction of SEC. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. the two classifications were merged. securities deposit center. approved by SET.8 billion in 1996. Consequently. there were two kinds of companies in SET—“listed” and “authorized” companies. with each facing different listing requirements. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. however. The listing application should be submitted concurrently to SEC and SET. Company applicants must have an established history of operating under substantially the same management. so now only listed companies are traded in SET. In 1996.
however. The Thai Rating Information Services. However. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. the Government issued more bonds to finance industrial development projects and perennial deficits. 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. A turning point of the corporate debt market was the enactment of the SEA of 1992. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. Beginning 1961. To gain some perspective of the size of the bond market in Thailand. which encouraged limited companies and public companies to issue debt instruments. The proportion of domestic convertible debt instruments increased until 1995. 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. in 1994. 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. and the Government did not issue new bonds during 1990-1997. In 1996. the first bond rating agency in Thailand.9 billion.11). it represented only 9 percent of GDP. Upon its founding in 1942. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. the size of the corporate debt market rose to B132. was also instrumental to the growth of the corporate debt market. the Bank of Thailand assumed responsibility for regulating the bond market. while secured debt instruments accounted for just above 10 percent. Four years after the passage of the SEA. it accounted for a small share of the entire financial sector. compared to 110 percent in the US and 74 percent in Japan in the same year.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. . The bond market in Thailand started in 1933. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. The budget surpluses of the 1990s eliminated the need for new bond issuance. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. The recent financial crisis.
2 — — 50.8 167.1 10.6 — 0.9 329.7 0.3 13.3 46.1 41.2 89. this had climbed to B200.3 — 14.4 billion.5 43.2 39.8 55.8 191.7 5.2 57.4 — 26.6 — — 0. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.1 8.4 — 9.3 46.7 5.9 37.0 281.7 7.5 10. turnover value had reached B51.1 6.3 — — 3.5 — — — — 1.7 90.0 — 5.7 — — 40.7 — — — — — 4.4 — — — 1.5 — 39. total offshore debt offerings had plunged by 68 percent to a mere B28.3 6.0 27.5 5. a surge attributed to capital inflows encouraged by high returns on Thai bonds.2 45.3 29.1 59.0 — 5.1 141.8 47. II Table 4.1 107.9 20.7 821. However.1 61. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.1 — — — 29.3 140.4 110.8 31. Total offshore debt offerings peaked in the run-up to the financial crisis.9 40.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.9 37.1 — — 6.7 — — — — — — — 77.1 12.5 37. by the end of 1997.5 — 0.2 2.7 95.5 billion. .3 3.4 57.7 28. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.11 Offerings of Debt Securities.6 billion.9 5.1 121. The following year.5 — — — 3.0 5. then declined substantially in 1996 and 1997.4 49.7 132.5 — — 32.0 0.0 333.0 60.0 33. By 1995.7 0. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.4 7.2 28.9 0. the year the crisis unraveled and the baht was floated. 1992-1999 (B billion) Item Government Bonds Treasury Bills State Enterprise Bonds Guaranteed Nonguaranteed Other Government Bonds Corporate Bonds Domestic Secured Unsecured With Warrant Convertible Short-Term Offshore Secured Unsecured With Warrant Convertible Total 1992 1993 1994 1995 1996 1997 1998 1999 — — — — — — 400.2 43.0 — 26.1 55.7 538.256 Corporate Governance and Finance in East Asia.1 21. Vol.8 2.0 7.6 19. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.0 86.0 26.1 315.3 8.0 17.9 30.5 55.3 22.5 138.3 50.1 289.
1 billion in 1998. Equity financing remains an important part of listed companies’ long-term financing. From 1990 to 1996. The average for all industries was only 22 percent. In any case. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. these comprised 31 percent.2 billion as a result of the default of debentures due to the Asian crisis. turnover value plummeted to B106.4. steadily easing up between 1990 and 1996. Across industries. 4. significant variations can be noted. At lower than 5 percent of total liabilities. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. judging by their relatively low levels of retained earnings. short-term loans accounted for more than 40 percent of total liabilities. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. In addition. Longterm loans accounted for about 20 percent of total liabilities. and marketable securities holdings. Companies in construction and property development seemed unable to generate internal funds.Chapter 4: Thailand 257 compared with investment in equities. In the same year. Turnover fell further to B72. a trend most apparent in the leap between 1991 and 1992. Construction and property development industries tended to have high proportions of long-term loans and debentures. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. There was also little change in the trend in retained earnings within the seven-year period. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. with equity levels remaining high despite an increase in debt. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. Retained earnings accounted for about 30 percent of total equity financing. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. while for the property development industry. cash balances. In 1997. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result.12).2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. The proportion of accounts receivable also declined steadily. For the construction industry. they also had a relatively small proportion of equity and . these accounted for 33 percent of total liabilities.
2 34.8 9.1 5.6 0.5 0.8 1.4 6.2 1.7 0.8 3.2 45.9 14.2 42.4 7.0 13.3 1.7 7.8 37.1 2.7 17.0 1.6 8.9 43.0 100.3 18. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.6 100.7 16.8 20.5 11.3 14.7 52. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.8 25.3 14.6 100. US.6 22.2 1.3 34.0 100.8 8.2 17.7 50. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.0 100.8 46.1 7.4 14.2 2.0 7.6 18.1 49.0 48. II Table 4.5 14. compared with the 44 percent general average.1 17.0 2.9 17.5 1.3 6.4 21.0 100.2 17.5 9.9 38.3 34.2 3.4 49.6 2.5 37.2 17.3 38.258 Corporate Governance and Finance in East Asia.6 12.5 1.6 0.1 18.2 22.0 6.6 13.8 10.9 15.2 12.3 21.9 49.1 36.3 1.0 100.9 10.9 40.9 14. Vol.8 21.1 50.9 0.0 100.6 36.8 35.8 37.2 43.0 100.4 49.9 6.6 50.0 12.8 34.6 0.1 13.6 10.2 16.3 12.6 0.0 15.9 20.6 21.2 43.9 14.5 1.8 9.7 15.0 100.9 16.2 2.9 14.2 17.3 17.0 10. The level of total liabilities for the group characterized by high ownership concentration .8 7.7 1.0 10.9 17.9 14. Printing and publishing companies had lower financial leverage than companies in other industries.3 49.8 6.6 38.0 100.4 2.9 2.0 100.9 3.3 50.0 100.2 1.0 Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.8 19.4 17.6 11.2 2.0 100.3 2.9 6.4 48.7 9.6 6.12 Common-Size Statements for Companies Listed in SET.4 43.7 14.0 14.2 16.13).0 100.5 9.0 51.4 8.6 14.5 43.2 35.3 18.0 100. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.9 18.6 51. were highly leveraged.7 36.3 48.2 15.4 17.9 50.8 17.6 15.7 16.9 12.8 14.7 18.3 25.2 2. medium.
6 14.9 2.1 36.1 44.0 16.3 100.6 2.4 37.8 13. For the high ownership concentration group.0 6.6 22.2 22.0 19.8 37.0 7.2 14.3 16.7 17.2 0.1 49.8 13.6 9.9 21.9 16.4 7. US.0 Medium 2.0 6.3 35.2 45.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.9 100.5 21.6 100.0 Low 1.5 13.8 12.4 50.4 18.2 11.3 1.7 percent for medium ownership concentration companies and 49. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.5 11.9 36.5 percent for low ownership concentration companies.Chapter 4: Thailand 259 Table 4.9 7.4 1.5 100.0 100.4 3. .4 13.0 14.1 18.6 15.3 1.4 35.9 0.7 19.3 8.0 100.0 41.13 Common-Size Statements of Public Companies by Ownership Concentration.6 0. 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 2.5 18.7 12.9 50.6 47. was 53 percent of total assets compared with 49.4 49.1 53.2 8. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.
4 12. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.0 50. The TIE ratio declined from its peak of 7.1 23.8 65.4 5.9 63.2 68.5 52.9 140. these firms more easily increased their leverage.8 151.14).9 14.1 in 1996. however. bond issues.6 125. 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 31. An overall picture of SET-listed companies’ financing and investment patterns in the 1990s shows a steady rise in the use of financial leverage (Table 4.1 16. Short-term debt accounted for most of the increase. After the crisis.6 41.0 145.7 percent in 1996.1 31.0 25. was the headlong deterioration of firms’ ability to meet their interest payment obligations.8 51. bond issues overtook loans from commercial banks as the second preference.4 139.9 51.8 65.5 38. minimization of transaction and interest costs.7 in 1994 to 5. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing. As a result. Vol.7 66.7 28.8 5.7 11.6 138. While further detailed investigations are necessary.7 34.3 61. US.1 44.7 12.1 64.4 44.4 7. Such deterioration of financial positions during the period was a common feature of listed companies. .9 7. and maintenance of the existing ownership structure. thus rendering them more vulnerable.15. and rights issues.260 Corporate Governance and Finance in East Asia.1 144.3 31. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. The ratio of total debt to total assets increased from 50.0 28.1 16.7 5.14 Financial Ratios of All Listed Firms.7 34.8 percent in 1990 to 52.2 49.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. Public companies relied more on short-term debt financing in the period before the financial crisis. however.2 35. More important. the choice of financing is determined by the company’s liquidity considerations. especially from 1994 to 1996. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. followed by bank loans. Generally.4 51.7 12.6 7.1 52. Table 4.
The proportion of external debt as a percentage of GDP consequently increased from 42.5. peaking in 1994 at 84 percent.1 High 6. Their average annual growth rate declined from 28.2 49.8 49.8 percent in 1986 to 52 percent in 1995.5 percent between 1985 and 1990 to 8. and a preponderance of short-term debt liabilities.8 14.15 Financial Ratios of Listed Companies by Ownership Concentration. on the other hand.4 13. Nonbank private debt increased from 27. US.2 percent in 1986 to 251. continued to slide from 1985 to 1997. unhedged foreign exchange liabilities.4 percent to 46 percent during the same period.7 percent from 1991 to 1996. however.6 30.16).3 42. This decline was accompanied.5 percent of external debt in 1996 (Table 4. The proportion of nondebt-creating capital flows.5 4.8 29. 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 6.9 percent in 1997.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. The composition and term-structure of this debt.0 64. is even more telling. debt-creating capital inflows rose to 65 percent in 1990.1 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. Additionally.4 27. the proportion of short-term debt increased from 15.5 148. .8 Medium 7. 4.Chapter 4: Thailand 261 Table 4.4 52. private debt accounted for 84. From only 34 percent in 1986.4 63.8 66. 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.2 124. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.5 126. such as direct equity and portfolio investment. From 45 percent of total net capital movements in 1985.6 11.5 34.8 28.
8 3.7 2.Table 4.16 External Debt.4 2.3 105. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.9 35.3 7.1 23.0 8.2 0.3 0.0 11.5 16.2 2.3 10.7 20.5 19.9 3.6 1.2 10.2 32.3 0.8 10.4 18.0 0.3 3.1 30.6 52.1 0.5 4.9 31.1 22.9 7.2 0.9 10.3 0.0 13.2 2.4 — — — — — — — 1.9 6.7 24.7 13.3 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.9 5.1 34.4 10.2 15.1 95.0 11.9 100.5 14.9 43.2 14.5 4.3 0.6 — 0.8 0.2 0.0 6.9 1.7 23.1 64.3 20.6 7.6 18.7 109.7 0.3 16.9 4.3 37. .8 12.8 31.9 6.3 — — — — — — — 6.5 12.5 12.3 12.5 1.3 0.1 0.1 0.1 2.8 13.9 0.8 3.9 29.9 10.9 13.9 11.9 3.4 15.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.9 1.0 21.1 12.3 2.4 3.0 4.4 5.3 3.1 5.3 0.8 108.1 0.7 1.7 10.0 3.3 0.6 Total 18.1 Source: Bank of Thailand.2 2.
and poor business confidence on the other. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. trading activity at SET had been on the downturn.281 in December 1995 and to 831. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. After that. reaching 45 percent of total outstanding credit in December. according to the Bank of Thailand. outstanding credit also declined throughout the second half of 1998. Similarly. the index declined to 1. based on the three-month past due definition. from its peak in 1995. . nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. On average. At the end of 1994. Even before the crisis. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. the number of newly registered companies dropped to a 10-year low in 1998. Aside from the problem of NPLs. banks would be recording more of such NPLs. With easy access to foreign funds. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998.17). If lending rates remained high. exposing the companies to disaster when the baht started tumbling on 2 July 1997. Meanwhile. Most of these foreign debts were not properly hedged. the liquidity problems faced by the corporate sector are likely to continue for some time.6 billion from the 1996 level of B201 billion. The effects of the crisis were felt across all industry sectors.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure.6 in December 1996. and drastic decline in the number and capital of newly registered companies. The ADB survey conducted for this study confirms this: 35 of the 46 respondents indicated that they took out foreign-denominated loans mostly from foreign banks. Due in part to liquidity problems on the one hand. and (iii) bankruptcies. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings.360. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. Foreign investors retreated from the market. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. leaving domestic investors with large capital losses. closures. the SET Index stood at 1. Trading volume has since been thin. It hit a 10-year low in the second quarter of 1998. suggesting that serious investors have not returned to the market. The value of public offerings sank in 1997 to B56.
105 4. But when assistance from other sources did not materialize.264 Corporate Governance and Finance in East Asia.2 billion for balance of payments support and buildup of the country’s reserves.409 6.095 14.695 3.792 7. 4. A steady price decline over the past few years has dragged down the ratio of market price to book value.410 37.677 Bankrupted/Closed 2. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.112 9.904 20.407 28. As part of the assistance package.2 Responses to the Crisis Initially.080 9.915 37.218 3.134 31.925 12. Ministry of Commerce.6 in 1997. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.797 4.052 36.933 25.410 5. The IMF financial package was a credit facility of $17.224 4.307 4. II Table 4. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. It also explains the higher dividend yield ratio. Vol. The price-to-earnings (P/E) ratio deteriorated from 19.066 19.201 24. Thailand.096 22. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.17 Number of Newly Registered and Bankrupted/Closed Companies. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.288 35.334 4.902 3.312 25.5 at the end of 1994 to 12 in 1996 and further to 6.777 11. the Government was left with no choice. .5.977 Source: Department of Commercial Registration.
IMF relaxed these key conditions. Under the old bankruptcy laws. increase profitability. secured creditors had to obtain the court’s approval before starting proceedings . The assets of the other companies were liquidated by auctions. and if necessary. For example. follow through with a civil or bankruptcy suit. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. loan provisioning. creditors seldom succeeded in obtaining payment against bankrupt borrowers. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. only two companies emerged intact from the suspension. There were many options for solving debt repayment problems. The Bank of Thailand also improved banking standards. Strict loan classifications. Regulatory Response by the Government The IMF program. Many believed that the process was inefficient. In early 1998. drawn up with World Bank and ADB assistance. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. it was widely interpreted as “having debts more than assets. and worked on revisions to the Secured Transaction Law. however. While no definition for “insolvency” could be found in the bankruptcy law. and did not recognize debtor-initiated bankruptcy declarations. also aimed at institutionalizing legal and regulatory reforms. debtors could drag out the process for many years. and Credit Foncier Businesses. The old law allowed only creditors to file bankruptcy suits. and income recognition were implemented. and restore solvency. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. By invoking procedural loopholes. These include repeal of the Commercial Bank Act. and the Act Regulating the Finance. Securities. Creditors could negotiate to reschedule debt repayments.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. As it turned out. the Civil and Commercial Code. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement.
Under the old Bankruptcy Act. In 1999. II for the recovery of debt through the realization of any collateral.266 Corporate Governance and Finance in East Asia. Enforcement of the new law is bound to be ponderous and lengthy. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. which means that a debtor could continue in business while the reorganization program was being implemented. To make matters worse for creditors. In Thailand. Chapter 11 is the main tool in restructuring bankrupted companies in the US. and (iv) the debts shall have been settled within a five-year period. the main purpose of which is to assist in the rehabilitation process so that a company can repay its debt and still retain its assets while remaining in business. and expensive process. The model for Thailand’s amended bankruptcy law was the US Chapter 11. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. The amended law also introduced the concept of automatic stay. The amendment added reorganization provisions to the Bankruptcy Act of 1940. Companies need . the amended law limits the rights of secured creditors. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. thereby allowing court-supervised corporate restructuring. The reorganization process is successful if (i) the debts shall have been discharged. In effect. time consuming. the company shall be declared bankrupt and liquidation of assets shall follow. For one. The original Bankruptcy Act dealt only with liquidation and composition. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. 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. If the process fails to revive the business. Vol. 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 judges and court officers have yet to learn and master the new bankruptcy procedure. The amended legislation also includes voluntary bankruptcy as a new feature. it covers only the court-supervised reorganization of distressed companies. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. but it is a complicated. There are other potential problems. (ii) management of the company reverts to the borrower. But more important.
minority shareholders’ rights are not adequately protected. Under the new law. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. 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.g. namely “liabilities exceed assets. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. questions have been raised regarding the appropriateness of the 1992 Act. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit.” The Foreclosure Act Amendment was likewise passed in 2000. SEC also examined the possibility of an amendment to the Public Company Act of 1992. after determining the legitimacy of the request. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. 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. shall have the power to call the extraordinary general meeting. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. The result. Without the necessary corporate restructuring. In case the board of directors does not comply. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. Consequently. and (ii) processing of default cases within four to six months of filing of a court claim. however. the court.” as opposed to the more appropriate criterion of “ability to pay when the debt falls due.. the test for insolvency still uses the balance sheet criterion. only tangible assets were the norm. has not been satisfactory. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting.Chapter 4: Thailand 267 to solve the problems (e. Still pending Parliament approval is the amendment to the Secured Transaction Law. In the past. . The amendment also remedies the slow process of executing or disposing of assets in a public auction. 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. Most important. Replacing the Public Limited Company Act of 1978. corporate governance) that caused the bankruptcy in the first place.
But because this is the assumption embedded in the regulation. The proposal for the amendment of the Public . But as demonstrated. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. The regulators are drafting a proposal to amend the provisions on related transactions. this is not so in publicly traded companies in Thailand.268 Corporate Governance and Finance in East Asia. with the approval of the board. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. Otherwise. the controlling shareholders have the exclusive domain to appoint or exercise management. and determine voting results on virtually any matter. in turn. The proposal clearly delineates duties of care and loyalty for directors of public companies. Consequently. who are also the managers. This may be true in countries where publicly traded companies are widely held. disrupts the company’s management and decision making. 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. Vol. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. 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. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. the main problem is overlooked. it permits directors. Directors enjoy unusual protection under the 1992 Act in that they can be pardoned by shareholders in the annual general shareholders’ meeting for any violation of fiduciary duties. without cumulative voting. which. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. However. In the absence of such a stock market boom now.e. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. i. subject only to approval by the board of directors. Most companies decide against cumulative voting. minority shareholders have no chance of being represented in the board.. the dominance of controlling shareholders. In addition. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. Because of high ownership concentration. vis-a-vis the minority shareholders. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. they face the prospect of being unable to compete for the scarce funds available in the equities market. Where equity will come forward. claiming that it creates fragmentation in the board of directors.
Some 82 percent of these cases have been successfully restructured. In addition. Cases for which negotiations were unsuccessful.147 cases (B1. accounting for B1. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. where bankruptcy procedures are swift and effective.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.1 trillion of outstanding credit. the court had more than 80 cases for disposition. methods. 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.068 cases involving B475 billion are undergoing restructuring.8 trillion had been completed. accounting for B1. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court.1 trillion in outstanding credit. and procedures for debt restructuring. the number of cases has abated. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. In response. However. Considerable progress has been achieved on this front.767 cases involving outstanding credit of B2. with the majority of the debtors coming from the commerce. although since then. contributing to the unprecedented rise in the corporate sector’s bad debt. As of November 2000. In particular. CDRAC’s target debtors comprised 10. 322. Within three months. only 7. Another 77. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. will be settled by the courts. The first bankruptcy court in Thailand opened on 18 June 1999. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. and manufacturing sectors. personal consumption. By October 2000. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. This point is crucial because compared with . Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. Commercial banks initiated 74 percent of these cases. the Government introduced debt restructuring-related measures to help resolve bad debts.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. as well as those that did not cooperate with CDRAC’s restructuring process.6 trillion.764 debt restructuring cases involving B1.
Financial information from listed companies will also soon be required to conform to International Accounting Standards. to push companies to harmonize their accounting with international standards.1 Summary. 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. It required listed companies to establish their own audit committees by the end of 1999. Such improvements in disclosure standards are part of the efforts of SET and SEC. Philippines. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. Conclusions.6. the Thai Government managed its economy with the corporate sector as the main engine of growth and development.270 Corporate Governance and Finance in East Asia. The . The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. despite the weakness of their disciplinary powers. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. the Government protected certain corporate sectors through tariffs and regulation. 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 1966.6 4. and promoted key industries through incentives. In the next three decades. 4. behavior. and performance during this period helps understand the causes of the crisis. 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. For this reason. and even Indonesia. The study covers the period 1985 to 1996. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. II Malaysia. Vol. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. Examination of corporate ownership.
Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. the Public Company Act of 1992 and the SEA of 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 impact of the crisis was felt across all industries. In 1995 and 1996. On average. After 1992. At the onset of the 1997 financial crisis. the top five largest shareholders hold about 56 percent of total outstanding shares. The SEA of 1992 also marked the beginning of an active bond market in Thailand. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. The number of newly registered companies in 1997 dropped by almost 10. Meanwhile. In 1992. the overall corporate sector was seriously affected. the overall pattern of ownership concentration seems to have been stable for the past 10 years. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. the number and value of public offerings of securities accelerated. there was a marked increase in the number of public corporations. One of the major findings is the high ownership concentration among Thai companies listed on SET. reaching its peak in 1996. During 1992-1997. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. Although there are some variations across industries.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. Subsequently. foreign debt in the Thai corporate sector increased continuously. the corporate sector entered a new era with the enactment of two major pieces of legislation. even after the development of capital markets. Although there was a decline in short-term foreign debt. Minority shareholders. The study examined the impact of ownership structure on corporate governance and financing patterns. at a time when most of them were already experiencing declining profits and high leverage. . the numbers of bankruptcy cases and company closures reached alltime highs. Because most of these debts were not hedged. Consequently. the profitability of publicly listed companies abruptly declined and their financial leverage increased. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999.000 from the previous year’s level. At the same time. Nonbank private corporations accounted for most of the increase. the increase in long-term debt more than compensated for the drop. Thai companies were vulnerable to exchange rate risks. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector.
II although larger in number. hold only a small portion of total outstanding shares. averaging 46 percent. Consequently. foreign and domestic.272 Corporate Governance and Finance in East Asia. protect the interests of all shareholders of public companies. Nominally. With financial institutions playing limited roles in the capital market. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. they have little influence over management decision making and control. Vol. The investing public holds the rest of the outstanding shares. In the past. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. All these. contribute to the lack of external controls on the corporate sector through the capital markets. Recently. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. Among the five largest shareholders of Thai companies listed on SET. Financial institutions hold a very small proportion. the Public Company Act of 1992 and the SEA of 1992. The key laws. the mutual fund industry has entered the picture but with limited roles and activities. there is a clear lack of outside monitors for these publicly listed but family-controlled companies. The highly concentrated ownership structure weakens the protection of minority shareholder rights. Institutional investors in Thailand. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. the existing legal and regulatory framework suggests otherwise. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. along with a highly concentrated ownership structure. It remains to be seen how reforms in bankruptcy procedures—including the increased threat of creditor control—could shift the incentives of controlling shareholders toward greater acceptance of equity finance and its consequent accession of control to new shareholders. the government pension fund was the only major institutional investor. Thus. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. through the use of holding and affiliated companies. The rules in both Acts governing . These laws stipulate rules and regulations concerning the activities of all public companies. Individuals and insiders hold the second largest proportion at about 19 percent. are not active. The absence of external market controls on the management of publicly listed corporations is dangerous. The implications of ownership structures that are concentrated to such a high degree are serious.
For example. posed formidable barriers in the minority shareholders’ exercise of their rights. The third issue involves creating external market controls through better regulation and development of the capital markets. Ownership concentration appears to have little impact on corporate profit performance. Specifically. because there is no separation between ownership and management. . these companies tend to become overleveraged. the degree of ownership concentration has a statistically significant positive relationship to the degree of financial leverage. Certain provisions. Consequently. the main challenge is not how the board can control management to maximize shareholder value. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. For instance. The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards. making them vulnerable to economic shocks. In this third area.6. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. The ownership structure of Thai listed companies also significantly affects company behavior. moreover. However. key reforms that will strengthen the regulation of financial institutions. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. In view of this. an aim that can be achieved mostly through legal reforms. because there are shared interests between the controlling shareholders and key management personnel. The second issue involves the protection of shareholder rights. Rather. 4. the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. but is significantly related to financing patterns. before the crisis.
and after the enactment of the SEA in 1992. SET was mandated to supervise listed companies. In this setting. with control delegated to professional managers. SET. Under the current system. It is important that the roles and responsibilities of each agency are clearly defined to the public. II encourage market competition. the Ministry of Commerce had the sole supervisory responsibility. Only then will these agencies be able to act promptly and effectively. If the principal shareholder is in fact chair of the board. voting only on major decisions. The owners of a firm rely on a board of directors to supervise the managers. the supervisory agencies also need to be empowered to enforce the laws. In reality. SEC was established as another supervisory agency. There is also supposed to be separation of ownership and control. three major government organizations (the Ministry of Commerce. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. and increase the participation of institutional investors are imperative. . the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. If this were the situation. The best approach may entail establishing a single. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. Once the roles and responsibilities are clearly defined. the supervisory system is fragmented and not as effective as it should be. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. Consequently. this is a problem in Thailand.274 Corporate Governance and Finance in East Asia. Vol. activate the market for corporate control. and SEC) are involved in corporate supervision. he/she often has the decisive vote. in most of Thailand’s publicly traded firms. This is due to the historical development of the Thai corporate sector: before 1975. in 1975. As in other crisis economies in the region. The board therefore plays a pivotal role. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders.
The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. To ensure a level playing field. regulators must increase transparency and step up enforcement. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. 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. SEC has been trying to lay the foundations of good corporate governance by espousing fairness.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. increasing penalties for directors engaged in misconduct. This move is expected to be unpopular among founding family members and original owners. SEC is exploring the possibility of amending the law toward this direction. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. 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. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. Through an amendment in the Public Company Act. the Government can change the shareholding limit for controlling shareholders. there has been much progress in this area. and . requiring cumulative voting for the election of directors. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. they should be monitored and regulated. The situation prompts two specific recommendations. The second recommendation is to dilute ownership concentration through the use of regulatory power. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. accountability. and a prohibition of connected transactions by directors or management. The slow improvement in the legal framework has likewise obstructed progress in this area. Since the Asian financial crisis. Because these holding companies control a number of large public companies in Thailand. transparency.
especially in the area of connected lending. Without a strong and efficient capital market. Vol. Accounting standards have also been under review. while a strong domestic debt market will also offer protection from foreign exchange risk. aimed at ensuring that banks finance only creditworthy projects. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. A well-developed domestic debt market will provide corporations with an alternative to bank financing. In an environment of highly concentrated ownership. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. The same goes for improvements in the bankruptcy system. which. the power of the capital market to discipline inefficient management is almost nonexistent. II responsibility among companies. This may not be possible without reforms in the banking sector itself. . there is a need to increase market disciplinary power through market competition. for instance. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. However. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. Further. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. Capital Market Development and Regulation Another important issue concerns the development of capital markets. In the stock market. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. 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. it will be difficult to improve corporate governance in Thailand. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. in turn. will lead to the emergence of a reference yield curve. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments.276 Corporate Governance and Finance in East Asia. The first step is to establish an active secondary Government bond market.
. The Stock Market in Thailand. Thailand. The Stock Exchange of Thailand. 1995-1999. US. Thai Accounting Standards. Bank of Thailand. PACAP-Thailand Database. Fact Book. The University of Rhode Island. Key Capital Market Statistics.Chapter 4: Thailand 277 References Annual Report. 1997-1999. The Stock Exchange of Thailand. The Thai Bond Dealing Centre. 1997. Bond Market Development in Thailand. Department of Commercial Registration Database. Bank of Thailand Monthly Bulletin. 1995. The Securities and Exchange Commission of Thailand. The Securities and Exchange Commission of Thailand. The Stock Exchange of Thailand. Bank of Thailand Quarterly Bulletin. 1995-1999. Ministry of Commerce. Bank of Thailand. 1995-1999. 1998. Kingston. 1997. Pacific-Basin Capital Markets Research Center.
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