Corporate Governance and Finance in East Asia

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

Country Studies

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

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


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

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

53 53 55 55 60 62 65

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

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

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

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

1992-1997 Table 1. Indonesia Table 1.8 OwnershipConcentrationofPubliclyListedCompanies. 1996-1999 Table 1.18 GDP Growth by Sector.5 Financial Performance of Publicly Listed Companies by Sector. 1992-1995 Table 1. 1990-1997 Table 1. 1985-1998 6 7 9 11 12 14 14 18 19 21 26 27 28 32 33 34 36 39 40 41 41 54 56 61 63 .1 Listed Firms with Positive Economic V alueAdded.12 CharacteristicsoftheBoardofDirectors Table 1. 1988-1996 Table 1. 1992-1999 Table 1.4 Development of the Stock Market.20 ROE of the Banking Sector.7 Growth Performance of the Top 300 Conglomerates. 1996-1998 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed List of Tables 1.11 CharacteristicsoftheBoardofCommissioners Table 1.1 Growth of the Banking Sector. 1986-1996 Table 1. 1992-1997 Table 1.19 DER and ROE of Publicly Listed Companies by Sector.6 GrowthandFinancialPerformanceofState-Owned Companies.14 Banking Sector Outstanding Loans.4 Growth Performance of Publicly Listed Companies by Sector. 1992-1998 Table 2.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1993-1997 Table 1. 1992-1997 Table 1.17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1992-1999 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization.21 Nonperforming Loans by Type of Bank.10 Anatomy of the Top 300 Indonesian Conglomerates.13 Presence of Board Committees in Listed Companies Table 1. 1996-1998 2. 1990-1998 Table 1. 1997 Table 1. 1992-1997 Table 1. Republic of Korea Table 2.3 Subsidiaries of the 30 Largest Chaebols Table 2.16 FinancingPatternsofPubliclyListedNonfinancial Companies.2 Foreign Capital Flows.2 KeyMacroeconomicIndicators Table 2. 1993-1999 Table 1.

1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1995-1997 Ownership Composition of Listed Companies.15 Table 2.11 Table 2.13 Table 2.vii Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.19 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector. 1999 InternalShareholdingsofthe30Largest Chaebols. 1997 Ownership Composition of Listed Firms in Selected Countries.27 Table 2.28 Table 2.26 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.23 Table 2. 1997 Ownership Concentration ofAll Listed Firms.5 Table 2.29 Table 2.9 Table 2.25 Table 2.6 Table 2.16 Table 2.24 Table 2.14 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.30 Private Capital Flows to Korea.22 Table 2.10 Table 2.20 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.7 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.17 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 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 . 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.8 Table 2.12 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.18 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.21 Table 2.

Thailand Table 4. 1995-1998 4.11 TotalandPerCompanySales. 1983-1997 Table 3. andAffiliated Banks of Selected Business Groups.17 Composition ofAssets and Financing of the Publicly Listed Sector.15 Financing Patterns of the Corporate Sector.20 Financing Patterns by Industry. 1988-1997 Table 3. 1990-1998 131 137 138 158 159 160 161 163 164 166 173 175 176 180 184 191 201 203 204 205 206 207 208 209 212 235 236 3. 1985-1997 Number of Firms with Dishonored Checks.12 Control Structure of the Top 50 Corporate Entities.14 Philippine Stock Market Performance. 1988-1997 Table 3.000 Companies.1 GDP Growth of SoutheastAsian Countries. 1992-1999 . 1990-1999 Table 3. 1997 Table 3. The Philippines Table 3.18 Financing Patterns by Control Structure. 1992-1996 Table 3.32 Table 2.Profitability andFinancial . 1989-1997 Table 3.1 Public Companies Registered.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. Flagship Company. 1997 Table 3. 1978-2000 Table 4. 1988-1997 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1989-1997 Table 3.19 Financing Patterns by Firm Size.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1997 Table 3. 1988-1997 Table 3.viii Table 2.16 CorporateFinancing PatternsbyOwnershipType. 1997 Table 3.21 OwnershipConcentration.SectorOrientation.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.1989-1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct.31 Table 2. 1988-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.33 Net Profit Margins of Chaebols.2 Public Offerings of Securities. Leverage Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3.2 Growth and Financial Performance of the Top 1. 1986-1998 Nonperforming Loans of General Banks.8 Ownership Composition of Philippine Publicly Listed Companies by Sector.22 Foreign Investment Flows. 1997 Table 3. 1989-1997 Table 3. 1989-1997 Table 3.

9 Table 4. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1.7 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1993-1999 Key Financial Ratios of Publicly Listed Companies.14 Table 4.15 Table 4.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 .1 Figure 3.8 Table 4.13 Table 4.5 Table 4. 1985-1996 Average Key Financial Ratios by Company Size. 1993-1999 Size and Composition of the Thai Financial Sector.17 StatisticalHighlightsoftheStockExchangeofThailand. Ownership Concentration.6 Table 4.4 Table 4.3 Table 4.11 Table 4.2 Figure 3. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability. 1992-1999 Common-Size Statements for Companies Listed in SET.16 Table 4.1 Figure 1. 1992-1999 Offerings of Debt Securities. 1990-1996 External Debt.ix Table 4.12 Table 4.10 Table 4. 1990-1998 Merger and Acquisition Activities. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration. 1990-1996 Financial Ratios of All Listed Firms. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies. Leverage. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.


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

Arvind Panagariya ChiefEconomist


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


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

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

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

1 Indonesia
Saud Husnan1



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

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

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

2 1.5 examines the corporate sector during the financial crisis in terms of its role. a gradual shift in public investment away from manufacturing took place. It also examines the statistical relationship between corporate performance and corporate governance characteristics. and its response. substantial volumes of private investment entered the scene.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. In the early 1970s.4 analyzes corporate financing patterns. and tobacco industries. how it was affected by the crisis.2.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Not all items in the questionnaires were answered by the respondents. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. 1. in the course of the fight for nationhood from 1942 to 1950. . The industries that emerged were highly import-dependent and reliant on tariff protection. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. Subsequently. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. Despite the oil revenues. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.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. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI).and large-scale companies were dominated by state-run industrial concerns. Section 1. Section 1. Up until the mid-1960s. while Chinese and indigenous entrepreneurs ran some large businesses in trading. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. However. textiles.2 Section 1. medium.

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

The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. Table 1. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. Through the years. began to face competition. The dominance of state banks started to erode.5 trillion. During this period. the capital market played an increasing role in raising long-term funds needed by the corporate sector. six SOCs had issued equities in the market. These included the opening of the banking industry to new entrants. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). 1. the banking sector has undergone many reforms. the number of private domestic banks increased. private domestic banks dominated the sector in terms of number and total assets. Interest rate regulations on state banks and credit ceilings in general were removed. The Government also allowed foreign investors to buy up to 49 percent of listed shares. But in terms of assets per bank. which up to then was channeling oil revenues to priority sectors. Thus. Further reforms along the same direction and affecting state-controlled banks came in the 1990s.3 The Banking Sector Despite the development of the stock market. from 24 in 1988 to more than 300 in 1997.1 shows that from 1994 to 1998. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement.2. to date. and increased access of domestic banks to international financial markets. Since 1977. with a total value of Rp16. state-owned banks were still among the biggest. However. However. Conglomerates carried out 210 out of 257 IPOs. the banking sector has been and still is the major source of credit for the corporate sector. reduced restrictions on foreign exchange transactions. However. In 1988. Consequently. more significant reforms were introduced. companies could no longer enjoy low-interest credit from state banks. which were previously constrained to 4 percent per day. The banking sector. the controlling shareholder of these SOCs is still the State. Partly as a result of these reforms. The initial banking sector reform was introduced in 1983. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. with a total value of more than Rp8 trillion.Chapter 1: Indonesia 5 At the end of 1988. . the number of listed companies in the stock exchange increased substantially.

6 Corporate Governance and Finance in East Asia.5 27 66. 1993 100.4 10 35.9 762. Bank Danamon (ranked 7th). while BUN has been closed down by the Government. Vol. The other banks among the top 10 were state banks.3 10 17. 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. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).3 201.5 528.7 351.8 31 10. II Table 1.4 34 12.8 10 19.9 291.6 34 14.8 29 6.8 27 200.9 304.9 248.6 7 7.5 7 9. Among private domestic banks.5 27 88.8 166 248. In terms of assets. Because regulation was weak.1 240 1995 122.9 10 11.2 161 214.0 234 1994 104. Bank Danamon.6 164 144 130 92 387. 1993-1999 Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks Source: Bank Indonesia.8 27 147.4 789.7 27 37.3 27 51.5 7 7 7 5 15.1 Growth of the Banking Sector. the 10 largest were all affiliated with major business groups.2 10 14.8 391. BCA. .4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.3 30 7.9 27 113. 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. Both BCA and BUN have shareholders linked to the former President Suharto.5 165 308. But the banking system proved incapable of performing its intermediation function.8 10 37. banks could earn profits even when they did not gather and process information about risk. and Bank International Indonesia (ranked 9th). Of these.9 39 18.1 10 47.6 7 12.9 31 9.

Until the onset of the crisis.00 2. Net FDI flows increased to $5.2.81 3.11 3. except in certain strategic sectors. there was a phenomenal growth in direct borrowings by Indonesian corporations. Increasingly. when the financial crisis hit Indonesia. they still amounted to a large sum for the economy to absorb.87 7. Source: IFS CD-ROM. the Government allowed foreign investors to own 100 percent of an Indonesian company.40) (0. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.78 2.59 4. November 2000.59 billion in 1996.01) (0.48 1. Table 1.15) — = not available. especially through bank loans. In the 1990s. such as metal goods. Indonesia received capital inflows averaging about 4 percent of GDP.63) (1. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).2.88 4.10 5. foreign creditors were eager to provide financing to Indonesia.74 5. initially from Japan and the Republic of Korea. . In 1994.09) 1.33 (13. Successive policy deregulation facilitated FDIs in various light manufacturing industries.88) — — — — — — 8. 1. there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. Most FDIs came in through joint ventures with business groups having strong political connections.01 (2. In effect. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. and footwear.09) (0. FDI flows were strong. September 2000.2 Foreign Capital Flows. IMF.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. But FDIs were only one form of foreign capital inflows to Indonesia.50 (0.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs). textiles. From the mid-1980s until July 1997. Between 1990 and 1996.09 1. foreign investment also had a strong presence in the services and infrastructure sectors. as shown in Table 1.

This is lower than the average borrowing rate of 18 percent for loans in domestic currency. Domestic corporate debt was about $50 billion equivalent. the average foreign ownership of listed companies was 21 percent. From 1987 to 1996. but declined to an average of 25 percent during 19951997. with the onset of the Asian crisis. state-owned companies (SOCs). total corporate debt reached nearly $118 billion. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 devaluation under the managed floating system. 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. 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. increasing the total trading value from Rp8 trillion in 1992 to Rp120. Vol. plus 4 percent for the depreciation of the rupiah. foreign banks became a significant source of financing for the corporate sector. and conglomerates. The Government relaxed this restriction in 1988. The external corporate debt owed to foreign commercial banks was $67 billion. In the 1990s. participation in the Indonesian stock market was exclusive to domestic investors. This increased to 30 percent by the end of 1993. Private borrowers preferred foreign loans since these were relatively cheaper.8 Corporate Governance and Finance in East Asia. especially the short-term ones. of which two thirds were rupiah-denominated.4 trillion in 1997. Due to data constraints.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 analysis focuses only on publicly listed companies. II Up until the late 1980s.2. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. foreign investors began to dominate daily trading. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. In November 1998. In September 1997. The following section looks at the growth and financial performance of the corporate sector. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. 1. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. By the end of 1997. . Consequently. the average borrowing rate for dollar loans was 9 percent. Between 1989 and 1992.

6 24.5 240. total sales of listed companies grew at an annual average rate of 31 percent.6 3. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines. In 1997.7 percent in 1997.3 3.6 percent in 1997. but dropped to 1.6 1994 50. Asset turnover was above 30 percent until 1996.0 10. but fell to 24.0 12. averaging 3. 1995. publicly listed companies as a group contributed less than 10 percent to GDP. 248 firms. Despite such rapid growth. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. 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. 250 firms.4 percent.4 1996 18. there were 204 firms.8 220.6 48. b Asset turnover is defined as sales over assets.1 4.4 1993 45.0 6.0 64.1 220.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.7 — 250.3 Growth and Financial Performance of Publicly Listed Companies.0 3.5 3.8 230. 226 firms. During 1992-1997.2 7. Table 1.8 percent between 1992 and 1996.7 3.2 30. 174 firms. Source: JSX Monthly (several publications). 246 firms. but turned negative in 1997. Return on assets (ROA) was also relatively stable during 1992-1996.0 12. but declined to 0.3 6.7 — = not available.2 1995 37. while total assets grew at 43 percent. Average return on equity (ROE) of listed firms was 11.0 11.4 1997 7. The growth of listed companies was sustained by continuing investments.4 31. When the crisis battered Indonesia in 1997. the average DER increased to 310 percent from 230 percent the .1 percent in 1997 when the crisis began to buffet Indonesia.5 34. although the contribution increased over time.5 34. and 1992.9 310. a Value added was assumed to be 30 percent of total sales.0 33.0 12.9 37.4 38.0 1. ranging from 220 to 250 percent between 1992 and 1996. 1996.8 6.3 shows the growth and financial performance of Indonesian publicly listed companies. 1993.5 37.1 0. 1994. Note: The number of firms is not identical for each year.

II previous year.7 percent during 1992-1996. real estate. with ROE falling to -11. followed by agriculture (Table 1. The finance sector’s contribution to GDP. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. miscellaneous industry. helped in part by the relatively strong demand for consumer goods. averaging 21. When interest rates increased. Meanwhile.3 percent between 1992 and 1996. averaging 17. In terms of sales and asset levels in 1997. finance.4). ROA of all sectors dropped in 1997. due mainly to the domination of the International Nickel Company of Canada. the mining sector ranked first. when the property sector was booming during 1993-1997. the mining sector had the lowest DER. consumer goods. During those years. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. In terms of share of value added to GDP. mining. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. From 1995. basic industry and chemicals. miscellaneous industry. This sector was less affected by the crisis. The consumer goods sector ranked second in terms of ROE.5 presents the financial performance of listed companies by sector. real estate. However. For instance. investment. the property sector was severely affected by the crisis. and trade. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. trade. only two sectors (mining and finance) showed a consistently increasing trend from 1992. and property. and services. the mining sector had the highest ROE. in terms of growth of sales and assets. Before the crisis. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity.73 percent in 1992 to 1. Four sectors (basic industry and chemicals.2 in 1997. property. Overall.10 Corporate Governance and Finance in East Asia. the companies in the sector did not operate with a high leverage. still posting a positive but lower ROE. although asset turnover was slow. property. The finance. which operated in nickel and copper mining in 1992 and 1993. and trade) even posted . the banks eagerly provided credit to property development companies. and services. But the sector’s ROE fluctuated a lot. The same applied to the trade sector. Also. Table 1. and building construction. ROE fell drastically because the sector had one of the highest DERs. increased from 0. infrastructure. indicating its reliance on equity to support growth. Vol. meanwhile. the dominant sector was the finance sector. investment.64 percent in 1997.

Source: JSX Monthly (several publications).7 1995 51.2 59.6 (0.3 0.7 62.7 (82.4 64.0 (28.4 44.1 1. Constn.7 34. and Bldg.7 24.5 45.1 32.3 0.8 32.1 (11. Infrastructure Finance Trade.8 24.0 64.3 17.1 (41.6 24.6 0. Industry Consumer Goods Industry Prop.4 77.4 1993 155.6 133.3 0.0 0.0 1996 1997 58.0) 46.6 1994 (75.0 31.5 (11.7 28.1 0.4 1.2 11.7 54.1 71.9 0..9 (7.5 13.0 0. Investment.2 41.7) (113.7 — 36.9 8.5 68.4 30.8 51.4 Growth Performance of Publicly Listed Companies by Sector.1 1.5 1.6 26.1 0.5 92.7 133.4 (149.1 0.6 (41. Constn.3 31.9 25.8 62.6 0. Real Estate.4 1.0 0.1 35.3) 39.9 53. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.8 28.1 0.2 5.5) 6.3 1.5 0.8) (12. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.5 28.9 59. and Bldg.4 1. Constn.6 135.9 36.6) 19.4 30. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.6 0.9 .3) 53.5 9.1 0.1 16.6 83.2 35..2) 0.4 103.6 85.5) 49.4 0.1 0.. Real Estate.9 64.1 1.4 38.0 22.0 18.7 0.1 67.9 54.5 95.0 68. Infrastructure Finance Trade. and Bldg.1 0.7 17. Real Estate.9 0.7) 17.3 (203.2 14.1 42.0 (192.7 40.6 15.. Industry Consumer Goods Industry Prop.0 24. Infrastructure Finance Trade. Industry Consumer Goods Industry Prop.5) 13.0 0.3 51.1 — 39.9 54.1 1.9 1.0 43.1 23. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.6) 119.5 0.2 0.8 1.7 0. Investment.5 23.7 21.5 (8.2 0.6) 25.7 43.0 16.7) 26.1 1.0 0.6 0.4) 8.8 27.6 22.2 41.8 66.4 43. Real Estate.6 51.3 92.0 (20.5 1.6 28.9 31.3 0.8 0. Constn.4 21.3 0.1 28.Table 1.8 50.1 0. Investment.8) 0. Industry Consumer Goods Industry Prop. and Bldg.0 0.3 31.4) 6.5 53.8 29.9 14.1 0.5 1.0 1.8 (76.7) (27. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.7 — — 11.4 170. Infrastructure Finance Trade.7 112.9 123.7 90.4 31.8 1.2 13.1 0.5 61.6 1.3 340. and Services — = not available. Investment.

Real Estate. Real Estate.1 10.0 39.7 61. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.1 3.0 700.4 4.1 4. and Bldg. Industry Consumer Goods Industry Prop.3 33.5 11.0 100.0 180.2 8.3 18.2 15.0 160.4 5.5 4.3 7. Investment.6 13.5 19.0 110. and Bldg.0 90.4 13.4 35.4 20.0 680.0 110.0 100.5 14.5 4.7 10.0 650.1 2.4 71.2 23.2 (4.0 630.9 17.0 11.3 17.7 8.0 140.6 (2.9 38.0 (0.6 8.9 40.7 4.0 1997 230.0 110. Industry Consumer Goods Industry Prop.2 30.0 210.3 38.1 1.5 5.6 8.4 17.9 14.6 18.7 12.1 89.7 (3.Table 1.9 7.5 17.7 10.8 8.0 86.0 120.. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.7 8.4 6.8 11.0 130.8 67.2 3.3) 5.0 120.0 80.1 (3.7 4.1 4.0 66.2 39.0 70.8 9.8 44.4 79.3 13.8) 8.1 1994 80.0 120. Infrastructure Finance Trade.1 8.0 50. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 70.1 10.0 3. Constn.7 13.0 60. Real Estate.7 10.0 80.2 1993 130.2 111.2 6.1 6.6 23.1 65.4) (1.6) 36.0 120.2) 7.0 100.5 13.0 560.1 9.0 150.0 14.7 46.1 9.7 1.7 5.6 14.9 29. Investment. Infrastructure Finance Trade.0 380.0 190.0 180.7 5.7 4.1 (5.9 87.1 13.0 150.0 650.0 8.0 70.2 11.0 160.4 6.1 11. Constn.7 12.5 Financial Performance of Publicly Listed Companies by Sector.9 42.0 3.6 13.6 74.7 71. Constn.4 1.0 9.2 3. 1992 20.8 168.8 20.0 8.6 (11.8 25. Infrastructure Finance Trade. and Bldg.4 13.3 17.8 5. Industry Consumer Goods Industry Prop.1 7. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.8 11.5 56.0) 7.0 100.0 15.4 .9 41.2 53.9 10.8 382.4 46.2) 15.3 64.8 81.3 7.7 12.9 4.0 12..4 46.0 110.3 5.0 170.7 26.3 73.0 160.0 110.0 220.8 479.0 150.0 80.6 19.3 1. Constn.0 110.5 7.2 13.2 7.7 1.1 4.6 1.0 180.0 17. and Bldg.1 10.0 190.6) 18.1 1996 100.2 7.4 35.0 46.5 1995 80.0 190.3 0..1 63. and Services Source: JSX Monthly (several publications).0 69.8 3.. Infrastructure Finance Trade.9 38.8 16.0 19. Investment.0 110. Real Estate. Industry Consumer Goods Industry Prop.0 140.5 43.7 9. Investment.

the Department of Finance supervised 30 SOCs. the subsidiaries and affiliates number 459 with total assets of Rp343. indicating SOCs’ declining contribution to GDP.3 percent in 1995. growth of net profits and assets was erratic.Chapter 1: Indonesia 13 negative ROA. Six SOCs were listed in the Jakarta Stock Exchange. averaging 24 and 31 percent. Asset turnover rates were lower relative to those of publicly listed companies. Just like private companies.1 percent in 1993.3 trillion. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. between 1993 and 1995. registering an average annual rate of 10 percent. State-Owned Companies At the end of 1995. much lower than that of companies listed in the stock exchange.1 percent in 1992 to 28. SOCs actively operated in various sectors4 under the supervision of “technical” departments. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. banks (seven companies). However. SOCs’ sales growth fluctuated during 1990-1996. increasing from 21. which collectively had the largest assets. This was due to large sales by the National Oil Company (Pertamina). Only the agriculture sector showed an increase in ROA in the couple of years before 1997. Similarly. By 1995.7 to 7 percent for publicly listed companies. respectively. The finance and miscellaneous industry. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). there were 165 state-owned companies (SOCs)3 in Indonesia. insurance (11 companies). and finance company (four companies). Trade had the highest ROA of 39.6). These growth rates were low compared to those for listed companies during the same period.6 to 8. SOCs diversified into many businesses.7 percent in 1990 to 6 percent in 1996. Assuming a fixed ratio of value added to sales. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. the ratio decreased from 8. ROA had been at high levels from 1992 to 1995. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. For instance. but dropped dramatically to 4. and basic industry and chemicals sectors had relatively stable ROA before the crisis. Taken together.8 percent between 1992 and 1995 (Table 1. .7 percent. The DER was slightly higher than for listed companies. there were 58 SOCs with subsidiaries and affiliates. SOCs’ ROE ranged from 6.4 percent the following year. This was relatively high compared to the 3.

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.1 12.0 17.4 7.1 6.4 13.7 13. Vol.7 Growth Performance of the Top 300 Conglomerates. a Value added was assumed to be 30 percent of total sales. II companies consistently declined over time.7 16.1 30.6 percent in 1994. Their total sales increased from Rp90.1) 5.0 8. Table 1.2 percent in 1997 (Table 1. a Value added was assumed to be 30 percent of total sales. 1992 — 7. Source: Indonesian Data Business Center. Assuming a constant ratio of value added to sales.4 13.7 1994 (9.4 16.8 21.6) 260.8 11.6 28.3 12.8 percent in 1990 to 13.7).1 310. SOCs’ asset turnover rates showed a downward trend from 32.6 1995 25.14 Corporate Governance and Finance in East Asia.766 business units.1 19.2 23.2 18. . In 1997.6 28.1 trillion in 1990 to Rp234 trillion in 1997.2 — 370. Table 1.5 3.0 24.8 12. Source: Indonesian Data Business Center. but dropped to 11.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.0 12. b Asset turnover is defined as sales over assets.2 — = not available. mostly private companies.0 7.5 percent in 1995.0 6.3 250.4 13.7 (2. the contribution of conglomerates to GDP increased from 12.4 percent in 1992 to 28.3 30.6 Growth and Financial Performance of State-Owned Companies.4 1993 16.0 28.4 percent in 1994. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.0 8. but climbed to 30.1 32. these conglomerates owned 9.

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

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

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

8.9 0.4 percent.8 68.6 4. On average. This is because a few companies in the transportation sector issued high proportions of shares to the public.1 13.1 0.0 0. Meanwhile.0 0. Vol.5 percent.5 12. Zebra Nusantara (taxi services).0 4.9 14. 13. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.2 11.9 percent of total outstanding shares.6 3. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). the controlling shareholders usually act as standby buyers.7 1996 48. respectively.7 3.0 2.5 1997 48.5 72. II Publicly Listed Companies Table 1. and 0. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48. for instance.3 1995 47. When a company makes a rights issue.5 Average 48.2 1. Table 1. 2. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.6 percent.2 67. Rig Tenders Indonesia (shipping services) issued 51.6.5 16. mining.6.0 67.6 13. When a company goes public.8 1. and basic industry and chemicals sectors than in others. the five largest shareholders owned 68.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. issued 93. consumer goods.9 2.18 Corporate Governance and Finance in East Asia.0 1.9 2.9 Source: The Indonesian Capital Market Directory.7 1994 48.6 3. the founder usually continues to own the majority of shares through a .1 4. The pattern of ownership concentration changed little over this period. The percentage owned by each of the five largest shareholders was 48. Table 1.6 68. 3.1 1.8 Ownership Concentration of Publicly Listed Companies.9.8 68.4 2. This preserves the pro rata share of existing shareholders.

1 1.6 percent of total market capitalization while the top 15 families control 61.1 1.7 percent of the market.5 4.4 1. (1999) also found. Constn.. In fact.6 9. In terms of capitalization.3 0.7 6. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.4 6. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.1 2.7 4.9 50.3 48. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.6 percent were widely held. Infrastructure.1 11. and Transportation Finance Trade.7 1. the rule of law.4 4. Industry Consumer Goods Industry Prop.1 1.1 0. and Services Average Source: The Indonesian Capital Market Directory.5 58. on the one hand.9 0.2 15.9 44.9 44.6 1. on the other.5 1. 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. (1999).1 1.2 46.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).7 13. that the correlation between the share of the largest 15 families in total market capitalization.3 0.1 13.4 44. Investment.3 36.2 2. the top family controls 16. which shows that in 1996. Table 1. and Bldg.1 2. two thirds (67.9 1.9 3. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.1 percent) of Indonesian publicly listed companies were in family hands.6 2.8 14. as well as the existence of corruption. Indonesia has the largest number of companies controlled by a single family. is strong.7 9.9 Ownership Concentration of Publicly Listed Companies by Sector.3 2.0 5.2 10.4 54. Real Estate. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. and the efficiency of the judicial system.1 2.2 This is confirmed in Claessens et al. in a cross-country study.6 0.1 0.2 0.. Claessens et al.4 11. Util.3 14. and only 0. and corruption. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .6 8.

But these benefits are few and often dubious compared to the high costs of concentration. and Padang. However. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. conglomerates established before 1969 dominated in terms of sales. resulting instead in a decline in the proportion of foreign investor ownership. Vol. Indian. The nonindigenous businesspeople are usually Chinese.42 percent in December. political affiliation. accounting for 64 percent of total conglomerate sales in 1988-1996. was able to create a favorable environment for business development. In Indonesia. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. their number increased to 5 In 1997.55 percent in August to 25.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. the onset of the crisis negated this development. with all its regulations. or other ethnic groups. Indigenous businesspeople include the Javanese. Among the top 300 conglomerates. In 1993. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Coordination is easier because informal communication channels exist. the proportion of foreign ownership declined from 27. numbering 162 in 1988 and 170 in 1996. but later declined and steadied at around 25 percent. 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. II the small number of families and the tight links between companies and the Government. From 193 in 1988. ethnicity. the legal system is less likely to evolve in a manner that protects minority shareholders. foreign ownership increased to 21 percent. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. 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.5 Conglomerates Table 1. most were established during the New Order Government. the Government allowed foreign investors to buy up to 100 percent of listed shares. Batak. it rose to 30 percent. During 1988-1996. In September 1997. However. and family origin. Sundanese.20 Corporate Governance and Finance in East Asia. .

Chapter 1: Indonesia 21 Table 1.4 32.0 58.5 120.4 16.8 28. its sales reached Rp1.3 20.7 64.6 34.4 68.7 89.4 69.8 12.1 58.0 15.8 Source: Indonesian Business Data Centre.1 33.2 30.2 23.7 28.4 59.4 37.3 120.1 percent of total .6 trillion in 1988 to Rp137.9 14.4 18.1 46. Their total sales also increased from Rp38.6 95.2 12.9 billion.9 13. While they supplied 20.6 114. more than five times its 1988 level. For instance.1 87.4 19.10 Anatomy of the Top 300 Indonesian Conglomerates.4 81.0 58.4 31.4 52.8 36. due to their “go public” activities.1 103.8 68. 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 59.9 trillion.0 116.4 48.9 73.4 31. Conglomeration Indonesia 1997.0 18.1 179.4 86.9 42.3 101. In 1996.2 159.7 49.9 77.7 106.5 106.4 trillion in 1996.1 25. 204 in 1996.6 17. sales of the Bakrie group before it went public in 1990 were only Rp369.3 134.6 54.5 22.3 43.0 28.8 38.0 31.9 137.4 15.7 95.7 24.2 48.2 33. the number of mixed groups declined from 86 in 1988 to 68 in 1996.3 80.8 30.9 47.3 36.1 42.1 41.0 44.8 49. Meanwhile.7 40.6 77.1 52.1 46.4 22.9 35.8 57.1 21.4 57.8 25.2 29.6 12.2 76.5 21.

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

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

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

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


Corporate Governance and Finance in East Asia, Vol. II

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

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

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

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

Chapter 1: Indonesia


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

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

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

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


Corporate Governance and Finance in East Asia, Vol. II

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

BOD 5 5 5 23 38

BOC 1 1 3 35 40

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

Chapter 1: Indonesia


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


Corporate Governance and Finance in East Asia, Vol. II


External Control

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

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

1992 1993 1994 1995 1996 1997 1998 1999 68. Private national banks and state-owned banks were the biggest domestic creditors.5 42.9 234.0 487.8 193.3 66. However.3 60.6 3. Vol. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates). 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.32 Corporate Governance and Finance in East Asia.6 292.2 6.4 24.6 4. From 34. Bank loans.6 6.4.6 48.7 112. .14 Banking Sector Outstanding Loans. Since then.5 108. companies considered alternatives to bank loans. and others offered by nonbank financial institutions or finance companies. equities became available to the corporate sector.2 71.5 7.4 1.0 3. when the Government reactivated the stock exchange.1 220.0 93.3 9.9 153.9 378.5 80. jointly providing almost 90 percent of loans until 1997. remain the major financing instrument for the corporate sector.0 6. bank credit surged from Rp122.0 168.7 50. this market was not well developed.3 14.2 27.9 150. including bonds. new instruments have been introduced to the corporate sector.4 trillion in 1998. II 1.7 18.2 5.6 150. however. the share of private national banks in outstanding total loans increased to 44.6 percent in 1997.14.7 122. Table 1.3 188.4 56. because of the restrictions discussed below.4 86. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. Data from Bank Indonesia show that from 1994 to 1997. stocks. private national banks overtook state banks as the dominant credit source.1 Equities In 1977.3 111. Bank Credit As shown in Table 1.4 percent in 1992.1 Corporate Financing Financial Market Instruments Prior to 1977.4 225.9 trillion in 1992 to Rp487.

0 70. They were not. In 1995.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares. In 1988.7 percent in 1997. and net open position). It gradually increased again starting in 1991.e.2 16.. credit cards. finance companies were increasingly used as channels for the inflow of foreign loans.1 1994 26. .6 859. the Government issued regulations to supervise and promote prudential practices in finance companies.6 123.1 17. 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 1996.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.1 18.0 206. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.Chapter 1: Indonesia 33 Some companies went public.4 207. During the 1990s. allowed to accept deposit accounts from the public.7 14.9 406.7 9. 1992 1993 11.8 48. Overall. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. when foreign investors were not yet allowed to purchase listed shares. capital adequacy ratio. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.15).5 1995 35. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.0 15. The ratio reached 8. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.9 1999 76. thus increasing the role of the capital market in raising long-term funds.6 91.4 1996 1997 1998 50.g.6 301. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. however. legal lending limit. shooting up to 18.1 10.15 Value of Stocks Issued and Stock Market Capitalization.5 333. i. factoring.7 15. and consumer credit.6 310. offering services such as leasing. Prior to 1995.. the stock market has gained a bigger role in corporate sector financing (Table 1. Table 1.

which are unsecured negotiable promissory notes with a maximum maturity of 270 days.8 17. This is in contrast to the lower share of borrowings during the same period. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. short-term borrowings were greater than long-term debts.2 26. In terms of composition.34 Corporate Governance and Finance in East Asia.5 21.3 16. Vol. 1996.4 23.5 (0.8 percent.9 16.6 8. averaging 26. respectively.16 Financing Patterns of Publicly Listed Nonfinancial Companies. Table 1.3 (0.0 1991-1996 16.0 39.0 1986-1996 17. at 81 percent of total borrowings. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).0 3. 1.6 100.0 100.1) 23.7 22.5 percent and 36. they were not rated by a rating agency.4. . In the second half of the 1980s.1) 23.5 11. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.3 37. PACAP Research Center. 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). otherwise it would be classified as a loss in the banks’ books. Thus in November 1995.4 13. II Commercial Papers Commercial papers.6 23.6 100. have been popular in Indonesia since 1990.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.6 12.0 — = not available.3 14.5 — 26.8 7.4 8.2 Patterns of Corporate Financing Table 1. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. While banks had some exposure to these instruments.

was due largely to a rapid rise in long-term debts. Most corporate charters require commissioners to approve debt issues or sign debt agreements. Corporate debts grew over time. 1. the corporate sector’s high leverage. Indofood registered losses of almost Rp1. while Semen Cibinong’s losses reached Rp2.9 trillion. which was masked by the rapid growth in investments. Two telecommunications companies.6 trillion and Rp1. Bank loans also surged when the banking sector was liberalized in 1988. corporate debts accounted for 39. the pattern changed. All companies in the cement industry suffered from foreign exchange losses.3 percent during 1991-1996.17 compares the DER of listed firms by degree of ownership concentration. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. except Semen Gresik (an SOC). reaching Rp229.3 Corporate Financing and Ownership Concentration It has been suggested. They also do not want to dilute corporate control and are more likely to finance growth with debt. that ownership concentration may be associated with heightened risk-taking by companies. . with longterm debts increasing rapidly.2 trillion (mostly foreign exchange losses). respectively. For instance. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market.4.1 trillion.4 trillion in 1993 to Rp112. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997.Chapter 1: Indonesia 35 In the 1990s. Indosat and Telekom. These liabilities grew significantly because corporate expansion was largely financed by debt. This amount doubled in 1997.9 trillion in 1996. Of the various financing sources. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. also suffered from foreign exchange losses but managed to post profits of Rp0. which managed to post significant profits due to low exposure to dollar-denominated loans. Table 1. 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. rising from Rp54.2 trillion. Hence. in the context of Indonesia and some other countries. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. The results indicate that firms with higher ownership concentration tend to have a higher DER. Many companies suffered big losses in 1997 due to their high exposure to dollar loans.

Source: Author’s estimates.0 1.0 386. Controlling parties rely on external financing to maintain their equity share and. Table 1. In addition. 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. Between 1987 and 1996. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. As a result. since commissioners represent the controlling party. and high ownership concentration among families with political affiliation. II However.5. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.5 1. The test of the difference between the two means found the t-value of 1.0 351.358. 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. 1. Vol.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. heavy reliance of companies on bank credits to finance investments. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.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. ultimately.36 Corporate Governance and Finance in East Asia. the borrowings swelled. aided .1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. decisions on debt are made with the implicit endorsement of owners. the private sector borrowed heavily in unhedged dollars. to maintain control of the company.56 significant at the 10 percent level.

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

banks did not lend on the basis of the soundness of the project. Vol. contracts were granted to the private sector. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. In many cases. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. and power generation) require huge capital. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families.5 billion was owed directly by corporations. In early 1998. politicians. Since the Government could not afford to undertake these projects. . by setting up their own banks. but on the basis of who the borrower was. most often to people who were close to the ruling regime. and investing shares among nonfinancial companies within the group and in other groups’ companies. II By mid-1997. Corporations were certain that they could roll over short-term loans when these fell due. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. where private banks are usually in the hands of big businesses. Projects involving massive capital investments and long-term operating deals (in telecommunications.5 billion. of which $64.38 Corporate Governance and Finance in East Asia. or both. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. toll roads. there was also almost universal confidence that the economic growth would continue indefinitely. total private sector foreign debt stood at $72. Families retain control by keeping the majority percentage of outstanding shares. partly because they used nominee accounts to register ownership rather than set up a holding company. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. Collusion between big businesses and the political elite was widespread in Indonesia. They ensure that commissioners represent their interests and maintain close relationships with the chairperson. as they had done so in the years before the crisis. This was often the case in the banking industry. This fact was usually not disclosed in financial statements. They enhance their control over companies through cross-shareholdings. and in the process maintain control of the company.

followed by property.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.8 7.18 GDP Growth by Sector. as shown in Table 1. when all sectors.4) 2. The construction sector was the worst hit. and Restaurants Transport and Communications Financial.7) (8. Only 86 companies reported profits. indicating a rapid rise in .8 0. and 128 companies reported a total loss of Rp46.0) 1999 2.6 8.2 8. 1996-1999 (percent) Sector Agriculture. and Business Services Other Services GDP 1996 3.6 4.4) (0.6 13. The average DER was found to be 1.370 percent. 53 companies reported negative equity of Rp6.0) (15. BPS).8) (11.Chapter 1: Indonesia 39 1.1 6.58 trillion (meaning their losses were greater than the paid-up capital).5. much higher than the 307 percent registered in December 1997.3 12.1) 1.18 shows that growth in most sectors significantly fell in 1997. and building construction. Hotels. Most sectors showed significant increases in leverage.7 1998 (0. Sectors with lower ROE generally had higher DER. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.6) (3.7) (2.4 7. Using the financial statements as of 30 June 1998 of 161 publicly listed companies. except utilities.1 5. DER and ROE were calculated per sector.4 7.8 1997 1.8 8. posted negative growth rates. and Water Supply Construction Trade.6 12.3 11.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. Table 1.19.52 trillion. Real Estate.2 (1. Gas.24 trillion for the first six months of 1998.1) (26.4 5.6) (0. Livestock.5) (18.0 3.0 5. The consumer goods industry reported the lowest ROE.7 6. real estate.1 (1.0 2.8) (13.6 (36.7) 2. This continued in 1998. Forestry. and Fisheries Mining and Quarrying Manufacturing Electricity.9 3. followed by the finance and trade sectors.

0 864. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104. as shown in Table 1. Financial and banking analysts estimate that by September 1998.0 1. but annualized to approximate full year values.0) 10.40 Corporate Governance and Finance in East Asia.0 191.4) 18.0 92.0 635.0) (78.0 697. and would have kept on increasing if interest rates had not declined.4 (6.395.0 111.20 reveals that the banking sector’s ROE decreased significantly in 1997. As the rupiah weakened and interest rates increased. the NPL ratio had reached more than 60 percent.2 23.0 177.5 percent in April 1998.0 158.0 1998 186. losses in operation were due to declines in sales and increases in the cost of imported inputs.8 (373. several publications. The huge losses suffered by most companies were caused by three factors. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. Third.0 2. the NPL ratio rose to 25. II Table 1. First.370.0 229.4) 8. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits. small foreign banks enjoyed the highest profits.0 2.0 205. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.1 (124.6) 15.8 17.7 1.0 307.2 13. Mostly suffering from a liquidity squeeze.097.0 1.21. private banks posted negative ROEs in the same year.19 DER and ROE of Publicly Listed Companies by Sector. Vol. Source: JSX Monthly.271.7) 6. Second.0 219.0 163.0 108.0 12.1 1. from only 8.0 a ROE 1996 1997 1998a 14.0 72.5 8.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.625.9 12.1 (5.0 631.2 (4. Impact on the Banking Sector Table 1.0 108.6) (115.0 177.1 (92.1) 7. . a Actual data for 1st semester only.0 193.6 (11.1 (3. foreign exchange losses came about with the use of unhedged foreign debt.0 1.0 105.1 30.3 7.0 65.0 1997 234.7 percent in July 1998.0 97. This figure further increased to 47.8 percent in 1996.4 5.8) 36.2) (264.

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 331.5 128.5 222.07 13. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.3 361.86 11.68 1996 1997 8.84 27.0 — 32.81 13.45 — 1993 15.9 297.5 34.2 8.6 — 13.73 30. 1992 7. private national banks overtook State-owned banks when their NPL ratio jumped to 57. Source: Infobank.9 11.9 Regional Foreign and Development Joint Venture Banks Banks — 9.6 6.25 22.07 1994 14. 230/1998.8 8.1 274.28 5.45 21.7 — 1.9 — 11. Source: The National Banking Association.2 47.43 10.09 (11.Chapter 1: Indonesia 41 Table 1.1 198.69 14.91 21.21 Nonperforming Loans by Type of Bank.7 106. The high and increasing NPLs.89 27.30 5.2 1.1 30. put pressure on the banking sector. however. coupled with negative spreads (deposit rate was higher than the credit rate).39 13. .70 1995 7.2 — 19.8 11. 1996-1998 (Rp trillion) State-Owned Banks — 140.1 1. 227/1998 and October No.06 20.20 ROE of the Banking Sector.7 4.5 57.2 37.0 129.5 2.15 20.09 11.47 20.7 — = not available.1 13.5 31.34 16.24 (4.9 percent.1 47.12 15.50 9.3 Private National Banks — 179.8 14.6 — 1.72 16.3 445.4 7.8 187.67 8.6 — 4.0 622.2 48.20) Table 1. In July 1998.37 19.2 8.0 — 4.7 29. State-owned banks initially had the highest NPL ratio.3 22.2 10.38) 11.2 — 8.8 3.44 15. July No.24 15.

the Government and private sector formed a committee to help corporates deal with the crisis. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. IBRA was formed to offer Mexican-style resolution for private sector foreign debt.5.000 eligible firms had signed up for the scheme.000/$1) in debt from domestic commercial banks. II 1. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. have been subject to restructuring deals under the initiative. In June 1998. 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.2 billion debt. By end-November. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. assembling the legal and policy framework to facilitate corporate restructuring. Corporate debt accounted for 46.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. Astra International (automotive). While the process of restructuring was in progress. by mid-September 1998.7 percent ($64. companies were not servicing their debts.7 billion of foreign exchange debt. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). and Ciputra (property business). Vol. Since September 1998.42 Corporate Governance and Finance in East Asia. Unfortunately. such as Garuda (a national flag carrier). 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. In addition. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. a more comprehensive scheme to tackle domestic and foreign corporate debt. a number of prominent companies.4 trillion of domestic debt and $6. none of the 2. the scheme failed. about 80 percent of which was private. particularly in terms of debt resolution. Aside from being described as overly complicated. only a . Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps.6 billion) of Indonesia’s total external debt in March 1998. In November. few companies were in a position to resume interest payments. However. The scheme encourages negotiation between creditors and debtors. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. On 9 September 1998. the committee launched the Jakarta Initiative. Thus.

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

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

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

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

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

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

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

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

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

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

1 1995 560 163 29. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. June 1999.1 1998 490 164 33. Koller. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. Vol.1 1996 561 163 29. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. . Copeland.1 1997 518 104 20. and improvement of bankruptcy procedures. and individual companies. II Table 2. This study collects and analyzes data on the Korean economy. Source: Korea Stock Exchange. 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. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35.4 1993 513 174 33. T. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace.9 1994 531 165 31. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. capital market discipline. especially chaebols. Weaknesses in the overall corporate governance system in Korea had many ramifications. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. and J Murrin (1995). Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms.1 Listed Firms with Positive Economic Value Added. which distributed and collected the questionnaire. The EVAs are the same as the economic profit as explained in T.54 Corporate Governance and Finance in East Asia. Government reform goals for the corporate sector include enhancement of corporate transparency. accountability of controlling shareholders and boards of directors. the corporate sector.

6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. It reviews such elements as shareholders’ rights. Section 2. From 1948 to 1961. and other necessities domestically. It then presents recommendations for further reform in corporate governance and financing. Section 2. creditors.2 presents an overview of the corporate sector. which account for a substantial portion of the Korean economy. the board of directors system. In the period 19481961. and naturally adopted an import substitution policy. corporate control by the Government.2. Section 2. Section 2. Yang. Section 2. The evolution of the modern Korean economy can be divided into four periods.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn.5 describes the state of the corporate sector in the financial crisis and draws on the results of the foregoing sections to outline the causes of the crisis. and employees and their role in shaping corporate governance practices. The Government tried to produce food. Major economic indicators for some of these periods are shown in Table 2. reviewing government policies responsible for the development of the modern corporate sector.2 2. clothing. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. and Yim (1998). the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation.2.4 contains analyses of corporate financing and its relationship to performance. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. This chapter is composed of six sections. It traces the country’s economic development. .Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. 2.

the Government called for an unprecedented average annual economic growth rate of 7. The Government tried . high unemployment and inflation.7 30. IMF.7 14.4 10.4 29.0) 492.2 314. Source: Bank of Korea. II Table 2.3 8. 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 8.0 27. modernizing the industrial structure.2 1.447.9 794. and implementing new budget and tax measures.8 12. Export Drive: 1962-1971 Between 1962 and 1971.265.7 37.1 29. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).949.4 29. In the Plan.2 Key Macroeconomic Indicators Annual Average (percent. e For maturities of one year or more.0 41.753. 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.8 (724.4 24.1 15.5) (1.8 15. This goal required very high savings and investment rates.855. International Financial Statistics.2 31. a Refers to 1971.9b 15.1 — = not available.8 (8.0) (297.1 9.2 757. largely because of political instability.5 250.2 1980-1989 8.6 11.2 30.9) (7.332.2 6.7c 11. Vol.1d 9.1 35.56 Corporate Governance and Finance in East Asia.4 1990-1997 7. lack of strong drive. c Refers to 1989. and large current account deficits.1a 21. b Refers to 1979. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.8 24.9 — — 21.5 38. the Government was not successful in solving the problems of slow growth.9) 1. and inconsistent economic policies.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries. Economic Statistics Yearbook. d Refers to 1997. However.4 (1.102.2 32.5) 8.2 452.

The well-educated. In 1963-1964.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. This change raised the import liberalization rate from 9. and maximizing mobilization of domestic savings on the other. channeling funds from curb markets into the banking sector.3 percent average between 1954 and 1959. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). The average growth rate of the economy from 1960 to 1964 was 5. Exports increased sharply from $41 million in 1961 to $2. In 1964. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. imports of consumer goods and luxury items were highly restricted. . Also. while the average tariff rate was 39 percent. However. up from 30 percent in the late 1950s. During this period. which laid a solid foundation for a steady growth path. 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. due to continuous current account deficits. a modest improvement over the 4. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. abundant. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. the Government tried to provide exporting firms with a free trade environment.5 percent. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. resulting in high real interest rates. but the average growth rate for 1965-1969 shot up to 10 percent. the growth of gross domestic product (GDP) raised domestic savings. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. But the liberalization trend turned out to be short lived as current account deficits continued. Bank deposits increased rapidly.3 percent to 60. During the first five-year plan period.4 percent. In 1971. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system.2 billion in 1972. the import liberalization rate was 55 percent. boosting internal investment resources. The exchange rate system was a kind of crawling peg until 1974. and cheap labor force was well utilized by the export-led growth strategy. but tariff rates were raised to 40 percent in the 1960s.

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

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

By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996.2 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. total assets. the import liberalization ratio reached 98. 47. and low oil prices. which gradually widened.1 percent.60 Corporate Governance and Finance in East Asia. total debts. The most important element characterizing chaebols is the concentration of ownership.9 percent. 13.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. 2.9 percent. In 1988.3 percent. The official rate fluctuated within a band. Industrial and trade policies were modified to be consistent with WTO. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. Korea began participating in many multilateral trade negotiations during the Uruguay Round. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. and total workforce.2. the Government committed itself to further liberalization of the goods and capital markets. The Government tried to adjust economic policies and regulations to meet global standards. and acceded to the World Trade Organization (WTO) in 1994. Korea adopted a market average exchange rate system. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. 4. Vol. with the 30 largest in the total economy in 1997 standing as follows: value-added. further increasing its pace of import liberalization. 45. . The low value of the dollar led to a low won and high yen. 46. giving up its foreign exchange controls related to the current account. 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). and declaring that it would follow Article XI of GATT. while continuous and large current account surpluses saved Korea from the foreign debt problem. whose business activities are controlled by an identical person.1 percent and average tariff rates 8.” A large-scale business group is called a chaebol. the importance of chaebols was increasing. Meanwhile. total sales. II world interest rates.9 percent. In 1993. In 1990. but it chose to liberalize gradually.

From the standpoint of the Government. the number of subsidiaries declined drastically due to corporate restructuring. and tax breaks to key industries to promote exports and industrial upgrading.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. it was more effective to deal with a small number of companies to secure tangible outcomes. chaebols that maintained a close relationship with the political authorities were able to grow fast.5 20. Since the 1960s.when the Government put a great deal of emphasis on development of the HCIs.8 22. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. Chaebols have a history of substantial concentration of ownership. One reason for this controlling power is inter-company shareholding among subsidiaries. reaching 669 in 1996. financial assistance. of Subsidiaries per Chaebol 20. The Government provided subsidies. Chaebols are also excessively diversified. 1993-1996 Year 1993 1994 1995 1996 No. However. and they are aided and supported by one another. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. Since the Government controlled most business activities.1 20. Table 2. . The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries.3 Source: The Fair Trade Commission. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. after the financial crisis. This policy contributed greatly to the expansion of chaebols. Table 2. This galvanized the fast growth of chaebols. of Subsidiaries 604 616 623 669 Average No.Chapter 2: Korea 61 War II. the ownership and management of a chaebol’s subsidiaries are not separate. Important managerial decisions are made primarily by owners. In the mid-1970s. In this sense.3 Subsidiaries of the 30 Largest Chaebols.

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

however. Second. The Korea Fund.151 117.5 406. . a country fund. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused.9 833.0 965. Inc.6 747.370 70. The aggregate Table 2. 1985-1998 No. was established to invest in domestic shares beginning in September 1985.989 137. the stock market grew rapidly during the 1980s.0 79.Chapter 2: Korea 63 During the 1980s and 1990s. continued until 1989.217 141. the number of firms listed on the Korea Stock Exchange almost doubled in the five-year period from 1985 (342 firms) to 1990 (669 firms).4 40. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies..9 34.4.1 Market Capitalization (W billion) 6.4 Development of the Stock Market.476 79. 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. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.4 654. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. Also that year.798 Market Capitalization as a Ratio to GDP (%) 8. As shown in Table 2.7 934.1 30.2 44.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service.1 16. the Government announced the gradual opening of the capital market to foreign investors in January 1981. Because of government policies and the booming economy. The policy to expand the size of the stock market. In this regard.0 49. Third. First. especially those paying small or no dividends. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.570 95. Beginning 1990.020 151.9 918. several important policy measures were implemented to promote the development of the stock market.

255 2. and other liabilities. The growth in the number of listed firms also slowed in the 1990s.455) 13.414) 5.583 25 10.817 16.183 12.875 21.870) (1.008) (3. . Source: Balance of Payments. However.296) (6.141 4.440 1. but rose again to 34. currency and deposits.149 13.017) 1. and 1993. The number shrank for the first time in 1998 to 748 firms from 776 the previous year. Table 2.339) (9.571 2.239 19.553 8. but increased sharply to 79.001 4.944) 8.852) (2.694) 2. The relative size of the stock market diminished to 44 percent in 1990. Other investments include loans.59 percent in 1998 and to more than 50 percent in the early months of 1999.347 3. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.868 (518) (418) 63 1.64 Corporate Governance and Finance in East Asia. Table 2.650 (1.534) 1. The aggregate market value of listed shares bottomed at 16. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.953 10.642 21.123 3. and stayed at the 30-40 percent level up to 1996.785 (1.500 7.942) 42.150 5.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.326 1.5 Private Capital Flows to Korea.546 (2.352 471 3.085 2.126 (1. Vol.264) (3.542) (1.433) (9.413) 56.86 percent of GDP in 1997.800 (7.737 (333) (297) (607) (2) 218 2.382 Permit basis.338 4. II market value of all listed firms represented only 8 percent of GDP in 1985.450 24.924 (1. Bank of Korea. 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 1986-1989.658) (3.910) 2.742 (3.714 1.858 4.287 (340) 73.453 (2.2 percent by 1989. due to declining stock prices. trade credits. 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.

7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. the growth rates of equity and sales dropped sharply in 1996 and 1997. excluding FDI. In addition to FDI. increasing to 76 percent in 1997. following the sharp depreciation of the won.7 billion and loans $42. However. Net private capital inflow.China. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. and high production costs were the main reasons for low FDI in Korea. This indicates that a substantial proportion of debt was denominated in dollars.6). Table 2. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. Taipei. The same categories will be analyzed in later sections. Japan’s was consistently higher. The growth rates of total assets. Return on equity (ROE) and return on assets (ROA) showed similar patterns. but between 1988 and 1993. weak incentives for attracting FDI.2. (ii) listed firms.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector.6 percent in 1997. equity.5). This would lay the foundation for evaluating the effect of corporate governance on performance. and (iii) chaebols. The contribution of the corporate sector to GDP was 73.Chapter 2: Korea 65 Complicated government regulations. Corporate sector net proft margins increased from 1993 to 1995. Profit rates of Korean firms were relatively low compared to those of Taipei.China and the US. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. and US.9 billion.2 percent in 1987. 2. The dismal performance of the Korean corporate sector compared to the . Korea had substantial current account surpluses and experienced net private capital outflow. Of this. portfolio investments amounted to $73. Between 1986 and 1989. and sales of the aggregate sector during this period were very high (Table 2. The ratio is generally in the same range for Japan and Korea. other net private capital inflows amounted to $130 billion during 1985-1998. but dropped in 1996 and were negative by 1997.

9 16.8) 297. ROA = return on assets (ratio of net income to total assets). Note: Ratio of ordinary income to sales = (ordinary income/sales).9 18.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.9 8.0 (0.6 318.3 308. Source: Bank of Korea.7 4.6 1.6 1.3 14.0 10.9) DER = debt-to-equity ratio.4 10.0 8.5 (0.3 335.8 8.4 2.9 3.2) (0.9 4.7 325. Financial Statement Analysis Yearbook.5 0.2 1.1 2.7 1.2 1.8 1.0 7.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.Table 2.5 2.1 — — — = not available.0 3.3 3. .9 5.7 4.5 1.3 1. 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 23.6 3.5 7.5 4.4 — 6.6 4.3 — 3.7 4.1 2.0 0.7 15.8 2.8 21.6 (4.7 15.0 6.6 2.8 22.6 13.9 5.7 3.2 1.1 6.9 2.4 1.4 2.7 2.1 8.4 4.2 13.3 21.5 3.1 2. Table 2.2 18.6 9.4 2.9 13.0 13.9 2.8 1.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.6 424.0 13.3 17.9 3.0 305.1 5.4 1.3) 5.5 1.2 19.2 9. Net profit margin = ratio of net income to sales. Source: Bank of Korea.3 21.3 6.9 16.9 18.4 19. ROE = return on equity (ratio of net income to stockholders’ equity).4 1.9 2.5 1. Financial Statement Analysis Yearbook.7 3.2 13.8 3.5 4. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).3 11.9 5.0 4.3 312.

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

4 474.8 16.6 655.9 340.0 16.3 15.3 18.6 11.0 18.1 1.6 3.2 6.8 0.5 16.2 5.7 4.4 2.0 2.8 3.5 306.4 9.4 .5 4.6 12.8 17.9 10.1 27.6 1.3 8.0 2.1 20.2 16.2 24.0 24.0) 0.5 (5.0 (0.8 10.1 17.6 375.8 24.0 18.0 1.0 16.5 28.3 10.6 24.5 14.7 317.5 6.9 2.4 2.2 0.5 569.7 21.7 16.1 7.5 239.6 0.0 1.5 (0.0 254.9 538.9 (0.8 345.3 14.8 2.4 4.3 15.5 23.8 13.4 10.5 1.8) 0.3 11.0 22.0 37.4 10.3 8.3 8.2 (1.4 0.8 1.1 2.1 0.4 740.4 1.6 6.8 35.2 315.8 7.1 21.5 338.2) 15.5 1.8 562.5 3.7 (3.6 7.3) (1.4 10.0 (0.0 2.0) 1.7 7.2 423.9 19.5 5.9 0.1) (3.7 17.4 10.4) 0.5 483.9 9.2 7.2 36.7 294.8 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 13.6 318.3 288.8 14.4 1.9 428.2 5.1 16.8 0.6 17.1 28.1 10.7 5.5 13.0) 4.5 (1.5 473.7 9.4 0.8 3.6 14.8 23.1 (0.0 22.7 1.2 0.9 10.0 7.1 296.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.8 16.0 1.2) 6.9 31.2 20.6 1.0 1.2 5.3 285.2 25.0 245.9 3.3 25.8 Real Estate.7 10.9 14.3 1.1 (0.5) 0.4 2.9 13.8 34.2) 22.5 5.5 1.7) 2.0 5.4 458. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.1 2.8 24.9 2.9 16.8 616.1 290.6 2.3 2.4 5.4 5.9 25.8 14.6) 3.9 (0.4 2.3 31.6 3.5 432.1) 3.4 (0.4 350.8 16.8 526.9 (0.6 16.7 228.8 22.1 1.2 241.3 13.3 10.8 461.4 14.4 17.0 1.0 15.0 15.5 1.3 1.9 1.0 2.3 8.7 514.7 30.0 1.0 23.7 0.0 9.4 2.5 27.4 15.1 1.3 2.9) 1.9 16.0 19.6 0.8 2.2 12.1 0.2 6.4 291.2 15.8 12.1) 0.1 1.1 396.6) (6.6 5.4 5.0 12.7 520.2) (0.8 302.7 22.6 15.5 6.8 2. Renting.9 5.1 0.8 32.2 2.2 20.1 22.6 14.7 (0.8 22.2 0.5 1.5 270.2 16.3 15.0) 0.3 11.6 17.0 21.4 12.9 29.6 12.0 22.8 12.0 1.2 18.8 10.0 24.5 30.3 15.0 3.4 3.9 16.4 348.5 286.5 1.3 14.6 14.5 19.0 5.Table 2.8 1.0 (4.

4 30.9 7.6 6.4 7.4 0.2 18.3 4.5 612.5 117.7 15.6 4.6 8.7 7.1) 5.5 8.7 2.062.8 6.9 1.5 11.2 10.7 11.7 14.4 6.4 1.2 14.6 1.7 11.3 4.8 3.2 1.6 8.3) 4.5 307.5 0.4 7.2 11.1 16.1 15.0 1.5) 22.3 18.2 122.6 172. Gas.3 125.1) (0.9) (8.5 14.3 17.0 7.3 0.1 11.7 16.4 21.1 15.0) 1.3 (2.4 3.6 3.3 524.7 2.0 2.7) (4.1 3.1 323.9 17.8 7.7 187.6 9.3 19.7 — — — — — 14.6 0.8 529.6 4.1 15. Storage.7 0.5 482.3) 15.1 17. Financial Statement Analysis Yearbooks.0 14.5 14.9 Electricity.1 21.4 (0.1 8.8 12.Table 2.2 143.1) 1.3 23.1) (0.2) 0.0 14.0 Transport. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.6 512.1 2.2 7.9 (10.4 16.9 9.8 15.6 18.5 30.3 8.1 6.4 0.5 12.2) 13.9 321.3 — — — — — 10.4 11.3) (1.9 10.5 11.3 112.7 510.7 19. .9 (11.3 9.7 116.2 698.2 3.3 1.8 0.5 14.6 12.0 21.5 26.0 1.8 0.5 13.4 2.6 9.0 (1.8) 1.3 740.8 14.4 (2.7 11.4 13.8 12.9 12.2 14.7 — = not available.5 15.4) (1.4 12.6 8.8 6.4 341.5 539.1 12.2 18.6 21.4 12.2 15.7 7.6 20.7) 0.5 (2.4 367.6 19.3 2.5 16.1 11.5 47.4 1.4 15.9 332.1 1.9 6.0 2.9 10.6 16. a New equity does not include capital surplus.0 5.3 4.4 10. b NPM denotes net profit margin.9 12.8 9.9 17.0 106.5 2.5 344.0 (15.6 12.4 14.3 1.7 20.7 0.3 12.4 633.4 9.9 4.9 4.3 3.1 14.8 (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 34.9 18.5 14.2 — — — — — 2.9 8.1 4.4 169. Source: Calculated using data from Bank of Korea. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.3) 11.4 1.8 3.9 9.2 2.6 14.1 (2.0 98.8 111.2 10.7 12.5 4.6 — — — — — 17.9 456.0) (0.8) (12.3 8.4 — — — — — 448.0 13.2 90.6 6.6 19.3 543.6 6.3 18.2 18.1 (11.3 34.4 6.0 5.4 0.6 — — — — — 0.2 10.9 8.2) 9.4 3.6 (2.4 3.3 0.1 (0.5 462.4 2.6 (2.8 8.0 89.0 921.6 15.0) 1.8 14.9 18.9 3.8 4.8 11.6 2.6 9.5 15.0 1.6 1.

9 percent).7 Net Profit Margin 0.6 22.5 19.3 percent).6 0. had 46 member companies. Kis-Fas. and net profits (46. The smallest group had 16 members in 1995.0 18.7) 0.3 2.9 6.12). In 1995. debts (47.7 percent) of the corporate sector.5 5. Chaebols have been the most important actors and engines of growth in the Korean economy. The criteria for selection of largest chaebols have changed a few times.4) 1.2 6. Between 1993 and 1997. In 1997.0 0. Vol.1 percent of the economy’s total value added (excluding the financial sector).3 20.1) 4.3 4.4 1.9 percent).4 2. The top five chaebols registered the highest growth rates.4 1.8 24.4 22. of which four were listed. the top 11-30 chaebols experienced a decline of .9 11. of which 16 were publicly listed (Table 2. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.1 1.70 Corporate Governance and Finance in East Asia.4 1.5 0. Hyundai Group. followed by the top 6-10 (Table 2. the 30 largest chaebols accounted for 13.2 2.7 1. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.1 6.5 ROE 3. 1985-1997 (percent. II Table 2.8 5.6 23. The number of Hyundai member companies rose to 57 in 1997. Generally.9 2.6 2.9 26.9 Source: Constructed using data from Korea Investors Service.4 0. sales (45.2 9.6 (1.11). but the number of designated groups has been fixed at 30 since 1993.9 2. 1998.7 (5.5 ROA 0.7 1.9 Growth and Financial Performance of Listed Companies.1 1.3 (0. the largest chaebol.12).9 21.6 1.9 1.2 9.6 and 2.2 0. It should also be noted that when the financial crisis struck in 1997.6 3.8 6.5 19.3 0. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.8 0.0 3. Performance of Chaebols This section uses available data on the top 30 chaebols.9 0. it is the chaebols’ large firms that are listed. and close to half of total assets (46.3 15.

6 9.6 13.5 17. 1988-1997 (percent) ROE Large 9.6 1.0 1.9 1.2) (1.6 2.9 6.9 1.6 0.3 Medium 14.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.3) 5.7 (1.0 1.9 25.9 (0.0) 1.0 16.9 0.9 2.6 3.9 5.8 6.8 0.0 1.6 6.3) 0.8 1.5 3.8 16.2 1.0 19.8 0.8 7.6 2.4 6.5 5.3 (0. .3 6.3 15.4 3.3 3.6 (1.4 1. Kis-Fas.2 3.8 3.8 0.8 10.5) 1.8) 6.6 2.2 2.9 3.9 22.4 11.9 0.3 9.6 5.2) 0.3 11.1 8.5 (1.0 4.5 1.0 1.9 2. Source: Korea Investors Service.2 2.8 0.0 17.2 0.7 18.3 1.9 14.9) (6.4 Medium Small Large Medium Small ROA Growth Performance Large 17.Table 2.1 11.5) 1.9 6.7 2.7 1.2 Small 13.6) 0.4 16.5 25. Others are medium firms.8 (5.6 1.8 17.6 1.2 7.3 15.2 12.10 Growth and Financial Performance of Listed Companies by Size.8 6.0) 0.6 (0.1) 5.6 3.7 (0.5 0.0 6.4 3.1 2.1 0.4) 1.4 1.8) 1.4 5.0 (4.0 15.5 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion. 1998.2 13.3 (0.1 2.2) (1.2 13.7 4.7 3.7 (1.6 8.9 2.2 (0.9 0.7 2.6 7.6 0.5 5.1 1.2 10.4 2.0 10.

370 6.455 22.996 1.995 2.766 3.395 31.376 35.11 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 43.427 9. 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.956 3.090 6.433 3.774 7.599 — 2.967 7.346 3.743 40.129 2.117 4.303 3.677 3.756 5.457 14.246 11.690 3.287 10.131 3.158 7.651 38.309 14.873 2.486 6.364 5.398 — 2.177 — 6.935 2.423 5.924 2.951 3.475 2.501 13. .Table 2.158 1. 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.929 12.910 3.798 — No.927 16.574 3.853 1997 53.597 351.445 4. Source: Fair Trade Commission.990 2.458 6.640 4.761 31.313 14.180 2.147 5.

3 0.9 20.1 (2.7 13.9 17.2 0.0 31.6 4.1 19.5 32.6 (0.2 20.7) ROE 5.9 3.0 19.4) (14.7 10.0) ROA 1.2 (2.0 2.5 5.0 2.9 18.2 (5.3 19.2 (16.8 27.5 20.1 10.5 (0.2) (0.9 20.5 2.5) (0.5) (0.5 27.9 3.3 3.7) Source: Bank of Korea.3) 0.1 (1.3 1.1) (0.3 9.2) (2.7 10.0) 12.4 0.3 16.8 Assets 12.1) (1.8 0.0) 3.5) (0.1 27.12 Growth and Financial Performance of the 30 Largest Chaebols.5 19.4 30.4) (0.4 38.Table 2.3 0.1) 0.4 26.7 1.9 1.2 (2.1 2.0 6.2 3.2 0.2 0.0 1. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.3 15.2) 1.0 17.7 4.7 15.1 (3.3 27. .0 0.4 12.2 11.6 18.3 14.6 Financial Performance Net Profit Margin 1.8 18.6 1.3 1.9 24.3 11.0 2.0 0.7 0.4) 1.1) 0.7 15.6 25.1) (0.2 1.6 19.4 (2.

internal and external control mechanisms. II 2 percent in their sales and a very low 4. and the companies that are under the control of the largest shareholder. 5 While “ownership concentration” can be defined and measured differently in different contexts. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. and government intervention interacted through a set of laws and regulations to bring about the existing structure. resulted in the chaebols’ excessive leverage. By the end of 1997. However. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. it refers to the degree of concentration and shareholdings in the hands of an “identical person. 2.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea.13).95 percent. his/her relatives. and led to a high concentration of ownership.” This “identical person.3.765 percent (Table 2. more important. weak corporate control. Their worst year was 1997 when ROE hit -15. There has been a wide range in DER among chaebols. Ownership patterns.5 Founding families are mostly still the largest shareholders and.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated.” in Korea’s legal and regulatory framework. 2. The absence of a well-developed equity market and the provision of subsidized credit. and vulnerable balance sheets. and access to credit. except for 1995. The Commercial Code stipulates the basic governance framework and applies to all corporations. In general. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. includes the largest shareholder. Only the top five chaebols registered a positive net profit margin in 1997. chaebols had a higher average DER than the corporate sector as a whole. the average DER of the 30 largest chaebols reached 519 percent.7 percent growth in total assets. a pyramidal structure of corporate ownership is prevalent. However. coupled with weak corporate governance. Vol. 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. technology. . from 190 to 3.74 Corporate Governance and Finance in East Asia. The better showing of the top five chaebols was a direct result of their dominance in human resources. in this instance. loopholes and inconsistent policies spawned strategic behavior and agency problems.

Lotte 11. Kia 9.4 622. Hanil 28.7 354. Haitai 26. Newcore 30. Halla 17. Daelim 14. Byucksan 1996 1. LG 4. Hyosung 18. Hanbo 15.1 3. Jinro Debt-to-Equity Ratio 376.1 477. Kumho 12. Kolon 21. Kia 9.3 328.8 312.5 343.5 337.7 416.3 315. Dongbu 24.244.2 328. Hanjin 8.5 383.0 486. Samsung 3. Lotte 11. Samsung 3.7 267.0 436.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.2 2.6 . Halla 13. Daewoo 5.441.4 556.Table 2. Dongkuk Steel 19.4 205. Tongyang 22. Hansol 17.6 516. Daelim 16.2 423.9 321.855. Daewoo 5.1 278.1 674.3 572.8 336.7 620. Hyundai 2.7 621. Ssangyong 7.0 506.2 292.2 924. Jinro 20. Hyundai 2. Kukdong Construction 29. LG 4. Hansol 23.6 936. Doosan 13. Dongkuk Steel 19. Kumho 12. Sammi 27. Dongah 14. Hanjin 8.5 464.2 471. Sunkyung 6. Ssangyong 7.6 409. Sunkyung 6.1 385.4 192.2 346.5 3. 1995-1997 (percent) Chaebols 1995 1.8 313.1 190.6 2. Dongah Construction 16.7 688. Hanwha 10.5 2.3 297.0 370.0 218. Doosan 15.4 175. Kohap 25. Hyosung 18.065. Hanwha 10.9 751.764.

Lotte 12.1 375.6 416.Table 2. Shinho 26.8 307. Hyosung 17. bBank of Korea. Haitai 25. Doosan 15.7 944. Dongah 11. Halla 13. Dongkuk Steel 20.5 323.600.5 386.5 1.8 347. Kohab 18. Dongbu 23.0 305. Daelim 14. Hanwha 9.5 576.501. Hansol 16. Kamgwon Industrial 30.6 478.3 399.1 438.13 (Cont’d) Chaebols 20. SK 6. Tongyang 24. Ssangyong 8.0 907.784.8 468.7 370. Tongyang 24.214.3 676.8 647.4 1. Kolon 19. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Miwon 30.0 505.1 472.4) 513.6 Sources: aFair Trade Commission. Dongbu 21. Jinro 23. Keopyong 29. Shinho 1997 1.5) 404. Samsung 3.225.1 359.5 (893.7 1.5 (1. Hyundai 2. LG 5. Hanjin 7.1 433.3 347.5 519.8 399. Kolon 21.8 658. Financial Statement Analysis Yearbook.9 216.9 490. Haitai 25. Kumho 10.6 424. Daesang 27.6 590.9 578.498.5 261. Anam 22. Newcore 28.3 1.9 465.8 590.8 338. Hanil 28.0 419.6 335. Anam 27. Keopyong 29.9 472. Kohab 22.9 1. Newcore 26. Daewoo 4. .

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

6 36.3 5.0 27.9 37. etc.7 4.1 10.3 2.0 28.2 17. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.0 5.1 11.3 8.4 5.9 19.6 9. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.3 1.7 9.8 59.1 21.4 14.5 62. investment trust companies.6 22.7 3.2 18.7 6.3 1994 521 1.5 60.5 12.0 60. d Constructed from data files of the Korea Listed Companies Association.7 59.2 2.5 7.0 4.4 6. and finance companies.8 5.Table 2.7 9.5 7. Listed Nonfinancial Companiesd 1988 406 0.4 13.9 1.6 16.0 5.6 16.3 17.6 Year No. of Firms The Statea Banks.5 1.1 60.9 36.14 Ownership Composition of Listed Companies.1 17.1 8. c Data from Korea Stock Exchange.8 1995 548 2.7 7.2 7.1 8.8 59.5 4.2 8.6 13.4 34.2 3.1 68.3 17.8 5.3 18.9 15.7 14.1 2.7 1990 531 0.9 2. .9 2.6 2.5 16.6 12.4 5.0 8.2 B.3 18.3 26.8 17.1 18.6 20.3 1996 570 2.9 4.4 Insurance Firms Other Corporations Foreigners Individuals 39.1 18. b “Banks. etc.9 5.3 1.9 17.5 6.7 18.1 1.2 8. a The State covers the Government and state-owned companies.2 1993 511 2.8 17.5 1989 498 0. merchant banks.4 1997 551 1.3 39.5 18.6 8.0 59.1 4.6 1991 505 0.8 2.2 5.0 7.8 2.5 1992 508 2.” includes commercial banks.0 9.6 19.b A.6 9.5 6.1 21.2 5.2 9.9 26.9 1.2 1.8 4.1 3.8 69.7 8.3 5.5 1.4 13. mutual savings.5 Note: Ownership is based on number of shares.4 18.2 4.6 16.2 9.

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

4 5.4 8.2 9.7 1.9 10.4 Banks.0 — 39.2 0.4 62.1 0.9 1.1 7.1 0.3 9.3 6.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.2 7.1 8.2 22.5 17.8 3.2 9.3 0.4 14.2 — — 0.1 0.0 9.6 8.6 — — 2.2 1.9 59.8 7.3 13.0 0.1 0.5 19.3 7.3 0.4 1.9 52.5 3.8 1.2 2. Paper.9 15.9 1.3 10.2 17.3 4.7 2.5 12.9 55.7 22.0 2. Motor Vehicles Electricity.9 23.7 14.3 62.6 5.1 1.1 65.3 11.0 20.4 8. Gas.1 4.5 — 1.8 3.Table 2.3 0. Etc.9 19.2 0.7 2.8 Individuals 83.2 0.2 — 0.7 20.0 8.5 85.3 1. and Printing Pulp.9 16.8 7.1 88.8 6.8 5.8 73.0 10.4 1.6 1.4 2.4 56.5 6.8 7.3 38.9 4.8 7.1 8.3 57.8 7.2 64.9 60.5 4.4 — 0.0 1.4 8.3 2. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.9 8.9 42.6 3.5 7.15 Ownership Composition of Listed Nonfinancial Firms by Industry.4 7.5 — — 0.3 1.2 1. and App. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.0 7.5 0.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.2 54.7 20.7 59.2 9.5 — 0.5 0.0 9.8 8. and Printing Chemicals.6 24.4 56.6 18.1 19. Elecl Mach.6 11.2 0.5 0.5 0. Paper.0 — 0.1 27. Rubber..7 6.1 10.7 64.7 2.0 9.0 9.7 17.3 2.7 63.9 66.7 29.4 0.7 22. 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 0.7 14.

Rubber.9 2.8 5.8 12.6 75. and finance companies.6 0.6 60.2 49.0 8.5 63.7 6. Source: Constructed from data files of the Korea Listed Companies Association.6 5.4 1.9 1.1 9.0 60.8 0.3 8.7 1.7 19.4 2. mutual savings.0 6.9 6.5 3.3 57.4 2.8 2. merchant banks.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.9 1.8 57.9 7.1 2.2 13.4 9.7 17.4 58. .1 3. Note: Ownership is based on number of shares.6 — = not available.5 12.9 6. Elecl Mach.9 1.0 1.5 1. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics. b “Banks.9 5. a The State covers the government and state-owned companies.4 0.8 27.4 45.1 3.2 5.3 7. and Printing Pulp.1 — 0.1 2.2 0.3 2.4 4.9 5.5 3.8 6.6 6.78 81.3 0.3 1.2 0.8 2.3 60.2 8.2 6.6 18.6 3.4 4.8 54. and App.4 3.” includes commercial banks.9 20.1 4.9 20.2 3.6 59. Motor Vehicles Electricity.2 4.4 1. investment trust companies.5 6.4 1.1 1.6 20.3 6.4 20.7 2.6 1.4 58.7 5.1 25.2 4.3 1.4 — 1.5 3. 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. Gas.1 — 1.2 7.9 2.9 2.6 2.6 6.1 1.3 31.5 — 2.5 7.1 18.5 0.7 4.4 68.6 14.9 7.1 54.9 78.1 6.2 4.0 4.3 65.3 15.2 4.1 9.4 43. Paper.6 7.7 2.8 0.0 43.2 1.5 5.2 1.8 4.7 23.0 3.3 6.8 3.8 11.4 76.7 2.4 6. etc.8 5.6 2.6 2.0 7.2 23.5 4.2 5.9 18. and Printing Chemicals.9 2.9 0. Paper.8 2.9 57.6 0.7 2.4 16.5 59.0 6.4 2.9 69.0 5.5 4.0 11.5 3.

7 Control Type No.c Securities Firms Insurance Firms Other Corporations Individuals 58.9 2.5 19. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.9 4.8 60.4 Firm Sizea No.4 21.7 1.0 6.8 2.7 6.5 16.4 1. Others are medium firms.4 5.8 6. b Table 2.5 2. c “Banks.0 Other Corporations 16.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.” includes commercial banks.4 61.3 Banks.3 6. The State covers the government and state-owned companies.1 6.4 4. and finance companies.4 2.8 1. 1997 (percent) The State 1.5 4.6 16.4 61. etc. Securities Firms Insurance Firms 2. of Firms Large Medium Small Total 211 208 80 499 a Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.5 Individuals 60.0 1.8 4.8 4. investment trust companies. 1997 (percent) The Stateb Foreigners 4.7 Foreigners 4.9 5.5 18.7 0. merchant banks.5 6.4 2. .7 8. mutual savings. etc.7 4.8 3. etc.4 5.5 62.16 Ownership Composition of Listed Nonfinancial Firms by Size.5 8. Source: Constructed from data files of the Korea Listed Companies Association.1 8.1 2.Table 2.6 60.1 Banks.4 17.2 1.

defined as those holding less than 1 percent of shares. In 1997.8 9.6 39. 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.1 financial institutions’ establishment of corporate pension fund accounts. only closed-end investment companies and traditional investment trust companies are allowed. 1997 (percent) Country Japan Korea Taipei.18 Ownership Composition of Listed Firms in Selected Countries. But these may . corporations held 70 percent of the controlling blocks of shares.6 Foreigners 9. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. the majority shareholder group in all listed companies consists of the corporate. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. including those of the largest shareholder.8 56.Chapter 2: Korea 83 Table 2.4 26.6 Individuals 23.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. investors (Table 2. This has had profound implications for corporate governance and the market for corporate control in Korea. and the companies under the control of the largest shareholder. Among nonfinancial listed firms.19).5 45. minority shareholders.5 20.3 54. Generally. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.China United Kingdom United States Source: Stock Exchange of Korea. his/her family members.8 10. while family members accounted for only 30 percent.7 16.1 8. Institutional Investors 42. At the moment. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. Foreign holdings of Korean shares were 9. for example. rather than the individual.3 6.3 47.20).

1 28.7 7.7 16.9 33.1 5.4 7.0 2.8 72.1 21.8 Individual Subtotal Other Shareholders Corporation 3.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41. .4 3.2 2.19 Ownership Concentration of All Listed Firms.9 32. his/her family members.0 1.5 43.9 3.8 8.6 5.6 22. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.6 2.9 7.3 18.7 44.9 Individual 2.0 4.6 26.9 2.3 30.Table 2.0 66.3 Subtotal 5.7 6.0 25.1 5.0 29.2 Minority Shareholders Subtotal 71. 1992-1997 (percent) Majority Shareholders Corporation 15.8 73.4 5.6 46.6 73.7 Note: The majority shareholder includes the largest shareholder.1 15.2 26.3 2.0 69.7 18. Source: Stock Exchange of Korea.1 23.0 22.2 2.1 14. and the companies under the control of the largest shareholder.9 6.1 32.1 4.1 37. Minority shareholders are those holding less than 1 percent of shares.

22).5 12. hiding shares offers no additional tax or other benefits.5 60.9 48. the Government has retained a large number of shares.1 50. Meanwhile. In such cases. Ownership concentration tended to be lower in large compared to medium and small listed firms. Majority ownership is also high in the chemicals. the majority owner held more than 20 percent of an average firm.4 28.20 Ownership Concentration of Listed Nonfinancial Firms. ownership was relatively diffused due to government regulation. 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.7 18.4 23. 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 2.9 29.8 28.5 13. in the small firms. which held less than 1 percent of a company’s outstanding shares as of 1997. minority shareholders. In most industries.9 25. The practice of hidden shares seems to have been less prevalent in recent years.21]). Besides. rubber and plastics. It was highest in medium-sized firms before 1993 and.8 54. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.Chapter 2: Korea 85 Table 2.4 Source: Constructed from data files of the Korea Listed Companies Association.8 25.6 58.9 Other Shareholders 18. and mining categories.6 11.0 58. thereafter. In telecommunications.6 57.0 22.2 15.9 27. collectively owned less than 50 percent of an average firm.8 Majority Shareholders 27.8 57. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.3 25. Across industry.0 20. .5 23.3 62.9 12. 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 2.8 12.

2 23.7 29.5 16. Elecl Mach.8 55.5 52.5 47.0 30. 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. and Printing Chemicals.1 17.1 19.2 26.0 21.8 44.8 25.0 54.6 50.7 17.7 36.7 21. Paper.6 19.5 20.0 39.2 19.5 23.8 51..5 21.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.4 53.5 19.6 34.6 38.1 43.2 22.2 48.8 24. and Printing Pulp.3 26.6 25.2 34.4 16.9 26. Paper.8 29.9 44.6 53.7 26.1 49. . and App.8 41. 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 36.4 11.2 37. Gas.0 51.21 Ownership Concentration of Listed Nonfinancial Firms by Industry. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.Table 2.7 27.5 44.8 21.8 31. Rubber.3 19.2 20. Motor Vehicles Electricity.9 10.9 Minority Shareholders Majority Shareholders Other Shareholders 12.3 39.5 41.2 46.7 24.

3 19.5 51.4 29.8 17.2 21.1 27.9 26.4 30. 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.1 58.9 12. 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 53.0 59.9 53.8 27.4 51.9 23.9 16.4 47.7 57.2 32.7 28.3 21.8 11.6 24.6 62.5 19.1 48.8 28.2 52.2 21.5 10.6 59.2 50.9 55.3 27.3 25.5 19.8 52.9 22.7 15.2 Majority Shareholders 26.7 17.7 16.5 21. .3 26.6 31.9 21.Table 2.5 12.4 30.2 56.9 17.8 52.0 24.1 16.2 Source: Korea Listed Companies Association.5 Other Shareholders 19.5 49.2 21.2 12.2 55.1 20.6 27.6 65.2 11.0 26.7 22.2 26.8 56.6 15.2 18.0 66.4 21.6 11.7 31.5 12.8 50.8 62.7 14.3 55.0 55.5 26.9 56.9 28.4 30.5 28.7 57.5 33.1 15.6 55.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.5 27.9 60.

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

The fact that corporations. Among the subsidiaries or firms receiving investments. 53 percent were domestic nonfinancial firms. together having a total of 292 domestic subsidiaries.5 percent. standalone setups. the average shareholding of the controlling owners and their families was 8. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. In the case of the 30 largest chaebols. In Table 2. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries.Chapter 2: Korea 89 guarantees from other members of the group at no cost. Partial results are shown in Table 2.5 percent of shares. Twenty-two of the 81 respondents were independent. For the whole sample. there are instances of direct cross-shareholding in Korean firms. and 319 foreign subsidiaries. These shares should be added to the control block although the financial institutions belonging to the 30 largest chaebols are prohibited from exercising their voting rights in the member firms of the chaebol. or an average of 13 firms per company.5 percent as of 1997. or about five subsidiaries each. Thus. for example. Of the 81 respondents. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. not individuals.23.4 corporations. 59 parent companies collectively had investments in 759 firms. the top 30 chaebols’ shareholding by subsidiaries was 34. 62 percent (16 out of 26) had a corporation as the largest shareholder. For the same year. Until recently. Thus. Among the 81 listed firms in the ADB survey. The extent of pyramiding can be seen in some of the previous tables. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms.14.5 corporations and two individuals.9 percent of shares. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. 59 were parent firms with one or more subsidiaries. or about four firms each. In many instances. 34 percent were foreign companies. If we define the internal shareholdings of a . together owning an average of 37. together owning an average of 38. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. Among chaebol affiliated firms. the top five shareholders consisted of 2. although they are likely to be insignificant. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. and about 11 percent were domestic financial institutions.

0 13. a Number of shareholders.5 31.8 38.5 2. A few companies reported less than five largest shareholders.0 3.4 38.2 37.7 39.5 1.4 1.3 26.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.6 3.7 19.5 24.6 16.1 3.0 1.4 21.4 18.0 1.5 18.2 25.1 1.4 25.4 2.0 21.0 17.6 34. 1999 Five Largest Shareholders No.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.5 4.8 31.9 21.3 12.Table 2.8 37.9 5.4 42.5 2. .1 22.9 29.6 3.7 5.5 4.8 18. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.6 3. 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 20.8 8.5 38.0 3.0 2.5 2.4 11.7 37.9 34.5 2.7 0.

4 1990 45. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. “Japanese Zaibatsu and Korean Chaebols.5 percent. Tamio.2 15.2 33. . 1989. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission.8 33.4 10. Table 2.24 shows the average internal shareholdings in the 30 largest chaebols.4 13. Hattori (1989) identified three patterns based on data in the early 1980s. 15 October 1998.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns.8 40.7 1992 46.” Paper presented at the Annual Conference of Financial Management Association.5 percent and member companies. Jae Woo. Based on these studies. Chicago. 34.24 Internal Shareholdings of the 30 Largest Chaebols.5 Judging from the historical record.6 33. New York: Praeger.2 1994 42.1 1997 43. Ungki Lim. pp.4 1993 43. it appears that the chaebol families have had a strong desire to expand their business bases.7 9. C.5 34. 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. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. edited by K. Chung and H. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. the ownership patterns can be described as follows. the controlling families owned 8. Lee. As of 1997. The family and member companies’ shareholdings have been declining over time. 79-95. Lee. 1997.2 12.” In Korean Managerial Dynamics. 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. 6 7 Hattori. 1987 56. Table 2. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols.7 31.0 8. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. H. 1998.

is an example of this type. the family controls the group’s member companies by its own shareholdings. Vol. The Hanjin Group. Thus.” Here the family directly controls a base company and a nonprofit foundation. The Hanwha Group can be classified as such a company. which then make investments in the subsidiaries. The family itself holds shares in some subsidiaries. and subsidiaries’ equity participation. or merged into. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. there is no controlling shareholder. Hyundai Motors acquired Kia Motors via an international auction. The second (Type B). A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. subsidiaries have extensive investments in other subsidiaries. it had 18 listed and 39 private companies. The Kia Group was about the only management-controlled group but was out of existence by 1999. Investments between the lower level subsidiaries are rare.92 Corporate Governance and Finance in East Asia. and his management team exercised full control over the group without much interference from major investors. But the former chief executive officer (CEO). and business activities. One of the . The controlling family has sizable investments in two base companies and smaller investments in many others. holdings of the nonprofit foundation. The Hyundai Group exemplifies this. As of 1997. completely dissolved under financial distress. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. consisting of eight listed and 16 privately held firms as of 1997. Sun Hong Kim. Also. II The first (Type A) is called “direct family ownership. The two base companies have investments in three other base companies. which in turn hold shares in some of the other subsidiaries. The fourth type (Type D) is “management control. The third (Type C) is “indirect control via complex shareholding. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. Its controlling family holds shares in three base companies through which they exercise control over the other member firms.” shows a simple pyramidal structure. called the “indirect control via base company. Most of its member firms were acquired by. other firms. financial. For example. It consists of seven listed and 24 privately held firms.” Under this type of ownership pattern. investments made by the base 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. It remains to be seen whether they will adopt the holding company structure in the future. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol.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. thus hurting the shareholders of stronger firms. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. bankruptcy reorganization. Initially. 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. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. One condition requires that the DER of the holding company should not exceed 100 percent. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. The Government is also considering whether to allow consolidated taxation for pure holding companies. At this early stage. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. Until the end of 1998. Also. Existing guarantees had to be resolved by March 2000. These amendments prohibited holding companies and direct cross-shareholding. They hindered early exits (liquidation. This limit was also applicable to banks and insurance companies. . The prohibition of holding companies was also abolished in 1999. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. This was the reason why chaebols chose to employ pyramidal structures. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. only operating holding companies were allowed to be established. and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets. the Fair Trade Act). A third disallows multiple layering of holding companies.

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

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

Moreover. 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. However. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. 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. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. were supposed to be outside directors. almost all companies succeeded in adopting cumulative voting. However. companies have to disclose in their annual reports the frequency of board meetings. Further. other than the representative director(s). 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. members of the board. 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. 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 1998.96 Corporate Governance and Finance in East Asia. . cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. In the 1999 annual shareholders meetings. II When the Commercial Code first introduced the corporate board system in the 1960s. A few large companies had more than 50 directors. Despite the qualification requirements. 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. and their positions (accept or reject) on matters voted on in board meetings. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. the 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. In order to address this concern. the attendance rate of outside directors. Vol. With the boards consisting only of insiders. all of whom were managers. Recent Reform Efforts on the Board System In 1997.

Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. and a nominating committee. The controlling shareholder of some banks is the Government. On average.4 directors. In September of the same year. a blue-ribbon committee. although some banks recently have established board committees. Meanwhile. an audit committee. In March 1999. Where the two were separate. Among others. This is because most banks. The average board had 8. 88 percent had plans to hold elections in the near future. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange.1 percent of outstanding shares of a listed company. Among the firms with no outside directors. the Korean Code recommends that large listed firms should have at least three independent directors. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. having no controlling shareholders. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. who would comprise at least 50 percent of the boards. Where the chairperson was not the CEO.9 percent on average. the chairperson of the board was also the CEO and on average held 10. In 78 percent of the responding firms.1 percent and outside directors 1. are required to have a majority of outside directors. he or she held 6. they had a parent/child relationship in 20 percent of the cases. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer).5 percent of the shares. this committee adopted the Code of Best Practice in Corporate Governance. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms. These results are in accordance with the new listing rules introduced in 1998.2 percent and the CEO 14. inside directors owned 16. which had extended financial support in their recent recapitalization efforts. the Corporate Governance Reform Committee. Directors were also chosen on the basis of their relationship with the controlling .

among the 81 sample firms. in some firms. The board or the management then determines compensation packages for individual directors. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. In 13 percent. These were established only recently. However. the board had a nomination and an audit committee. II shareholder (30 percent). Most frequently. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. the package for the chairperson is directly proposed at the annual shareholders meeting either by the board (31 percent of the firms) or by the management (9 percent). a total of 562 directors were sitting on two or more corporate boards. The current chairperson has been in office for 6. About five directors per firm have been in office for more than one term. In 1997. relationship with controlling shareholders (21 percent). As discussed earlier. 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 management determines the remuneration. Vol. Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. in 23 percent. The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). and fixed fees plus performance-related pay. In some instances. and shareholding (10 percent).98 Corporate Governance and Finance in East Asia. In a very small number of firms. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. the management nominated director candidates (64 percent of the directors). According to the Commercial Code. the board had no committees. . In 91 percent of the sample firms. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms). the term of appointment of directors and board chairpersons is three years.2 years on average. founders of the company acted as the chairperson (22 percent). In one case. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. including stock options. Less frequently. one person was sitting on nine boards and this person was the CEO of a chaebol firm. This rather long tenure must be due to their status as controlling shareholders in most firms. In most firms.

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

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

The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. they also have the power and duty to monitor the activities of executive directors. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. The new rules also require financial institutions to recognize realized losses and allowances for potential losses arising from guarantees in the current year’s financial statements. Consolidated reporting was introduced before the outbreak of the crisis. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. Thus. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. but 49 percent confessed that they have not followed international standards at all. Notwithstanding a regulation limiting the votes of the largest shareholder to a maximum of 3 percent of the outstanding voting rights in selecting an internal auditor. Only 10 percent of the respondents have followed all international accounting standards. 41 percent of the companies believed that they have followed some international accounting standards. The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC. In the ADB survey. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. Under the Commercial Code. the internal auditor is considered to be a subordinate of the . Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. 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. In practice. however.

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

However. This shows that a relatively larger number of shareholders send in their proxies.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. small shareholders do not attend the annual meeting and that. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding.21 percent of total shares issued.79 percent of the shareholders. for some firms. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). charter amendments. The management is the most important proxy. Under the Commercial Code. These voters represented only 5. 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.” Companies can increase the number .93 percent of the shareholders but 26. The securities companies and banks are the second and third.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. representing 62. About one fifth of the listed firms issued nonvoting preferred shares. A total of 326 shareholders per firm. amendments of the articles of incorporation require a “special resolution. corporations cannot issue common shares without voting rights. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. the Depository is instrumental in getting resolutions passed. The Depository represented 20 percent of the shares attending the meetings.77 percent of the shares. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. No companies have so far introduced voting by mail.53 percent of the total shareholdings. the Depository is subject to “shadow voting. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. One common share should have one vote. or 10. However. in general.Chapter 2: Korea 103 2. or telephone. attended the last annual general meeting. The above results indicate that. respectively.3. Internet. Approval of mergers and major divestitures. 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. and dismissal of directors and internal auditors require a “special resolution.” The survey shows that the Korea Securities Depository holds 69. Thus.

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

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

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

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

In this connection. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. The new ways through which creditors. are summarized below.3. major creditors. Second. the Korean Government maintained a policy of protecting the incumbent management of listed companies. 2 percent by holding companies. Under a contract signed between the creditors and the debtor. Role of Creditors in the Corporate Restructuring Process In the current process of business restructuring and workouts of an unprecedented number of firms under financial distress.108 Corporate Governance and Finance in East Asia. including commercial and merchant banks. the delegation has the right to approve wide-ranging financial activities of the firm. and in continued monitoring of debtors. Separate from but emulating the CRA. have been the driving forces for restructuring activities of the largest 64 chaebols. First. banks and other institutional lenders are playing more important roles than ever before. will get involved in the restructuring and workout processes. In cases where the creditors are unable to reach an agreement on a workout plan. Behind these new strengthened roles of creditors is the newly set-up FSC. Vol. especially banks. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. 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 . This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. II by other affiliated companies. This committee was set up in accordance with the provisions of the CRA. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. 4 percent by subsidiaries. and 1 percent by the Government. Third. 2. the main vehicle for implementing the workout concept (or the London Approach) is the Corporate Restructuring Agreement (CRA) signed by 210 financial institutions in July 1998.

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

Vol. Many of the takeover targets in the past did not have a controlling shareholder (group). are designated as public companies. Another reason is that many listed firms belong to chaebols. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. an electric power company. was newly listed. Charter amendments have also been employed by some firms to limit the maximum number of directors. The Government-owned listed companies. In 1998. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. As of the end of 1997. For the others. Currently the limit is 3 percent. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols.3. the limit will be eliminated when it is fully privatized in two years. Some had two or more large shareholders who had joint control of the firm but could not cooperate. 2. As of February 1999. and a bank had government ownership.110 Corporate Governance and Finance in East Asia. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. in which the Government still holds the largest ownership. In their charters. For the steel company. Hostile takeovers in Korea will be rare in the future. One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26. 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.7 percent on average as of the end of 1997 for nonfinancial listed firms). except for the banks. In 1999. 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.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. . Korea Telecom. 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. It is harder now to find such firms. a steel company. 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.

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

II shares of their companies through employee stock ownership plans. the management usually consults the union on major issues relating to the management. of which 2 percent were senior managers. Vol. operation. which were generally much lower than estimated values. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. Under another law enacted in 1972 to induce private companies to go public. In these firms.1 in 1997.654 employees per firm on average. Collective bargaining is. but 27 percent of them felt that it was strong. Two thirds of the respondents had an organized union. The typical collective bargaining agreement has a one-year duration. The union had no influence on the management in 17 percent of the firms. Local unions in the same industry have established industrial labor federations. employers are required to meet with representatives of labor unions at least once every three months. About half of these firms considered the influence of the union on the management of the company to be weak. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. 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. carried out at the enterprise level. In actuality. The relevant regulation was amended recently in order to facilitate voting by individual employees. Under the Capital Market Development Act of 1968. In 70 percent of the firms with organized unions.112 Corporate Governance and Finance in East Asia. and 2. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. they delegate their voting rights to plans’ representatives. union members account for 54 percent of the employees. At the national level. The percentage of shares held by the employee stock ownership plans in listed companies was 1. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices.5 in 1990. the council meetings have been superficial. and development of the company. Trade unions are organized on an enterprise basis. and 66 percent manual workers. In 1987.9 in 1980. 2. in principle. 32 percent technicians and professional staff. The respondents of the ADB survey had 2. Under the Labor Management Council Law. there are two federations of labor unions. .

Chapter 2: Korea 113

2.4 2.4.1

Corporate Financing7 Overview of the Financial System

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

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

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

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

Chapter 2: Korea 115

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

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

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

Chapter 2: Korea 117

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

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

25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. including all sources other than retained earnings. comprising internally generated capital (retained earnings. The SFR averaged 28. Equity capital represents the shareholders’ commitment to the business. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. particularly in the short term. and 1997.Chapter 2: Korea 119 and net capital transfers from the Government. It measures the degree of financing growth in total assets by additional debts. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent.25. This means that internal funds after dividend payment were insufficient to finance growth in total assets. Table 2. and allowances) and new equity capital. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. Financing Patterns of the Aggregate Corporate Sector Table 2.26 shows the four measures of corporate financing calculated from Table 2. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. In securities finance. but it remained less than 10 percent of total financing. The corporate sector used . was 71 percent during the period. Before 1988. Meanwhile. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. capital surplus.4 percent in the precrisis period 1988-1997. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). depreciation. particularly in the 1990s in response to the liberalization of the capital market. the corporate sector’s most important source of external finance was bank borrowings. In 1988 when the stock market boomed. financing by corporate bonds and CPs was more significant than by new equity. It measures the degree of financing growth in total assets by additional equity. the proportion of foreign borrowings in total finance rose steadily. depreciation. and government transfers. except for the stock market boom of 19871988. except in 1991. Securities finance became a more important source from 1988 onwards. 1994. 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. on average. The share of external financing. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets.

5 13.6 1.6) 5.7 1.1 3.7 71.1 (1.1 — — — — 12.4 0.8 8.5 9. .3 72.1 27.5 0.7 6.7 — — — — 9.5 16. Bank of Korea.6 0.0) 12. b Includes capital surplus.2 34.4 — 28.7 11.3) 15.2 1.4 8. and net capital transfers from the Government.8 1.7 32.7 15.7 8.6 9.3 — — — — 8.7 2.6 77.2 0.3 6.4 1.1) 4.6 8.9 73.1 3.2 2.1 72.4 15.1 0.4 2.6 11. 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.1 1.6 3. and Flow of Funds.6 (0.7 14.4 10.8 17.0 2.0 16.5 0.6 25.25 Flow of Funds of the Nonfinancial Corporate Sector.8 1.8 30.6 0.0 1.1 17.0 5.9 10.0 17.7 10.1 1.1 2.4 11.1 3.5 2.1 10. Bank of Korea.1 1.1) 6. Source: Understanding Flow of Fund Accounts.6 0.8 1.3 5.8 4.2 5.3 25.6 3.4 0.0 0.0 11.4 27.7 4.4 71.6 0.7 10.9 28.4 (0. 1988-1997 (percent) 1988 43.4 27.2 13.3 3.7 (0.3 3.6 4.0 3.2 — 28.8 1.3 1. 1994.4 3.3 10.8 -2.9 0.6 2.4 2.1 36.3 30.4 (2.1 23.8 1.0 9.9 2.1 — 27.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.0 3.7 14.9 72.5 16.4 21.2 26.0 22.3 1.2 14.6 5.8 (0.9 6.5 2.0 3.7 13.0 9.3 6.6 11.2 — — — — 9.7 2. which is the excess of current value over issue value of stock.6 4.7 12.5 0.8 — 26.4 27.3 6.3 16.2 15.4 1.1 2.9 38.3 2.0 70.2 13.2 6.6 14.0 0.8 15.6 10.9 9.0 10.6 9.0 1997 26.7 8.8 56.1 0.1 (0.7 73.1 8.4 2.8 0.Table 2.4 9.5 2.1 12.9 10.5 29. depreciation.5 2.1) 4.6 4.4) 13.3 1.7 1989 1990 1991 1992 1993 1994 1995 1996 22.2 (0.8 27.0 — — — — 8.7 10.2 10.7 2. a Includes retained earnings.7 4.9 34.7) 11.2 6.0 (0.3 27.3 — 30.6 9.7 1.7 7.4 2.3) 11.

Incremental financing from equity was 40. and IEFRs were declining.2 percent of the growth in total assets. Bank of Korea. . additional equity to finance 12. Source: Calculations from Understanding Flow of Fund Accounts.4 IEFR 63. On average.1 53. and the total debt ratio was much higher in 1996 and 1997 at 62.4 12.5 31.3 60.9 28. NEFR registered 20. higher than the aggregate 40.3 73.1 percent in 1988 during the stock market boom.8 percent of its total asset growth through debts.1 12.1 39.0 57.1 17.26 Financing Patterns of the Nonfinancial Corporate Sector.7 40.7 28. Across industry. In periods of high economic growth such as in 1988. Lower income diminished the industry’s equity position toward crisis year 1997.6 Excludes capital surplus.6 62.0 27.9 46. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.5 12.5 percent in 1997. IDFR reached 73.7 26.7 percent in 1997. but also continuously fell.4 37. respectively.3 11.4 percent. Bank of Korea.6 percent. 45. declining to 26.4 percent.3 percent in 1997.5 and 76. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.6 26. The balance.Chapter 2: Korea 121 Table 2. There were significant time trends.3 59.27).7 30. higher than the aggregate 28. the corporate sector relied heavily on external financing for its expansion.6 percent.3 12.7 40.7 40.0 42. Its IEFR and NEFR dropped to 23.2 37. an average of 59.2 percent of incremental asset growth was financed by equity.6 percent over the 10-year period. was financed by additional debts.5 68. respectively.8 62.8 10.6 percent and 1.4 NEFRa 20. NEFRs.2 IDFR 36.0 11.5 percent. average SFR was 37.9 percent by 1997 when net profit margins were negative.9 22.8 28. but plunged to 5.4 27. Manufacturing financed 54. in the manufacturing sector. It dropped to 28 percent the following year.0 5. 1994. and Flow of Funds.3 59. dropping to 26. While SFRs. SFR peaked at 44 percent.3 27.1 26.7 9. indicating a high financial risk position.9 60.4 percent (Table 2.

8 IEFR 65. and steam) and the transportation.2 percent in 1993.4 3.2 62. retail. Financing patterns of the wholesale. gas. and communication sector had relatively high incremental equity ratios.8 4.8 percent in crisis year 1997.8 50.6 53.7 37.4 47.0 57.9 IDFR 34.6 37. the proportion of short-term borrowings in total financing has been high.0 42.1 percent of total asset growth for the period. explaining partly the collapses of several construction companies in 1995. and hotels sector and realty/renting/business activities sector were similar.6 3. one year ahead of the other industries.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent) Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.6 4.0 3. On the other hand. this dropped further to 15. Vol.9 percent. In 1997.3 28.1 29. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. from 17.0 30.7 percent in 1996. then increased to 20.4 54. Table 2.2 5.2 3. Categorized according to company size.6 54.5 7. their average SFR was higher. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.and medium-sized firms.0 42.6 53.4 46. and fell to about 10 percent in 1997. and low total debt and short-term borrowing ratios. Since 1992. storage.122 Corporate Governance and Finance in East Asia.6 45. Since large firms were more profitable.6 37.6 62. the two sectors also had low equity financing ratios and high debt financing ratios.7 47.5 1.6 36. Total debt financed an average 74.5 76. Equity financed an average 25.2 . which decreased to 8.4 37.4 45.9 6.5 NEFRa 9.3 52.5 23.4 63.9 percent of asset growth. large firms showed more cyclical patterns in these financing ratios than small. II The construction industry showed the most cyclical pattern in annual asset growth.2 21.8 percent in 1990.7 37. the utilities (electricity.7 47. It had the highest average SFR in 1988 at 31.

3 (9.3 4.5 87.27 (Cont’d) Year SFRa NEFRa IDFR 53.5 20.7 1997 8.9 29.9 1.2 18.9 52.5 1.7 6.0 1990 50.7 53.5 70.9 15.1 4.5 12.9 20.3 7.2 3.5 76.2 25.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.3 57.4 IEFR 46.6 9.1 59.8 74.6 1997 29.9 1.7 78.1 Trasport. Household Goods.0 74.3 10.8 29. Storage.9 80.5 21.4 2.3 4.8 2.8 1994 15.9 30.0 4.7 80.8 1991 51.0 0.1 84.7 42.4 26.1 70.2 1995 16.1 66.0 60.6 4.7 1994 53.2 8.5 29.0 65.7 1989 26.8 76.2 5.4) 2.9 1989 63.8 70.0 10.3 84.2 20.2 29.9 1993 63. Hotels 1988 33.6 8.0 1990 12.8 25.0 82.9 9.5 23.9 1992 56.6 37.2 4.9 47.6 37.0 40.6 14.8 4.0 34.8 81.1 25.7 Wholesale/Retail Trade.4 62.2 74.2 23.2 10.4 1995 53.7 41.8 9. and Communication 1988 64.6 71.7 15.0 17.3 47.5 1993 22.9 Average 19.1 69.9 1.6 73.7 15.0 1992 24.4 28.6 2.1 19.5 62.5 1996 42.3 19.7 78.9 16.6 9.0 68.2 Average 53.8 54.6 8.0 .Table 2.7 7.3 21.9 2.2 70.9 33.0 3.6 7.1 1991 14.2 46.0 1.3 8.0 31.3 1996 16.

3 207.3 29.5 77.1 1993 55.7 69.8) 7.1 70.4 0 0 0 0 1.4 1.8 1990 19.6 7.0 0.8 36.9 28.9 65. The trend was reversed in 1996-1997.8 135. IEFR = incremental equity financing ratio.9 45.0 43.0 46.6 Real Estate.4 5.8 17.6 1995 17.0 1.3 81. however.1 0.4 1995 62.124 Corporate Governance and Finance in East Asia.8 Average 22.2 1992 18. SFR = self-financing ratio.9 57.9 64. Long.1 35. NEFR = new equity financing ratio. Gas.3 62.3 92.9 Average 75.9 IDFR 31. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.4 1994 72.and mediumscale firms.4 1996 45.7 1996 18.4 47.6 1. Financial Statement Analysis Yearbooks.1 1989 34.4 0.and short-term borrowings of these firms shot up in that period.1 34.0 56.7 14. and Steam Supply 1988 118.9 29.0 1997 24.0 79.3 Electricity.3 3. Source: Calculated using data from Bank of Korea. Vol.5 8.0 1992 51.0 0.1 54.0 33.3 85.27 (Cont’d) Year SFRa NEFRa 6.4 IEFR 69.6 1991 18.7 70. a Excludes capital surplus.8 1993 11.3 31. The large firms had a higher proportion of external financing in 1996-1997.5 22.1 42. Renting.0 (0.6 IDFR = incremental debt financing ratio.8) (35.7 37.2 63.6 1997 23.0 53.3 7.4) 3.0 67. when large firms had much lower equity financing ratios and higher debt financing ratios than small.7 18. . II Table 2.6 1989 118.1 71. Their average IEFR was also higher and IDFR smaller.7 1994 8.6 52.6 1990 82.4 (107.0 21.1 1991 56.4 7. and Business 1988 51.

the top 11-30 chaebols had the highest guarantees commitments at 207.8 percent of their total finance in 1997.8 percent. The proportion of their short-term financing averaged 72. about the same as that of the corporate sector as a whole. 91. but higher than that of listed companies.6 percent of total asset growth.9 percent. In 1997.5 percent and their total external financing.3 percent of their equity capital in 1997 (Table 2. External financing reached 94. 153.30). The chaebols’ drive to expand their empires resulted in heavy borrowings. and were large borrowers. . The largest borrowers were the top 11-30 chaebols. In 1997.2 percent. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. Financing Patterns of Chaebols For chaebols. All of the top 30 chaebols relied heavily on short-term borrowings.3 and 89.6 percent. for listed companies.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 2.4 percent.29). Group-member firms borrowed less. They were able to borrow easily from banks by issuing corporate bonds and CP. The average IEFR of the top 30 chaebols of 29. the lowest ratio of 58. The average IEFR and IDFR were 10. and using cross-payment guarantees among affiliated companies. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. and the top five chaebols.7 percent for all listed companies. and higher than that of listed companies (Table 2.5 percent is lower than that of the corporate sector in general. In 1996-1997.7 percent.7 percent. at an average 70. the average SFR was 28. compared with the entire corporate sector’s 35 percent and 65. Their shortterm borrowings accounted for 86.9 percent. respectively. Cross-payment guarantees have been declining since 1993 and reached 91. The debt financing ratio of listed companies was high since they relied more on external financing.1 percent of their equity capital. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially.28). the IDFR of listed companies increased to 93. the top 6-10 chaebols. compared with 89.

6 IEFR 42.2 23.6 1.2 10.4 1.5 2.8 22.9 7.3 IDFR 57. 1994-1998 (percent) SFRa IDFR 85. Source: Calculated using data of Seung No Choi. .9 NEFRa IEFR 14.1 93.3 5. Korea Federation of Industries.Table 2.28 Financing Patterns of Listed Companies.6 0.2 NEFRa 1.5 8.4 29.6 11.4 12. Largest Business Groups in Korea. 1994-1997 (percent) SFRa 41.4 38.5 2.4 88.8 76.1 1.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.5 91.3 86.8 89. Table 2.9 6.3 28.7 12.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.7 1.1 8.6 61.6 70.2 36. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.7 13.2 1.3 1.5 8.29 Financing Patterns of the Top 30 Chaebols.

the Government provided implicit guarantees on bank lending and large businesses. Further.9 — — — 1994 258. According to the ADB survey. . Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. Factors Influencing Corporate Financing Choices Until recently. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469.1 — — — 1995 161. Second. especially in the 1970s when real interest rates of bank loans were negative. the Korean economy was plagued with high inflation. Firms now prefer internal funds and new equity capital. and reserves and retained earnings.0 1997 91.30 Cross-Payment Guarantees of the Top 30 Chaebols.Chapter 2: Korea 127 Table 2.9 153. the Government applied high tax rates on net profits of corporations. in order of ranking. so that the firms engaged in lobbying to gain access to them.3 200.7 150. And fifth. There were several reasons for this. Few firms ranked loans from NBFIs as their first preference. Interest payments on debts were considered a loss when calculating taxes. more than half of bank loans were priority loans with low interest rates. and loans from NBFIs. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. bond issues. loans from banks.9 — — — 1996 105.0 207. Source: Fair Trade Commission and the Federation of Korean Industries. poor financial and corporate governance resulted in overlending by banks. and underdevelopment of the stock market. bond issues. Third. This change implies that firms now give more attention to financial risks. Financial institutions did not strictly screen their loan projects and monitor their debtors.1 — = not available. Korean firms preferred debt financing (bank and nonbank borrowings). First. company preferences in financing investment projects before the crisis were. Fourth. rights issues. and extended loans based on cross-payment guarantees. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees.3 64. These are followed by loans from banks. inefficient investment and excessive diversification of corporations.3 58.

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

the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period.2. . except in 19931995 when semiconductor prices were extraordinarily high. Table 2. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. the top five chaebols’ ratios were much higher. (i) In terms of total borrowings to total assets. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. But since 1992. The extremely high leverage and the ability of chaebols to survive for several years with huge debts are evidence of poor internal governance of both the corporate and financial institutions. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. 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. They were also higher than those of the top five chaebols until 1992.3. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. (ii) In terms of net income to total assets. but the ratios of independent firms were much lower. the top five chaebols and the top 6-70 chaebols had similar ratios. 1999).. as well as lax financial supervision (Nam et al. 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. These findings indicate that independent firms have had a lower leverage and performed better financially. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA).Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. (iv) In terms of EBITDA to total assets. However. Among the main findings were the following. They were also higher than those of the top five chaebols until 1991.13). except in 1991. Nam et al.

The degree of diversification of chaebols that fell into default. During 1985-1997. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. The differences in the degrees of diversification among the three groups are substantial. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. the degree of diversification was highest in the top five chaebols. Government intervention.130 Corporate Governance and Finance in East Asia. its profit rate declined. The diversification of the top five chaebols remained at about the same level within the period. The diversification of chaebols under workout was much lower than that of the top 6-30. court receivership. second highest in the top 6-30. larger research and development expenditure. rising nonperforming loans (NPLs) and falling . II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. debt guarantees for free. had easier access to credit than the top 31-72 chaebols. Indicators such as increasing debt-to-equity ratios. had a significant role.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. 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. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. Their subsidiaries. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. Vol. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. too. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997.31). In terms of the net profit margin (the ratio of net profits to sales revenue). except in the recession years of 1996-1997. however. 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. 2. and lowest in the top 3172 chaebols. Meanwhile. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. and easier access to cheap credit.

7 0.5) (1.2 1.3 3.9 0.6) 0.1 0.1) (1.3) 12.4) (6. p.6 1989 1.6 7.5 (0.4 0.1 2.8 0.5 1.8 1.0) (4. Court Receivership.6 0.2) 2.8) 1.3 1.8) 0.9 1.9 1.4) (1.7) (0.7 0.4) (1.4 0.7 (4.0 (7.9 (0.8) 0.3 0.4 1.7 — (0.1 0.0 1.7 2.8 1.9 0.2) (13.8) (37.5) (2.7 (1.1 (4.2) (0.1 0.2) (13.1 1.2 1.9 1.1 1.6) 0.8) (4.3) 0.2 (0.3 (3.6 1.1) (1. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.4) (4.8) (20.5 (6.4 1.3 0.2 1.5 4.6) (20.8) 0.6) (12.8 0.1) 0. 1998.5) (0.1 1.8) 1997 0.1 (0.0 1987 1.4 2.8) (1.5 (0.4 (0.3 (0.2 (0.6) (0.8 (0.6 (10.7 1.0 1992 1994 1.2 0. Beyond the Limit.9) 2.4) (2.2 1.6 1.11.1) — = not available.4 1.7 0.1 0.6 3.3 (0.8 3.2) 2.1 1.9) 2.0 (0.8 0.2) 0.0 1.3 (0.8) (11.5 1.1 (3.5) 0.5 (4.8) (3. Chung Ang University.3 1.4 (1.9 0.8 0. Background and Task of Structural Adjustment.0) 0.6 0.3 1.5 2.4 0.0 0.7 (0.1 1.3 1.4 (0.3) 0.6 0.3 0.7 0.8) 0.0) (0.3) (0.9 1.6 5.7 (0.4 (1.9) (1.7) (1.7 0.6 (0.1 (1.6 0.2) (4.7) (0.0 6.3 1.3) 0.1 0.7 1.2) 1.2 (0.5 1.3 1. Management Research Institute.0) (3.1 (4.2 1.4 1996 0.6) (12.7) 0.4) (1.8 1990 0.1 4.6) (0.3 1.2) (4.Table 2.5 1.6 0.8) (1.4) (0.7 1.0 4.9 0.9) 0.1) (5.31 Net Profit Margins of Chaebols.1) 1.5) (2.8 (0.2 (17.6) 0.5 (0.6) 0.3 1.6 (0.6 1.0 0.5 (0.0) 0.6 1.6 0.1) (2.3) 1.3) 0.1) 0.4 0.1 (9.9 8.3) (12.9) (8.3) 0.2 1995 3.8) 0.2 1.0 (2.7 0. .3 1.1 0.3 0.0) 0.5 1.3) (0.9) (9.9) 2.8 3.1 1.6 0.1) (6.0) (0.2) (0.2) (4.2) 1.3) 0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.2 (1.4 (0.7 1.5) (7.1 0.8) (0.2 4.6 0.3 (0.3) 1.8) 2. Source: Whan Whang.2 (0.2) (3.1 0.4 1.1 0.7 3.1) 2.1) 1.5 0.6 1.1) 2.3) 0.8 0.4 (1.3) (1.1 1.4 (2.3 1.3 0.8 (0.7) 0.2) 1.3 1.

2. internal auditors cannot be expected to perform their function independently of management. the controlling shareholder or CEO generally selects the internal auditor despite a legal provision limiting the votes of the largest shareholder to a maximum of 3 percent. a firm’s board of directors had the power to appoint an external auditor. But in 1998. Along with government policies to protect the status quo. 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. Now. after the crisis. the independence and objectivity of the external auditor were often questioned. Meanwhile. 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. and creditors should select (recommend) the external auditor.5. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system. outside directors. the boards of all listed companies were composed of insiders only. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. Thus. Thus. this has led to entrenched management. Ownership concentration also had ramifications on corporate transparency. . II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. Until 1997.132 Corporate Governance and Finance in East Asia. Moreover. and to the development of the market for corporate control. A remote trigger in the Thai crisis was all that took to push the economy over the edge. a committee composed of internal auditors.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. Vol. They were then almost automatically elected at the general shareholders meeting. Until 1997.

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

134 Corporate Governance and Finance in East Asia. II strong financial links among its member firms through investments and cross-guarantees. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. share issues. while (non-chaebol) independent firms had much lower borrowing ratios. and other individual markets. as the latter are well established in most business areas. 2. bond issues. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. Financing preferences changed drastically after the crisis.5.5. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. and a high degree of inefficiency in the economy. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. Further. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. 2.2 The Role of Government Intervention Strong government intervention in the early stages of economic development was useful for overcoming inefficiencies in financial and capital markets and for managing high investment risks. Vol. capital. However. Such problems may eventually cause ripples through the entire economy. and internal funds. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. the typical chaebol firm had an extremely high DER. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. financing choices of listed firms in order of preference were bank loans. As mentioned earlier. The Government’s supervision and regulation of financial institutions were poor. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. The new preference ordering is as .

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

The Government could hardly help them because of the number and magnitude of business failures. Doubtful loans are those for which interest is not received for six months or longer. and the pursuit of growth through excessive diversification and inefficient investment. It jumped to 17. and there is collateral. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. Before the crisis. The monthly number reached more than 3.000 during January-September of 1998. and there is no collateral. and shareholders’ equity of all industries. In 1997 they became negative. Vol. and returned to about 1. According to the “six months” definition. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices.000 from December 1997 to February 1998. starting 1 July 1998. excluding the financial sector. Further. These were the definitions until 30 June 1998.136 Corporate Governance and Finance in East Asia.000 in September 1998 (Table 2. the NPL ratio reached 7. nine out of the 30 top chaebols failed. especially chaebols.32). regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. However. decelerated from March 1998. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. has given rise to various types of self-dealings by the controlling shareholder. The banks and merchant banks lent to large businesses. . were low in 1996 and 1997.6 percent in June 1998. reaching highs of 6 percent in 1997 and 8. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. The inevitable result of inefficient investment was a fall in corporate profits. the NPL ratio of commercial banks increased rapidly from 4. Moreover. they are defined as loans for which interest payments are overdue by three months or more. Fixed loans are those for which interest is not received for six months or longer. Financial Sector Vulnerability Because of financial losses in the corporate sector.1 percent in 1996. and estimated losses. total assets. the NPL ratio8 of banks and other financial institutions began to increase.7 percent in 1997. then 20. the ratios of net profits to sales.200 in 1997. Meanwhile. without strictly evaluating the creditworthiness of businesses and the profitability of projects.000 per year starting 1992. Following the “three months” definition. legal and other barriers prevented the exit of financially nonviable firms. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. They utilized mutual payment guarantees among their affiliates and believed that they would never fail.

107 6.647 8.135 1.386 5.850 3. In 1990-1993. Compared to ROAs and ROEs of domestic branches of foreign banks. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents. This was mainly due to the high ratios of NPLs. Meanwhile.69 20. 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.985 Services 3.457 2.657 3.210 1.637 6.754 3.751 1. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.544 2.250 2. Source: Bank of Korea.Chapter 2: Korea 137 Table 2.33).China.589 171.890 4. 2.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September. As a result they had largely overvalued currencies.472 2.856 7. the ratio reached 7-8 percent.992 11.32 Number of Firms with Dishonored Checks. and declined to 4-6 percent in 1994-1996 (Table 2.979 8.265 6.5. those of domestic banks were lower in the 1990s. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.673 Construction 380 354 242 195 294 585 1.573 3. European countries. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.027 Manufacturing 1.859 3.502 11.238 4.769 9. and Taipei.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.259 2. The current account deficits in terms .159 10.053 5.759 6.244 3. and continuous and large current account deficits.114 811 706 696 866 1.255 13.133 3.517 2. This speculation was said to be one of the causes of the financial crisis in Korea. low efficiency. and large government-directed loans.553 3.855 6.131 1.

which led to large corporate losses. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.170 1.537 10.192 Doubtful (B)b 952 1.584 2. and 30 percent in 1996.562 18.6 percent (1995).1 percent (1995).2 4. In addition to the overvaluation of the won. the ratio of short-term debt to foreign reserves was very high.221 8. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997. II Table 2.652 29.584 Fixed (A)a 5.910 1.1 6.8 percent (1996).1 7.954 9.116 1.138 Corporate Governance and Finance in East Asia.176 7. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.China.649 375. of percentage of GDP were as follows: Malaysia -8. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.739 241.0 7. Korea -4.China. .520 194.832 337.6 percent (1995). Source: Bank of Korea.556 118. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.705 160. Related to this.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.077 NPL Ratio (%) 8. Meanwhile large businesses could not legally lay off workers. and Indonesia -3. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer. In 1997.0 8.600 10.929 11.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.310 6. Land prices and real estate rents were also high compared to trading partners.484 11. Businesses served as a social safety net.475 143. even in times of economic slowdown. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.160 11. Thailand -8.190 9.266 10.33 Nonperforming Loans of General Banks.390 12. Mass layoffs became legally possible only after the economic crisis.0 7.8 5.639 1. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.4 5. although per capita income in Korea was much lower.874 22. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei. Vol.736 8.430 12.827 289. because of the rigid labor market.997 9.

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

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

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

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

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

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

As for promotion. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. have been instituted for FDI: . 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. beginning on 1 April 1999. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. which was passed in August 1998. including financial subsidization. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. In addition. including tax exemptions and reductions. either partially or fully. and (viii) as of 1 April 1998. 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. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. 21 industries were further liberalized or newly opened to FDI (now. 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. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. an additional nine industries will be opened or further liberalized. (v) by the end of May 1999. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. These new standards are and will continue to be strictly enforced. 514 listed companies had appointed 677 outside directors). various supporting measures. Capital Market Liberalization Since 1998. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. (vii) by the end of March 1998. only 31 out of 1. (iv) during April and May 1998. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. administrative procedures for FDI will be dramatically simplified and made transparent. According to the law. financial institutions could no longer require cross-debt guarantees.Chapter 2: Korea 145 (as of the end of May 1998.148 industries remain closed. to FDI).

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

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

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

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

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

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

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

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

Whan. S. Ungki. KIEP Working Paper 98-05. Seoul. Corporate Governance in Korea. H. 1999. Lee. Yim. Real Exchange Rate and Policy Measures.. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Kim. 1996. K. J. 1998. Lim. I. March 1999. Yang. . Kim. Nam. H. 1999. C. 1998. October 1998. I. Background and Task of Structural Adjustment. J. K. Y. Y. K. Chicago. Conference on Corporate Governance in Asia: A Comparative Perspective. October 1998. Korea Finance Institute. Business Groups in Korea: Characteristics and Government Policy. January 1995. Korea Institute for Industrial Economics and Trade. Vol. J. Beyond the Limit. A New Trade and Industrial Policy in the Globalization of Korea. Korea Institute for International Economic Policy. S. Yonsei University. Whang. 23.154 Corporate Governance and Finance in East Asia. Kang. Joh. II Lee. Ministry of Finance and Economy. Ungki. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. and H. Korea’s Economic Progress Report. Korea Institute for International Economics and Trade. Chung Ang University. Sohn. Management Research Institute. 1998. and J. Annual Conference of Financial Management Association. Korea Development Institute and World Bank. and J. S. Lee.. 2nd Sangnam Forum. September 1998. 1996. Wang. November 1996. W.. C. U. Korea’s Trade and Industrial Policies: 1948-1998. S. Capital Liberalization. 1998. 1995. KIET Occasional Paper No. Y. Lim.

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

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

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

2 During 1988-1997.3 9. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.2 Korea.2 (0.5 percent per year (Table 3.2 7. net sales of the top 1.9 6. This rate of growth was sustained by a comparable 18.8 10.1 5.2 Thailand 11.1 8.5) 3. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.1 GDP Growth of Southeast Asian Countries.9 7.5 (7.3 9.0 8.5 8. Vol.000 Corporations covers financial and nonfinancial companies.1).2 9. Its growth rate began to catch up with others in 1996. Table 3.7 (13.0 (6.9 (1.0 8.4 Philippines 3.1 4. 3.2) 0.000 Philippine companies grew 17. In this section.8 5.3 8.7 8.7 5. Key Indicators of Developing Asian and Pacific Countries 2000.3 2. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.2.2 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 1.9 5.2). only nonfinancial companies were used. .5 9.000 corporations.2 7. however.5) 5. which was taken as a representation of the Philippine corporate sector.8 8. Rep.8 5.4 4.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.2 Source: ADB. II market. With economic reforms introduced in the 1980s and 1990s. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context.6 7.7) (10. of 9.0 (0.8 4.1 5.2) 4.6) 0. only to be unsettled by the crisis of 1997.7 Malaysia 9.7) 10.2 8.8 8.158 Corporate Governance and Finance in East Asia.0 7.5 8.3 7.

5 508.697.4 411.5 887 0.4 1.000 Corporations in the Philippines. net profit margin = net income/net sales.978.2 Compound Growth (%) 17.9 629.8 22.4 188.191.1 468.8 902 1.1 51.1 33.5 1.3 862.1 73 5.7 218.9 1.0 148.5 14.561.1 714.8 26.893.7 20.3 121 12.2 2.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.317.8 4.9 78 6.225.3 46.7 443.8 618.1 615.4 602.2 4.2 27.9 2.1 6.0 1.8 411.131.5 51 4.781. return on assets (ROA) = net income/total assets.6 35.6 102 16.1 1.5 193.6 109 12.9 149 6.6 149 12.4 898 1.3 68 7.3 941. return on equity (ROE) = net income/ stockholders’ equity.5 64.8 6.1 4.4 260.4 63.1 197 14.4 861.0 900 1.2 1.2 2.8 77 7.7 73 6.6 954.2 136.6 144.8 5. turnover = net sales/total assets.1 54 11.177.9 898 1.7 28.7 1.5 570.160.9 896 2.5 Leverage = total liabilities/stockholders’ equity.4 555.1 95.647.1 1.9 3.9 617.3 898 1.123.394.332.2 900.0 1.5 1.512.9 96.6 1990 1991 1992 1993 1994 1995 1996 1997 1.1 181 11.5 446.6 896 0.9 480.6 75 6. .3 382.1 66 12.6 1.3 306.6 18.6 290. of Companies Sales per Company (P billion) 899 0. Source: SEC-BusinessWorld Annual Survey of Top 1.5 72 7.3 107 13.000 Companies.2 Average 146 12.4 776.4 3.1 5.4 8.341.5 4.7 903 0.Table 3.2 Growth and Financial Performance of the Top 1.5 119 12.3 60 10.6 900 1.2 338.2 378.1 Other Indicators No.5 1.5 192.209.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14. 1988-1997 1989 519.1 72.7 1.6 5.6 426.2 707.7 238.1 881.8 741.9 952.

000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.8 19.160 Corporate Governance and Finance in East Asia. . indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. Asset growth was funded by debt that grew at an average of 20. and the SEC-BusinessWorld Annual Survey of Top 1.474 1.394 1.4 24.1 19.8 percent per year.352 1. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997. Return on equity (ROE) and return on assets (ROA) averaged 12. for the 10-year period.3 The Corporate Sector and Gross Domestic Product.427 13.8 17. and by equity that grew at a higher average annual rate of 26.5 17. Vol.4 20. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.2 percent. Sources: ADB.9 percent for the period. II assets. These rates of return are high compared with other Asian countries. Assuming Table 3. Total assets grew at an average annual rate of 22.979 17. Key Indicators of Developing Asian and Pacific Countries 1999. 1988-1997 Top 1.178 1.9 21.1 Net Sales (P billion) 465 519 630 741 862 954 1.000 Corporations in the Philippines.5 Value-added is assumed to be 30 percent of net sales. respectively.5 16. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.693 1. but the extent of the increase was not as dramatic as in other Asian countries.000 companies averaged 7.697 1. Net profit margins for the top 1.172 2.906 2.248 1. This is high compared with developed countries but compares favorably with other Asian countries.9 23.3 percent. Further.077 1. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3.3). leverage increased from 109 percent in 1996 to 149 percent in 1997.7 percent.6 percent and 5.5 Ratio of Estimated Value Addeda to GDP (%) 17. various years.

1 22 10. Averaging 42.4 190 5.0 5.3 9.1 Financial Ratios (%) Leverage 89 ROE 15. %) 17. The foreign-owned companies were the Table 3. .000 Corporations in the Philippines.3 22.7 22.4 Stockholders’ Equity 32.4 Fixed Assets 19. of Companies 73 Sales per Company (P billion) 2.5 GovernmentOwned 4.3 42.3 27.0 31.4 Total Liabilities 26.5 27. various years.8 3.5 Retained Earnings 30.3 22.8 percent of the corporate sector’s total sales between 1988 and 1997.2 9.9 22.1 ROA 8.3 146 6. privately owned companies constituted the largest group (Table 3. these figures suggest a significant and increasing contribution of the corporate sector to GDP.Chapter 3: Philippines 161 a constant ratio of value added to sales.0 4.8 ForeignOwned 21.5 Other Indicators Share of Sales (%) 17. size.8 606 0. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.1 12.6 Total Assets 29.4 Growth and Financial Performance of the Corporate Sector by Ownership Type. (iii) Government-owned.3 11.9 17.8 Growth Indicators (Compound Annual Growth Net Sales 20.9 26.0 28. 1988-1997 Indicators Publicly Listed Privately Owned Rate.9 196 1.5 23 4. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. corporate control structure. The premise is that these variables have a direct bearing on corporate performance and growth. and (iv) privately owned.8 14.0 Turnover 53 Net Profit Margin 15.7 2.9 158 13.0 5.4 28.8 No.4).0 Net Income 19. A study of company performance by ownership type. (ii) foreign-owned.2 103 5.8 22.8 2.0 142 22.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.

these companies were comparatively large. were among the top 1. while there were few of them. Vol.75 billion per company for foreign-owned companies.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. but lower than those of foreignowned and publicly listed companies. and the second lowest asset turnover. The government-owned companies had the highest leverage at 190 percent but lowest ROA and ROE because these are primarily public utilities and companies in the energy sector where turnover is low. a level high by Western standards but at par with those of other Asian countries. Publicly listed companies had a minor though steadily increasing share in total sales. Governmentowned companies in the top 1. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. The compound annual sales growth rate was 21. However. with an average ROE of 22. With an average leverage ratio of 142 percent.000 companies in 1997. These were mostly large public utilities. . followed by publicly listed ones. Bases Conversion Development Authority. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. 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.2 percent and ROA of 9.5 percent. meaning that the remaining 62 percent were relatively small in sales and assets.5 percent average growth rate of the entire corporate sector. foreign-owned companies borrowed more than publicly listed ones. although small in number.162 Corporate Governance and Finance in East Asia. and low return on investment is the norm. the highest net profit margin of 15. Privately-owned and Government-owned companies grew at slower rates. exceeding the 17. Their ROA and ROE were both more than twice as high as those of government-owned companies. Publicly listed companies had the lowest leverage at 89 percent. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income.000 list. II second largest at about 27. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). But by being most efficient in employing assets. the asset base is large.3 percent.1 billion per company in 1997. they generated the highest return on investments. compared with P2. the second best ROE and ROA. or 38 percent.9 percent. registered the largest per company sales at about P9 billion in 1997. selling an average of P4. The privately-owned companies had a high average leverage ratio of 158 percent.

various years.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. the corporate sector is divided into large.7 Total Assets 32. %) Net Sales 20.6 715 0.8 Growth Indicators (Compound Annual Growth Rate.3 Total Liabilities 30.7 2.0 166 15.2 Fixed Assets 25. and small companies. grew faster. compared with 32.3 No.3 Other Indicators Share in Sales (%) 32.8 6.8 ROA 8.6 26. But the conglomerates were larger measured in sales per company. Table 3.3 percent for the conglomerates.Chapter 3: Philippines 163 Performance by Control Structure By control structure.0 22.1 124 5.7 Stockholders’ Equity 34. Performance by Firm Size By firm size.3 Financial Ratios (%) Leverage 98 ROE 15.2 Net Income 21. depending on assets and sales.4 24.0 25. 1988-1997 Indicators Group Member Independent 18. Sales and resources of the .2 23.1 Source: SEC-BusinessWorld Annual Survey of Top 1. and achieved higher returns on invested assets than independent companies (Table 3.5).000 Corporations in the Philippines. had a lower leverage ratio.1 Retained Earnings 32. of Company 159 Sales per Company (P billion) 2.0 Turnover 67 Net Profit Margin 12. a company can be a member of a conglomerate or independent. medium.0 55.

4 28.9 Financial Ratios (%) Leverage 158 ROE 13. of Companies 79 Sales per Company (P billion) 7. Medium-sized companies also performed better in terms of ROE.000 list. averaged only P920 million in per company sales during the same year.6 36.6 47.9 32.1 ROA 5. 1988-1997 Indicators Large Medium 19. II Philippine corporate sector are highly concentrated among the large companies.5 12. Vol. %) Net Sales 15. indicating that they deployed resources more efficiently than large and small companies.8 percent of the total number of companies in the list (Table 3.6 Small 19.4 Total Liabilities 18.2 Stockholders’ Equity 18. defined in this study as the next 200 largest companies in the top 1. averaged a far less P3 billion in per company sales. for this study. sales of mediumsized companies grew faster than large companies.1 81 9.6).0 156 16.9 89 1.9 26.6 49. various years.0 730 0. . Table 3.000 list. However.9 Retained Earnings 13.5 73 6. are defined as the largest 100 companies in the top 1. Medium-sized companies. Large companies accounted for 56. Sales per company in this group averaged P13.164 Corporate Governance and Finance in East Asia.000 Corporations in the Philippines.5 Total Assets 18. while small companies.7 Net Income 1.3 Turnover 65 Net Profit Margin 8.3 Fixed Assets 15.1 25.3 Source: SEC-BusinessWorld Annual Survey of Top 1.5 Growth Indicators (Compound Annual Growth Rate.0 7.6 Growth and Financial Performance of the Corporate Sector by Firm Size.1 No. averaging 16 percent.6 31.2 Other Indicators Share in Sales (%) 56. which.5 128 10. although they comprised only 8. referring to the remaining companies in the list.2 25.7 44.0 32.1 4.2 29.1 percent of the total sales of the corporate sector.4 billion in 1997.5 25.

6 percent.4 percent in 1997 from 11. unlike their counterparts in other Asian countries. net income.Chapter 3: Philippines 165 Small companies. averaging 10.e. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. i. Performance by Industry This study also looked at corporate performance by industry. The Asian financial crisis affected large companies most severely. Net income declined from P54. and assets was much higher for the real estate and property. Growth of sales.8 billion in . at 156 percent.2 percent for large ones. and the construction sectors than for the manufacturing. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets.5 percent for medium-sized companies and 8.8 percent. Sales revenue and net income declined from P76. net income. are shown in Table 3. The sector showed consistent growth in sales. as indicated by the negative annual growth. Large.7 percent in 1997 for medium-sized companies. of net income. specifically those industries least and most affected by the financial crisis.7 billion and P35. and construction. and equity up to 1996. manufacturing. profits. utilities.1 billion in 1996 to P4. and utilities and services sectors. at 158 percent on average during 1988-1997. The growth and financial performance of selected industries. at 128 percent for the period.7 percent in 1996 to 8. although the largest in number. but suffered its largest decline in net profits in 1997. and profitability in 1997 when the crisis started.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. Mediumsized companies’ leverage level was slightly lower. with their ROE dropping to 3. 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. real estate. but lower than that of construction. The real estate and property sector also suffered significantly in sales.8 the previous year.1 percent. showed the lowest ROE.. Leverage was the highest for large companies. assets. For small companies.7 percent a year earlier. compared with 9. at -12. and utilities and services sectors. from 14. ROE dropped from 10. Poor returns appear to have been caused by the low profit margin at 6. reflecting to some extent a “bubble” phenomena in the former two sectors.2 billion in 1997 for this sector. But small companies’ leverage was significantly lower.8 percent in 1997. especially during the period 1994-1996.7. ROE dropped to 7.

8 48.2 12. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.3 20.2 28 0.9 23.6 Growth Indicators (Compound Annual Growth Rate. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.8 Stockholders’ Equity 21.7 192 9.3 55.9 17.5 Other Indicators Share in Sales (%) 82.4 3. 1988-1997 Utilities Real Estate and and Services Property 39.8 41.7 Net Income (12.1 24 42.7 10. it does not appear to have been excessively exposed to foreign currency-denominated loans.4 percent. of Company 454 17 Sales per Company (P billion) 1.7 billion in 1997. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.4 16. Vol. respectively. .9 2.166 Corporate Governance and Finance in East Asia. and was also much more limited compared with the property sectors in other Asian countries.7 ROA 5. 1996 to P56.4 19.000 Corporations in the Philippines.4 Source: SEC-BusinessWorld Annual Survey of Top 1.4 Total Assets 19.2 37.7 83 2.0 25.7 Indicators Manufacturing Construction 27. II Table 3.0 31 0. As a result.6 Total Liabilities 18.3 Fixed Assets 20.6 Financial Ratios (%) Leverage 142 181 ROE 13. the sector’s ROE dropped from 15.8) 17.3 5.2 45.0 23.9 2.6 69 16.7 52.7 Growth and Financial Performance of the Corporate Sector by Industry. various years.7 percent to 10.2 8.3 Retained Earnings 17.9 billion and P24.5 12.1 2.0 21.1 10.0 Turnover 112 24 Net Profit Margin 5.9 5.6 No.7 19.7 28.000 companies’ total sales on average during 19881997. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis. %) Net Sales 16.

3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. 3.2. Two other pertinent laws are Presidential Decree (PD) 902-A. For publicly listed companies. and dissolution of corporations. the Corporation Code of 1980 is a compilation of important juridical rulings. It provides the basic constitutional structure for the organization. reaching up to 313 percent in 1997. and the Insolvency Law. which regulates banks and nonbank financial institutions except insurance companies. which was based on American corporate law. contains some provisions affecting corporations’ dealings with banks. and amount of authorized capital stock. (iv) term of existence. and restrictions. 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. and residences of incorporators and directors. unlike in neighboring countries hit by the Asian crisis. nationalities. It specifies the minimum information to be indicated in the articles of incorporation. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. The articles of incorporation may also include other matters such as waiver of preemptive right and classes of shares such as founders’ or redeemable shares describing their rights.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. privileges.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. administrative regulations. The General Banking Law. which is also the organic law governing the operations of SEC. and (viii) names. and residences of original subscribers. par value. . the leverage of all four industries was low. (vi) names. operation. (vii) number. (ii) purpose of the corporation. Under the Code. Overall. (v) number of directors (not less than five nor more than 15). (iii) principal office. and recognized rules on corporate practices. nationalities. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. The currency devaluation bloated the foreign currency-denominated loans of these companies. and amount subscribed and paid by each. One month after registration.

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

Chapter 3: Philippines 169

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

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

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

Chapter 3: Philippines 171

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

3.3 3.3.1

Corporate Ownership and Control Patterns of Corporate Ownership

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

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

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


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

Chapter 3: Philippines 173

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

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

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

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

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

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

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

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

4 1.7 0.2 3.0 1.2 1.9 52.0 0.3 26.5 12.5 0.8 66. and Other Services Property Mining Oil Average Shareholdinga 33.3 0. Distribution.0 0.1 8.1 a Weighted by market capitalization.3 37. and Tobacco Holding Companies Manufacturing.8 21.0 1.5 26.3 0.6 0.6 2.4 2.1 7.7 0.2 59.0 10.8 0.7 3.9 36.8 0.2 0.3 2.8 11.0 0.3 0.0 2.0 0. .0 0. and Trading Hotel.0 5.2 10.4 19.3 1.5 4.0 0.1 1.2 0.Table 3.0 2.0 5.1 0.9 6.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. Source: PSE Databank.6 0.6 0.7 1.0 0.0 0.3 0.0 0. Beverage.7 0.0 0.4 0.2 0.9 0.2 5.4 5.0 1.3 1.0 1.1 0.2 3.4 8.6 0.7 3.5 53.0 0.0 1.0 5.0 1.2 0.5 2.0 0.0 0.6 33.5 4.6 0.7 0.1 5.7 0.2 0.6 9.3 12. 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.9 0.5 13.0 1.7 0.3 0.0 1.0 4.5 0. Recreation.0 0.0 7.2 3.6 1.6 5.3 5.6 2.2 3.3 5.0 45.6 0.0 5.6 18.6 0.0 0.1 9.6 12.1 6.4 29.8 0.7 67.

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. As a group. . securities brokers (1.1 percent). accounting for P258. Investment trust funds were the most important institutional investors. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. 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. financial institutions did not have a significant ownership in nonfinancial corporations. Because of limited ownership by institutional investors. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. The investment funds’ presence in these sectors ranged from 8. and insurance companies (0. while still allowing the public to own minority shares. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. Holding companies were themselves 66 percent owned by other nonfinancial corporations. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.1 percent).6 percent of market capitalization in 1997.Chapter 3: Philippines 177 companies and share in the risks and profits of the group.7 percent of shareholdings).7 percent of market capitalization of the nonfinancial publicly listed companies. respectively. and San Miguel Corporation (SMC) in food and beverages. commercial banks (1.5 to 12. Such advantages have contributed to the popularity of holding companies among publicly listed companies. They can also better manage their income taxes because income from affiliated companies passes through a holding company.3 percent). Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. 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.2 percent in 1997. Holding companies as a sector had the largest market capitalization in PSE in 1997. with an average of only 7.6 billion or 26. The 7. Petron and MERALCO in power and energy. there was no real market for investment information.

suggesting that most publicly listed companies are parts of business groups. 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. .7 6 7 The study used publicly available shareholder information and published reports. Commercial banks hold the largest share. 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.4 percent of the top 1. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. To understand the ownership and governance characteristics of family-owned business groups. identified the companies belonging to each of these groups. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks.000 companies. but they comprised only 23. However. the study put together a list of prominent business groups. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. This is significant considering that there were only 31 local commercial banks in the country in 1997. Still.178 Corporate Governance and Finance in East Asia. For this reason. Vol.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. Some 20 financial institutions were affiliated with these groups. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. Prudential regulations. including 16 commercial banks. Large shareholders and their families own these banks directly or through their controlled companies. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector.8 percent of total companies in number.11). about three fourths. and increased the capital requirements for all types of banks. so far limiting their involvement to selected products. The Central Bank deregulated interest rates and foreign exchange. Corporate financing depends on intermediation by banks. many companies in family-owned groups are not publicly listed. using data on the Philippines’ top 1. Family-based groups have larger companies since their total sales were about 33.000 Corporations in the Philippines. remain in force to control excessive lending of banks to insiders. and tracked the financial performance of each company from 1992 to 1997.000 corporations’ sales. suggesting that business groups are common in all major markets. A common feature of corporate ownership of a business group is the centrality of a commercial bank. including SBL and DOSRI rules. of the financial resources in the country. 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.

a substantial proportion of group profits came from its financial subsidiaries. 25 out of the 50 top corporate entities were familybased groups. In terms of number of companies. the top 10 family-based business groups had only 119 companies in the top 1. The main constraint may be the availability of family members that could be drawn for top management positions.12). which was majority-owned by the Henry Sy group. Cojuangco. Gokongwei. It is also noteworthy that. and Ayala. the study used the four largest business groups—Ayala.000 corporations in 1997. broadcasting (49. retail merchandising (69. Lopez. Together. or an average of about 12 per group. with 27 affiliated companies in the top 1. To show this. the nonfinancial sector was real estate (60. the biggest private company in the Philippines. for the Gokongwei Group. an average group in the Philippines has fewer member companies. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities.6 percent of the total sales of the top 1. the three largest entities were family-based groups. the principal owner of SMC. for the Lopez group. and more than 20 percent for the Lopez group and Henry Sy group. Interlocking Relationship between Financial and Nonfinancial Firms Although financial institutions as a whole did not own directly significant proportions of shares of nonfinancal corporations in the Philippines. These corporate entities accounted for 53. it was manufacturing (36. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. and for the Henry Sy group. For the Ayala group. In terms of sales. Significantly.8 percent).000 companies.1 percent). as discussed in previous sections. the largest was the Eduardo Cojuangco group. in most . In 1997. with the exception of Banco de Oro. construction. the largest family-based business group was the Ayala Corporation Group. for each of these groups. Foreign-owned companies mainly serve the export markets. including business groups and independent companies. the two were closely related through their affiliations to business groups. Commercial banks are often affiliated to a particular business group. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. namely. real estate. Lopez. Family-based business groups are most dominant in sectors such as manufacturing.Chapter 3: Philippines 179 Compared with other Asian countries. ranged according to their sales (Table 3. In the meantime. Also. and banking.4 percent of the group’s 1997 profits).2 percent).000. and Henry Sy—as examples.

beverages. of Affiliated Companies Total Sales (P billion) 123. 10. and packaging Power distribution and mass communications Real estate.6 2. 5. 4.3 11. 16.3 3. Beverages.5 26. 7. 9.6 3.4 . and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines.6 7.1 4. beverages.0 5.0 13.9 2.4 6.1 2. and food Food. and Affiliated Bank of Selected Business Groups. 8.7 98.1 4. Flagship Company.5 47. food. Real estate.5 2. telecom. Sector Orientation. 14. and mining Management.2 1.0 Average Sales Per Company (P billion) 6.4 10.4 48. and tourism Credit card 18.5 46.5 49. 17.3 2.8 84. 3.3 15. food. Consunji 4 3 Food and dairy products Construction and mining 10.0 17.0 26. construction. 13. power.5 17. and personal care prods Shipping. and dairy products Investments. real estate.2 16. Eduardo Cojuangco Lopez Family Group Ayala Corp. agriculture. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.11 Total and Per Company Sales.2 1. 11.6 3. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M. 6.5 13.Table 3. coconut oil.5 44.9 3.5 6. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. 15. 2.

0 1.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.7 1.9 6. Ramos Gaisano Family Group Felipe Yap Felipe F.0 5.0 2.1 2.4 5. 33.9 1. 39.7 4. 35. mining. 37.2 4. 29.1 0. SEC-BusinessWorld Annual Survey of Top 1.7 0. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore.5 8. 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. 32.1 1. .2 6.4 1.9 7.6 0.8 1.3 2.5 2.3 2.19.3 7.9 1.8 6.2 1. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 20. 31. and various company annual reports.6 2. 23.0 0. 26.9 0.9 1. P. 38.7 0. 21. distribution. 22. 30.8 1. 36.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 24.1 1. 4 238 1.8 1.4 3.6 5. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.7 0.1 805.6 3. 27. 25.9 0. 28.4 3.000 Corporations (1997). 34.7 3.

13. 14. 11. 4.11 (continuation) Total and Per Company Sales. 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. Flagship Company. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. Consunji Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Large Large Medium Medium Medium Large Large Large Medium Large Medium Medium Medium Medium Medium Medium Medium Medium Medium Small Small San Miguel Corporation MERALCO Ayala Corporation Toyota Motors Robinson Shoe Mart Philippine Airlines Phil. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . Alaska Milk Corporation DM Consunji. Inc. 7. Uytengsu/General Milling Group David M. Sector Orientation. 21. Eduardo Cojuangco Lopez Family Group Ayala Corp. 3. 2. 8. 10.Table 3. 9. 1. 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. 17. 5. and Affiliated Bank of Selected Business Groups. 16. 20. 18. 15. 12. 6. 19.

33.65 billion to P4. 26.. 37. a b Size class is measured in terms of sales: Large = greater than P4. P. Ramos Gaisano Family Group Felipe Yap Felipe F. Cruz & Co. unless otherwise indicated. 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. 39. 38. SEC-BusinessWorld Annual Survey of Top 1. 25. 30. 32. small = less than P1. 35.48 billion. 24. medium = P1. PT&T Corp. 27. Inc.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. F. 29. 34. and various company annual reports. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 36. Fil-Estate Development Inc. 23. Kepphil Shipyard Inc. 31.65 billion. Sources: PSE Databank. 22. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. Refers to commercial banks.000 Corporations (1997). 28.48 billion. .

1 60. and personal care products Shipping. telecommunication. food. Texas Instruments (Phils. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. and bank Real estate. car manufacturing. beverages.5 26. Inc. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. and telecommunications Department store and banking Airlines. 11. 15.2 Business Group Business Group Business Group Government.0 24.5 15.4 48. 9. 8.5 44. 10. Beverages.4 19. food. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.2 49.12 Control Structure of the Top 50 Corporate Entities. 5. and mining Gold and other precious metal refining . 24. and food Food. construction. of the Phils. and real estate Banking.). 18. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp.5 47. and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate.8 22.8 84.8 53. 19.6 18.1 17. mass communications. 3.5 77.7 98. Inc.Table 3. Fujitsu Computer Products Corp. 6. 22. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. 13. food. 2. 14. banking.6 26.0 37. 23. and dairy products Investments. power.2 16.3 15. 12. 7. Philippine National Bank Mercury Drug Corp.0 38. bank. 16. 17.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 1.5 17. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.). beverages.5 46. 4. agriculture. coconut oil. 20. and packaging Power distribution. First Pacific/Metro Pacific Group 21.

41.7 10.2 7. W. 43.0 11.9 14.1 9.9 7. real estate. National Steel Corporation National Food Authority Phil.0 12.6 1. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. Consunji Uniden Philippines Laguna. Inc. 36. 14. . 49.4 8. 33. Inc.5 10. 50. EAC Distributors Inc. 42.000 Corporations (1997). and various company annual reports.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 38.3 8.5 8. 35. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. corn (unmilled). and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. Amusement and Gaming Corporation Mitsubishi Motors Phils.0 13.9 7.9 6.6 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.A. 29. 40.0 5. 27.7 10. 37. Jollibee Foods Citibank N. 44. 39.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. 47.. 26.3 13. Philip Morris Philippines. 30.6 12. 45. 31. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 9.4 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. Corp.8 9.6 9. 34.8 6. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.7 13. PSE Databank. Philips Semiconductors Phils. Uytengsu/General Milling Group David M. 48. 28.290 53. 46. Inc. 32.25.5 8.

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

Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. The longest was 27 years for board chairpersons and 14 years for board directors. the average number of years of holding office was 6. In a few cases. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. with a maximum of 36 percent.7 percent). and determining remuneration for board directors and senior management.5 for board members. 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 percentages of shareholdings (28.9 percent). . In practice. 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. appointing senior management. a fixed fee plus performance-related bonuses (30 percent). According to the ADB survey.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. board directors were the founder of a company. More than half of respondents indicated that board directors were elected during the shareholder general meetings. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions. appointed by the Government. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. in a descending order. or a per diem for meetings (18 percent). protecting shareholder interests. ensuring that a company follows legal and regulatory requirements. Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. But professional expertise is also an important criterion (28. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31.7 percent). or the Government without approval by shareholder general meetings. Making day-to-day management decisions was not regarded as an important board responsibility. or representatives of creditors.

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

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

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

Table 3. An average of about 4.8 56.4 70.6 30.13 summarizes rights that the shareholders of the responding companies enjoyed. The responding companies had on average 43. Nominees held about 45 percent of the outstanding shares.3 56.2 69.2 43.0 51.8 92. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.0 48. appointed either by the board or shareholders during the annual general meetings. Table 3. protection. About 333 shareholders per company voted by proxy.7 43. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.Chapter 3: Philippines 191 in a few controlling shareholders and families.4 No 0. The ADB survey provides further evidence on shareholder rights. representing 3.0 63.0 36. followed by management and banks.4 percent of shareholders but 58 percent of outstanding shares. a company that is widely held but has a large shareholder. Yes 100.2 7. The brokers or securities companies were the most important proxy voters.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor. About 93 percent of the respondents contracted . 1999.900 shareholders per company did not vote during the last annual general meeting. the successful hostile takeover by First Pacific Group of PLDT. representing about 24 percent of outstanding shares. and their activism in the corporate sector.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.522 shareholders each. Nevertheless.8 30.

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

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

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

(47. (58.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings.. Inc.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. Inc. Inc.96%) Privately-Held Pure Holding Company Public Investors (41.Figure 3.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. .

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. however.7 times Ibid. Diversification and Efficiency of Investment by East Asian Corporations.98% x 42. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42.14%] / [6. and Larry H.76%)] [39. see the World Bank research papers by Stijn Claessens. is illustrated in the Lopez Group (Figure 3. Expropriation of Minority Shareholders: Evidence from East Asia.5%] [39. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company.3% x 5.2). P. Fan.11 The Lopez family’s control rights over MERALCO was 5. and a minority-controlled holding company. The Separation of Ownership and Control in East Asian Corporations.44%] / [25%] = 1. Generally. Rockwell Land.64% +37. 1998. First Philippine Holdings Corporation. [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. and 1999c.64%) + (37. MERALCO.8%] 5. companies in the Lopez Group are large and minority-controlled. Joseph P.7 times 12 . Benpres Holdings.44%] = [42.196 Corporate Governance and Finance in East Asia. H.44%] / [58. Lang: 1999a.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. Being in the public utilities sector. Lang.5%] / [(88. P.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. Who Owns and Controls East Asian Corporations? 11 Ibid. Simeon Djankov. and Larry H.14%] / [1. a privately owned company. The control of companies through indirect corporate shareholdings. defined as control by large shareholders of an operating company through minority ownership by several companies. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank.5% x 14.10 The Ayala family’s control rights over BPI was 1. 1999b. Simeon Djankov.12 These examples show that even when large shareholder groups are minority shareholders. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights.3% x 1. The situation offers large shareholders tremendous incentive to move resources 10 For details. Vol. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. See also Stijn Claessens.

76% Operating Company MinorityControlled 24.3% 11.64% MinorityControlled 14.7% 62.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998. Privately-Held Pure Holding Company 88.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.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. Inc.Figure 3.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24. .

The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments.198 Corporate Governance and Finance in East Asia. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. However. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. Suspension of Payments of Debts Under PD 902-A. 3.3. The average company. and (ii) how the legal framework protects creditor interests and rights. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid.3 The Role of Creditors in Corporate Control This study examines the role of creditors in corporate control by looking at (i) how corporate borrowers perceive the control power of their creditors. Vol. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. whether for working capital or capital expenditure. the data suggest. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. 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. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. Control by Creditors According to the ADB survey. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems.

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

and convertible securities. Equity instruments include common stocks. Even in the real estate sector. preferred stocks.200 Corporate Governance and Finance in East Asia. The ratio of market capitalization to GDP over the last 15 years put the development of the Philippine stock market at par with other developing markets in the region (e.. is far ahead of the flock.4 billion (or $59 million using the average exchange rate). Foreign portfolio investments also remained small.7 billion. As a result. Interest rates. was one of the smallest in the region at $47. most listed companies are controlled by their five largest shareholders. especially short-term debt. this is because. Vol. less exposed to foreign debt. II sector.g. 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. however. Equity financing through IPOs was active. The corporate sector raised a substantial amount of . while interest rates were at high levels and volatile. Most publicly listed companies issue only up to 20 percent of total shares to the public. but not to the same extent as it did in other Asian economies. about the size of Thailand’s. Of the 221 companies listed in the Philippine Stock Exchange in 1997. compared with other economies. Foreign funds were wary of the Philippine stock market because of its limited liquidity. companies expanded only at a moderate pace. From the 1970s up to the early 1990s.14 shows that the average volume of daily trading in 1997 stood at P2.5 billion). The period 1993-1997 was one of lower inflation and declining lending rates. the Republic of Korea (henceforth. Table 3. In part. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. the country experienced double-digit inflation. However. The crisis affected the Philippine corporate sector.000 companies. and Indonesia ($61. inflation. The Philippine stock market is not a liquid market. The market capitalization of the Philippine stock market in August 1997. Rising stock prices during the Ramos administration reflected to some extent the business optimism. The stock market was depressed up to the early 1990s. and less engaged in risky investments. only 84 had sales large enough to be placed in the top 1. Korea) ($143 billion). Philippine companies were less leveraged. compared with Malaysia ($186 billion). the minimum required to qualify as a public corporation. Malaysia. Korea and Thailand). and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. They invested in only a few large companies whose shares were relatively liquid.

3 0.545.1 524.5 16.3 4. 1983-1997 Daily Trading Volume (P million) — — — — 129.2 1.9 1.8 1.686.1 0. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.5 12.445.692.6 1.2 0.5 1.1 88.3 2.0 0.8 0.421.8 1.3 0.2 59.9 608.5 571.5 26.8 799.171. Source: PSE databank.0 0.077.3 59.0 161.2 3. .1 5.1 0.906.4 9.7 0.0 2.Table 3.2 ($ million) — — — — 6.088.9 2.515.386.248.9 12.7 2.2 0.474.2 297.2 1.7 207.4 1.3 314.7 391.2 61.3 — = not available.7 41.9 114.2 57.4 728.351. P billion) Gross Domestic Product (current prices.3 Market Capitalization (year end. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.121.6 261.3 158.373.8 102.1 0.0 1.9 2.0 0.251.5 1.2 925.4 Ratio of Market Capitalization to GDP 0.9 682.8 1.6 1.5 Year 369.7 1.1 0.5 72.14 Philippine Stock Market Performance.

tight regulations. sells these commercial papers through brokers.2 Patterns of Corporate Financing The study looked at retained earnings. which were the principal source of corporate financing in the Philippines. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. The measures used in the analysis are: . of which 85 percent was raised from 1993 to the first half of 1997. lack of competition among financial institutions. and debt as sources of corporate financing by using flow of funds analysis.202 Corporate Governance and Finance in East Asia. However. However. From 1988 to 1997. which buy commercial papers either for their own account or for their clients. new equity. Corporate bonds are another type of debt securities. and inventory financing. Under SEC regulations. which ultimately influences the pricing of commercial paper issues. 3. Debt instruments include negotiated credits and debt securities. asset-backed credits. and high transaction costs. by volatile interest rates and the absence of a secondary market. Debt securities include commercial papers and corporate bonds.6 billion. and the dominance of large commercial banks. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. Only a few large companies floated commercial papers because of the limited market. because business groups often own large commercial banks. The picture of the financial system that emerges is thus one of limited capital markets. leases. a strong regulatory system for bank supervision is imperative. include bank credits. moreover. discounting of receivables. Negotiated credits. The largest buyers have been commercial banks. are in a position to provide such discipline. Vol. corporate bond issuing was even more limited. which in most cases is an affiliate of the issuing company. Capital markets cannot provide the market discipline that corporate investors need. The corporate bond market was stunted. about 127 companies went public with a total value of offerings of about P134. the rights issue was a popular way of raising equity capital. Only the commercial banks.. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997.4. The underwriter. by virtue of their large stakes in the financial system. Because existing shareholders wanted to retain their proportionate control over their companies.

It measures a company’s capacity to finance asset growth by equity capital. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.15.1 Average 1. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.8 0. the average SFRF was high at 109 percent.9 0.2 0. It measures a company’s reliance on borrowings in financing asset growth. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. it is one minus IDFR.4 0.5 0.4 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. As shown in Table 3.3 0.7 0. during this period.5 Source: SEC-BusinessWorld Annual Survey of Top 1.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.5 2.000 Corporations in the Philippines.5 0.5 0. .9 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.1 0.5 0. 1988-1997.5 0.3 0.1 0.5 0.3 0.2 0.3 0.6 0.8 0.4 1.9 0.1 0.2 0.1 0.3 0. the SFRT was low at Table 3.8 0.4 0.4 0. It measures a company’s capacity to finance asset growth by internally generated funds.1 0.000 Corporations in the Philippines from 1988 to 1997.3 0. By definition.6 0.9 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.4 0.5 0.4 0.2 0.6 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.15 Financing Patterns of the Corporate Sector.5 0. On the other hand.4 0.0 0.0 0.5 0.2 0.3 0.

1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. II only 19 percent. except in 1991.9 0. Vol.and foreign-owned. Retained earnings were the least important. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. the SFRF was higher. In 1997.3 0. 1991.3 0.3 0. and 1997. In periods of an economic crunch such as in 1989. In all the years. internal funds were not a significant source of financing growth in total assets. debts were the most important source of financing.1 a Excludes negative balances. Corporate Financing by Ownership Type As shown in Table 3. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 Privately-Owned 0.6 0. with debt providing 93 percent of the financing requirements. for all three types of companies—publicly listed. Companies financed fixed assets from internal sources in hard times. As a result. reflecting the capital flight caused by political instability in the early 1990s. the level of corporate leverage increased. 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. when it financed 45 percent of it. On Table 3.16.2 0.0) 0. 1988-1997. There were significant year-to-year variations.5 Foreign-Owned 1.7 0.16 Corporate Financing Patterns by Ownership Type. except for foreignowned companies that had a negative new equity financing ratio. retained earnings declined and few new equity investments flowed into the corporate sector. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.5 0.3 0.8 0. Total assets grew by 23 percent that year.2 (0. implying that internal funds were far from sufficient to finance growth in total assets. This was mainly caused by the declining contribution from retained earnings.204 Corporate Governance and Finance in East Asia.000 Corporations in the Philippines. privately. Source: SEC-BusinessWorld Annual Survey of Top 1. .

4 2.Chapter 3: Philippines 205 average. especially bank loans. .4 43.7 2. publicly listed companies relied more on new equity financing than privately.1 50.8 100.0 9.0 9.4 100.1 15.6 26.and foreign-owned companies.2 3.1 13.8 38.9 16.0 13. 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 14.9 24.1 7.7 13.1 49.3 11.6 37.5 27.5 16.9 4.3 48.7 100.000 Corporations in the Philippines.7 4.6 43.9 0.5 12.3 12.3 51.8 39.8 3.9 100.8 17.9 3.17 Composition of Assets and Financing of the Publicly Listed Sector.0 53.0 6.0 38.8 4. Foreign-owned companies relied more heavily on debt financing.0 12.4 12.4 41.6 0.8 16.4 10.9 16.8 51.9 38.4 100.0 1995 1996 13.6 48.3 13. 1988-1997. significantly Table 3.3 10.9 16. It presents a composition analysis of assets and financing sources for the period 1992-1996.9 12.6 48.5 0.0 8.0 1993 14.1 10.0 1994 19.7 13.2 12.0 9.4 2.3 12. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.8 26.2 3.0 100.8 0. The sector built up its short-term debts.1 9.7 23. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.8 0.2 42.0 Source: SEC-BusinessWorld Annual Survey of Top 1.17.3 4.3 10.7 2.5 9.5 41.0 10.7 7. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.0 10.0 9.4 100.8 46.2 100.2 51. contributing 90 percent of growth in total assets.3 12.4 3.2 100.8 3.4 100.

group companies usually financed their investment in member companies by equity rather than debt. Vol.000 Corporations in the Philippines.18 Financing Patterns by Control Structure. The traditional measure of liquidity.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. and economies of scale in fund raising.206 Corporate Governance and Finance in East Asia. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. II in 1996 and became more vulnerable to the financial crisis in 1997.13 was at 1.9 0. . their inherent ability to pool risks. For these two reasons. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. as opposed to 94 and 30 percent. respectively.45 in 1996.6 Independent Company 0. Group companies were generally more profitable than independent companies. Group companies financed an average of 45 percent of growth in total assets by debt.3 0.2 0.5 0. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. 1988-1997. On average. the current ratio. 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.3 0. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. compared with an average of 54 percent for independent companies. the average SFRF of business groups was higher compared with that of independent companies. the easier access to external credit.5 0. The normal standard liquid position is a current ratio of 2 or higher. As shown in Table 3.1 0.3 0. for independent companies. Table 3.18. Further. indicating that many publicly listed companies were likely to be in a tight liquidity position.

With assets growing at a fast pace during this period.8 0. Table 3.1 0.9 0.6 0.5 Medium 3.3 0.000 Corporations in the Philippines. There was also increased reliance on debt financing. equity financed 42 percent of incremental asset growth. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.2 0. Large companies’ IDFR of 0.76 for small companies and 0. 1993 with 96 percent. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0.19).08 and SFRT of 0.Chapter 3: Philippines 207 independent companies.2 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. Source: SEC-BusinessWorld Annual Survey of Top 1. These years were 1991 with 110 percent.55 was substantially higher than the small companies’ 0. On average. The corresponding ratio was 0. Excluding .47.5 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. with an average of 3.06.3 0.88 for large companies (Table 3. Large firms consistently increased their reliance on debts from 1994 to 1997. compared with 55 percent for large companies and 47 percent for small ones. 1988-1997.3 0. averaging 61 percent of growth in total assets.5 Excludes negative balances. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.50 (Table 3.4 Small 0.19 Financing Patterns by Firm Size. medium-sized companies used more debts.6 0.2 0. and 1997 with 131 percent.20).

the manufacturing industry financed 57 percent of its total asset growth by debt.3 0.5 Utilities and Real Estate Services and Property 0. The sector had the highest leverage among all industries that year. Table 3.79 and in 1997 at 0. II 1991.91. Equity financed an average of 62 percent of total asset growth.7 0. achieving an average SFRF of 3. the industry generated internal funds. SFRF for the sector averaged 0.58 and SFRT of 0.04.3 0.20 Financing Patterns by Industry. . Incremental equity financing amounted to an average of 44 percent of total asset growth.4 0. Up to 1997. The utilities sector showed weaknesses in internal fund generation in 1989-1994. 1988-1997.5 (0.32.47 two years later. the total debt ratio was much higher in 1996 at 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.6 0. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.6 0. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. Excluding 1997 when fixed assets declined.208 Corporate Governance and Finance in East Asia.6 a Excludes negative balances. debt financed about 78 percent of asset growth in real estate.4 0.5 0. The construction sector was a heavy user of debt financing. many of the leading real estate companies successfully went public during that time.3 0. The real estate industry financed its growth by substantial equity funds.2) 0. The situation improved beginning 1994. In the eight years preceding the crisis. During the crisis year. While this level is considered prudent.1 0.3 0. while SFRT averaged only 0.4 3.5 0.000 Corporations in the Philippines. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. increasing to 0.4 Construction 0. with an SFRF as low as 0. the incremental equity ratios of the industry were high.4 0.29. Vol. ranging from 41 to 118 percent. Since the real estate boom coincided with that of the stock market. Source: SEC-BusinessWorld Annual Survey of Top 1. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. when debts declined.6 0. The effects of the crisis of 1997 were adverse.27.

and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. 14 See for example Michael Jensen (1993). Journal of Finance 48: 831-880.Chapter 3: Philippines 209 3. knowing that if an investment turns out to be successful they could capture most of the gain.008 5.14 Large shareholders may borrow excessively to undertake risky projects. ROE. while if it fails. and the Failure of Internal Control Systems. ownership concentration = the total shareholdings of the top five shareholders. Using the PSE database.230 Leverage 0. ROE. alternatively. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. and financial leverage are all positively and significantly related to the degree of ownership concentration.3 Ownership Concentration. 1992-1996. Profitability.21.287 0. Source: Author’s estimates based on the PSE databank. .421 0. ROE = return on equity. ROA.860 Leverage = the ratio of total assets to total equity. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.130 ROA 0. more profitable. Exit.00125 2. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. and leverage. Large shareholders may also overuse financial leverage to avoid diluting ownership and control.21 Ownership Concentration. Table 3. at the same time. the degree of ownership concentration.00056 1.009 5. The Modern Industrial Revolution.004 3.00036 2. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. measured by the percentage of shareholdings of the largest five shareholders. as the dependent variable.769 0. As shown in Table 3. creditors bear the consequences. Financial Leverage.4. was regressed against measures of profitability and of financial leverage. ROA = return on assets.

5 3. II 3. and agriculture at 21 percent. with commodities accounting for the balance.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.” that is. After a . which averaged 4. raw materials.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). foreign investments in the country have been low.8 percent of GDP from 1995 to 1997. 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. Although much lower than those of other Asian countries. The export sector had a very narrow breadth. Garments was the second largest export sector at about 9 percent. Net investment inflows were $3. In sum. but its share had been declining by 4 percent per year since 1995. Compared to other East Asian crisis-affected countries. In 1997. the economy still showed vestiges of its import-dependent and substituting character.5. industry at 34 percent. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. an overexpansion of capacities. Commercial and industrial activities in the country were largely oriented to domestic markets. the country was less dependent on foreign private capital. with a narrow exporting industry base. Vol.5 percent per year from 1992 to 1997.210 Corporate Governance and Finance in East Asia. their growth gathering momentum only beginning in 1992. The country experienced balance of payments surpluses but these were due to transfers. Manufactures accounted for about 85 percent of exports. Net trades in goods and services averaged a deficit of 4. Historically. more than half (52 percent) of exports were semiconductors. and intermediate goods. notably remittances of overseas workers. 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. Exports were growing at about 20 percent per year in the three years preceding the crisis. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. The largest contributors to GDP were services at 43 percent. Because of limited local capital. the country’s GDP growth pace indicated that it did not have a “bubble economy.

which. In the Philippines. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. 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. Profitable operations since 1992 had allowed it to build equity. the country and the corporate sector had no access to foreign currency debts from the international financial market. assets grew at a compound annual rate of about 31 percent. After hovering in the range of 100 to 127 percent. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. resulting in stability in the short-term debt to reserves ratio. From 1993 to 1997. fueled also by successful IPOs during the stock market boom of 1993-1996. average ROE was 13. and a relatively healthy banking system. an average Treasury bill rate of 13. From 1988 to 1996. Total debts were only 52 percent of assets or 108 percent of equity. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3.1 percent. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. while sales grew by only 20 percent per year. 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. unlike their counterparts in the region. a government fiscal surplus from 1994 to 1997.8 percent. Closer analysis. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. Eventually. The lessons from debt restructuring became the basis for the Government’s economic policies.3 percent. the Government sought stability and achieved this in 19921997. During this time. an average inflation rate of 7. however. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin.6 billion as of March 1997. .5 percent. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. a positive balance of payments from 1992 to 1996. depended on the quality of the corporate sector’s investments. the Government restructured its debts into longer tenors with a maximum of 25 years. in turn. The corporate sector was in a relatively stable financial condition around the time of the crisis.

517 1. mitigated the effects of the pullout and liquidation of investments in the aftermath.0 1998 739 555 328 69. Debts financed a large part of this expansion. but to a lesser degree.749 26. net FDI remained stable at more than $1 billion. But portfolio investment amounting to $406 million flew out of the Philippines.22.101 92.212 Corporate Governance and Finance in East Asia.073 (406) 121. These patterns in investment and financing are similar to those of other countries in the region. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. 1997 = 29. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. growing by about 34 percent per year from 1994 to 1997.101 billion or 196 percent of net FDI in 1996.06.5 billion in 1995. Table 3.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. Net foreign portfolio investment amounted to $1.485 145. Sources: Bangko Sentral ng Pilipinas and SEC.650 32.5. the other immediate impact of the crisis was that on foreign investment flows. It financed 26 percent of corporate capital growth.074 2.718 30. In 1997. precisely.22 Foreign Investment Flows.71. Data for 1998 cover only January-August. or 114 percent of net foreign direct investment (FDI). 1998 = 41.47.22). It rose to $2. Most of this leverage happened during the boom years in the region. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.0 1996 3.7 Note: Peso-dollar exchange rates used are: 1995 = 25. the country’s economic and corporate sector growth in 1994 to 1997 appeared to have been part of a positive “contagion” effect of optimism by investors and creditors about the region. .609 1. Vol.4 1997 762 1. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. In sum. 1995-1998 Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1.300 1.” 3. 1996 = 26.303 23.

The resources of the financial system that year totaled P3. By March 1988. the sectors with the highest outstanding loans had reduced their credit exposures. the corporate sector became vulnerable to loan calls and high interest rates.2 percent was barely above inflation rate. The real problem of the corporate sector during the crisis was the rise in interest rates. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. with commercial banks holding P2.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. which held about 75 percent of the assets of the financial system in 1997. Companies deferred investments in new fixed assets. Loan calls. in varying degrees for each sector. By October 1998. The interest rates on Treasury bills.369 billion.9 percent. depended on the liquidity and capital position of commercial banks. With the increase in borrowings and reduced liquidity.2 to 28. they were willing to restructure and renegotiate existing loans by corporate borrowers. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond.513 billion. Although corporate borrowers were not highly leveraged. Loans outstanding of commercial banks declined by the first quarter of 1998. and leverage increased to 149 percent compared with 109 percent in 1996. ranged from 11 to 13 percent from 1993 to July 1997.7 percent in January 1998. in turn. Average bank lending rates climbed to their peak of 25. Because commercial banks were strongly capitalized. the commercial banking sector’s capital remained strong at 17. lending rates also came down. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. Lending rates were well above the 20 percent level from July 1997 to March 1998. Net profit margins were at a 10-year low at 4. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets.3 percent of assets. When the Treasury bill rates eased in March 1998. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. then rose to a high of 22.2 percent in November 1997. ROE at 6. new borrowings financed asset growth. and the wholesale and . albeit at current market interest rates. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. sparking a rise in interest rates on corporate loans. Because of weak internal fund generation. meanwhile.

II retail trade sector. 3. The move retained the liquidity position of banks but lowered their cost of reserves. and the financial system. This allowed the Central Bank to convince the banks. by 12 percent. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. As for nonperforming loans (NPLs). as with its counterparts in other Asian countries.5 percent by September 1998. These figures show that adjustment problems were industry-specific and that the real estate industry.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. However. and set up a hedging facility for borrowers with foreign currency-denominated loans. single-digit NPL ratios began only since 1989.214 Corporate Governance and Finance in East Asia. and its experience of low. The Central Bank adopted other measures to strengthen the financial system. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. and subsequently went down to 13. set limits on overbought/oversold foreign exchange positions of banks. real estate loans averaged 11. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. thereby reducing overall intermediation costs.5-6 percent. In March 1997. These peaked at 14. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986.3 percent in December 1997. Still. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. the fiscal position. through the Bankers’ Association of the Philippines. Vol.9 percent of bank loan portfolios. was a problem sector. But the Philippine banking system had gone through worse crises in the past.5. including (i) a regulatory limit of 20 percent on banks’ loans to the . to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. the ratio increased to a high of 11. 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.6 percent in June 1998.

Chapter 3: Philippines 215 real estate sector. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. The policy directions and actions taken by the Government appear to have ushered in recovery. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. took more action. subcontracting and outsourcing. and the legal framework for reorganization and liquidation conditioned its response to the crisis. the Asian crisis opened a unique opportunity for foreign investors. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. First Pacific Corporation. the country’s flag carrier. the largest telecommunications setup in the Philippines. Financially strong companies were able to survive the crisis by effecting such internal restructuring. bank loan rates have also come down. In response to calls for lower bank intermediation costs. (v) improving disclosure requirements on the financial position of banks. With its weakened financial position. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. (PAL). The economy avoided a recession in 1998 and achieved 3. changing technologies. The acquiring company. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. Large companies with heavy loan exposures such as Philippine Airlines Inc. 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 1998.6 percent growth in 1999. its accessibility to foreign capital. consolidating business units. the corporate sector dealt with the crisis as any company facing a recession and drying up of credit would—companies cut costs by reducing staff. the Government kept inflation below 10 percent. PAL. was known to have a policy . Average Treasury bill rates have cooled since mid-1998. and giving up noncore businesses. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. Responses of the Corporate Sector The corporate sector’s financial position. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. With prudent monetary management.

Consequently.1 Summary. is whether there are sufficient safeguards to prevent controlling shareholders from . eventually took over PLDT and announced a restructuring plan for the entire group of companies. By itself. the Soriano family. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. SMC is another widely-held company managed by a minority shareholder. When companies are highly profitable. Corporate governance is conditioned by the high ownership concentration of these large companies. Its stock price and returns to shareholders had stagnated. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986.6.6 3. 3. Vol. Although considered the prime industrial company in the Philippines. In a legal process that ended in his takeover of management. First Pacific. The question. II of investing to control companies that are dominant players in their industries. When Cojuangco took over. Ownership is highly concentrated and a few dominant players control major industries. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. using some or all of these means. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. controlling shareholders can capture these profits by excluding public investors from ownership. however. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. A second method was to purchase the shares of other large minority shareholders. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. concentrated ownership of companies is not equivalent to weakness in corporate governance. at a premium over the market price to reflect the value of management control. the Cojuangcos. One mode was the outright purchase of shares in the open market. 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.216 Corporate Governance and Finance in East Asia. the stock price of PLDT was buoyant during the takeover period. Conclusions. 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.

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

and leverage were all positively related to the degree of ownership concentration. Large. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. as typified by the Ayala Group. Larger disparities in control over cash flow rights imply higher incentives for large shareholders to (i) expropriate wealth of shareholders not belonging to the controlling group and (ii) invest in empirebuilding and high-risk projects. A commercial bank is an important part of most business groups. and sustained growth. the bank usually accounted for a large share of each group’s net profits. A business group is an effective business organizational model for achieving leadership in industries. II type gave similar results. Business groups with pyramiding structures heighten the issue of corporate governance. The pyramid model is useful for centrally managing smaller companies. Ownership concentration was positively related to both returns and leverage. superior profitability. selective public listing of companies in the group. and centralized management and financing.218 Corporate Governance and Finance in East Asia. ROA. The difference between management control and ownership rights is usually substantial. ROE. Large companies owned or controlled by business groups tend to dominate their industries. and the extent of supervision of outside institutions such as independent auditors and SEC. The extent of governance problems depends on internal control policies of the controlling shareholders. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. After controlling for industry effects. Vol. with the foreign-owned companies found to rely more on borrowed funds. . Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. 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. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. Even in cases where the group owned only a minority share of a commercial bank. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. family-based shareholders gain control by such means as the setting up of holding companies.

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

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

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

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

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

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

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

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

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

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

The fixed exchange rate policy. Korea). the Thai baht came under pressure from speculative attacks. and Lea Sumulong and Graham Dwyer for their editorial assistance. and Philippines all depreciating significantly. Faculty of Business. the Stock Exchange of Thailand for its help and support in conducting company surveys. Thai corporations were collectively overexposed to exchange rate risks. David Edwards. The banking system. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. short-term private debt obligations grew to about 60 percent of total private sector debts. had been plagued with prudential problems for a long time. Asian University of Science and Technology. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP). In the prelude to the 1997 crisis. with Thai corporations overutilizing short-term foreign currency-denominated loans. For the period 1994-1996.4 Thailand Piman Limpaphayom1 4. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector.1 Introduction In May to July 1997. the Thai Government conceded and adopted a floating exchange rate regime. both of ADB. with the currencies of Indonesia. As a result. The majority of these debts were not properly hedged.” After mounting an aggressive defense of the currency. 1 Associate Professor. Republic of Korea (henceforth. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. but also the stalling of East Asia’s “economic miracle. . Chonburi. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. Malaysia. The corporate sector also contributed significantly to the crisis. heralding not only a financial crisis in the country. It was inefficient in financial intermediation. But it also laid bare weaknesses in both the financial and corporate sectors. magnified the impact of these problems on the economy when the crisis hit. poorly regulated and sheltered from competition. The author wishes to thank Juzhong Zhuang. the banking system merely validated the financial risks. Thailand.

Import tariffs on machinery and heavy equipment were removed. 4. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET). the Government increased tariffs on products that could be produced locally. 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.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. To protect domestic industries. This study examines these and other factors that might have weakened corporate sector governance in Thailand. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. Section 4.2. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts. Section 4. its growth and financial performance. Vol. Section 4. as well as its legal and regulatory framework. lack of transparency and adequate disclosure. . The First and Second Plans (1961-1971) Under the first two plans.4 provides an overview of Thailand’s financial markets and examines patterns of corporate financing and investment in the years prior to the 1997 crisis. while new industries were encouraged to reduce the need for imports.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth.2 4. with government policy providing support but avoiding direct interference. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Section 4. The study then considers policy recommendations with emphasis on corporate governance improvement. The country initiated national economic development planning in 1961 when the economy was growing rapidly.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand.230 Corporate Governance and Finance in East Asia.

The focus shifted to export promotion. Unemployment. leaving the Government no choice but to resort to overseas borrowings. textiles. including luxury goods. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. To close the fiscal gap. At the same time. The decline in imports was steady.15 billion per year or 4. However. Budget deficits remained a major problem during the Fifth Plan.Chapter 4: Thailand 231 During this period. Inflation levels were low. including a weakening of the dollar.6 percent per year. and increases in world food and oil prices. But the sustained importation of heavy machinery and equipment resulted in large trade deficits.4 percent of GDP. Thus. the current account registered a surplus in 1986. resulted in increases in the current account deficit. processed steel. became a major problem as domestic investment declined. lower than anticipated due to a worldwide economic recession. with the devaluation of the baht in 1984 a major step in this direction. Industrial sector growth was also rapid and many industries (tires. Budget deficits also increased throughout the Fourth Plan. External factors. averaging 1. remaining high until 1981.3 percent in 1974. it proceeded with its development plan for the industrial sector. the value of the baht remained stable. canned foods. capital inflows. the Government borrowed $6. an improved trade balance. the government’s debt burden escalated. gross national product grew by about 7 percent per year. however. however. helped offset these deficits. Fourth. Average growth for the period was 4 percent per year. and reduced current account deficits. The average budget deficit reached an all-time high of $2. . As a result. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. chemicals. with the agricultural sector the major contributor. The Third. the industrial sector grew at a faster rate than the agricultural sector.4 billion from overseas and increased taxes on numerous items. The results were increased exports. Consequently.5 percent in 1973 and 24. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. Inflation reached 15. especially foreign aid from the United States. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. and automobile assembly) emerged. The Government had to shift emphasis to restoration of economic stability.

6 percent. compounded by a slump in property sales. property development. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. From 1989. The country also attracted a large amount of foreign direct investments (FDIs). With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. Growth of exports and imports averaged 14.4 percent targets.2 percent target.8 percent. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. compared with the 8. Vol. from only $31 billion in 1992. increasing its share in total export value from 42 to 76 percent. By 1995. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. better than the 5. Most of the FDIs—originating mainly from Japan. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. China—went to export-oriented manufacturing industries. The exchange rate was steady at around B25 to the dollar.2 and 13. The manufacturing sector became a dominant force in the economy. and Hong Kong. Private sector investment grew at an average annual rate of 7 percent. and the stock market. combined with its liberal financial policies. invited a deluge of capital seeking profitable investments. while exports expanded considerably. Average annual growth in real GDP was 8 percent. respectively.7 and 11. On top of its predominantly “borrowed” nature. Singapore. Thailand became a debtor’s market.5 to 13. averaging 10. Growth rates during 1987-1991 ranged from 9. compared with the 14. Europe.232 Corporate Governance and Finance in East Asia. rather than to productive activities.8 percent.5 percent. The country’s high ratings in the international capital market. Inflation was 4. . reaching an annual inflow of $2 billion in 1991. the bulk of domestic investments went to speculative ventures such as real estate. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. the property sector began to collapse in 1996.2 percent per year. United States.6 percent target of the Seventh Plan. with private foreign debt reaching $92 billion by the end of 1996. an oversupply of housing emerged. lower than the target of 8.

on account of an overvalued baht that weakened export competitiveness. with growth shrinking from 23. In 1969.3 percent in 1996. the Bank of Thailand and . In 1972. Before the capital market emerged. its policy had always been to protect domestic banks. SET officially became “the Stock Exchange of Thailand” in 1991. Foreign banks were barred from competing directly with domestic banks. In May 1974.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development.Chapter 4: Thailand 233 Toward the end of the Plan period. prepared a comprehensive report entitled “A Capital Market in Thailand. the capital markets didn’t play a significant role until 1975. In 1978. Exports went into a tailspin. a policy that held throughout the first six economic development plans. which raised the debt service ratio. the corporate sector’s main source of funding was the banks. Robbins. In his report. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. the Government amended the “Announcement of the Executive Council No. However. a former Chief Economist from the US Securities and Exchange Commission. 4.” extending its control and regulatory powers to the finance and securities companies operating freely at the time.2. And because the Government considered the banking system vital to the development of the economy. which was amended in 1979 and 1985. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. the signs of an economy about to falter were there. the Government passed the Public Limited Company Act. The deficits caused the Government to rely on even more external borrowing.8 percent in 1995 to 1. Robbins recommended an overhaul of the existing informal stock market established earlier by a group of local brokers in favor of a centrally regulated institution. placing all publicly listed companies under regulation. many companies considered the Act too restrictive and a hindrance to growth. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. Sidney M. Under the 1962 Commercial Banking Act.” which later became the master plan for the development of the Thai capital market.

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

Real Estate. however.1 trillion and paid-up capital of B1. 4. Storage. Worldwide.6 2. Ministry of Commerce.3 83. and Water Construction Wholesale and Retail Trade. and Fishing Mining and Quarrying Manufacturing Electricity. The majority of the companies are in manufacturing. Financial deregulation and liberalization were key to realizing that vision.9 261. Forestry.3 trillion have been registered with the authority (Table 4. .2 Type of Business Agriculture. The result was a corresponding growth and development in Thailand’s capital markets. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.0 Paid-up Capital (B billion) 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. Social and Personal Service Total Note: The data for 2000 is as of October 2000.2.5 791.101.Chapter 4: Thailand 235 fast-growing neighbors.0 19. and Business Service Community.9 34.9 16.9 1. finance. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4.5 50. Source: Department of Commercial Registration.291. with B1.0 21.6 1.2 11. and Restaurants and Hotel Transport.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. and Communication Financing.1 Public Companies Registered.394. the financial sector is the largest. Thailand. Insurance.0 110. about 661 companies with total registered capital of B2. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. the country became recognized as an economic development model for other emerging economies.6 350.1 78.5 111. and wholesale/ retail trade and restaurant/hotel sectors. Hunting. In terms of capital.4 trillion in registered capital and B791 billion in paid-up capital.1).1 30. in that order. Gas.6 23.

3 22.7 27. reaching a precrisis peak in 1996 (Table 4.1 599.9 37.6 — = not available.5 39. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994. These peaked at B89.6 8.1 — — — 6.9 1998 1999 15.3).6 7.5 1. the capital market became instrumental in the rapid growth and development of the corporate sector.7 7. Securities and Exchange Commission of Thailand. respectively. The stock market also became an invaluable source of funds for corporations.1 286. from only B20.3 6.7 9.2 Public Offerings of Securities. The development of the corporate sector closely followed the development of capital markets.8 151.2 5.9 31. II B261 billion.1 54.3 31. Table 4.2 12. meanwhile.5 billion and B1 billion the previous year.7 136. 1992-1999 (B billion) Type of Securities Equity Debt Instrument Domestic Offering Offshore Offering Hybrid Instrument Domestic Offering Offshore Offering Total Funds Raised 1992 1993 1.0 20. allowed Thai financial institutions and corporations to obtain funds overseas.3 1996 1997 65.8 201.5 1. Vol.8 1995 64.7 5.0 1994 82. Domestic and offshore debt issues reached B54.8 billion.8 — 26. reached .2 25. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. While a rebound was apparent beginning in 1998. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.7 billion in 1996.0 0.2 40. the value of public offerings rose steadily. Source: Key Capital Market Statistics.2).1 2.4 34.7 billion and B27. moreover.3 194.6 174.5 — — 56.236 Corporate Governance and Finance in East Asia.4 96.4 277.4 51. Market capitalization. The signing of Article VIII with the IMF. The number of listed companies and securities steadily increased until 1996 (Table 4. After the passage of the SEA of 1992. the year before the crisis struck. reducing the value of offerings to a little more than a quarter of the previous year’s level.6 39. The 1997 crisis battered the primary market for securities.

1 by 1996. in the end. ROE similarly fell from 21.360 1. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3.560 1. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. The key financial ratios of all companies listed on SET bear this out (Table 4. Throughout the 1990s. the averages for all three profitability ratios took a downswing all the way until 1996. resulting in their inability to fulfill debt obligations. Corporate profitability.268 2.3 percent in 1989 to 3. Meanwhile. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the .114 1.535 1.133 1. had been on the rise throughout the 1980s. the average times interest earned (TIE) was down to 5.3 Statistical Highlights of the Stock Exchange of Thailand.4 percent in 1996. pulled down by active public offering activities. But instead of shifting to a low gear. The financial leverage of all companies declined until 1994. The trend reversed in 1995.4). ROA dipped from 10.565 2. and gross profit margin. their share rising from 17 percent in 1993 to 43 percent in 1997. The upward trends for ROE and ROA continued through 1989. then stalled in 1990. was the ominous deterioration in the key financial ratios of publicly listed companies.5 at its peak in 1987. Source: Securities and Exchange Commission of Thailand. From 10.303 930 855 1.325 3.8 percent. By the early 1990s. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments.Chapter 4: Thailand 237 Table 4. Foreigners accounted for an increasing proportion of SET’s turnover value.683 1.193 2. however. not all public companies are listed on the SET. as measured by return on assets (ROA). corporate profitability had been declining. the companies could not generate enough net returns from their assets and equity. Side by side with this surge of financing for corporate growth. return on equity (ROE).4 percent to 5.6 trillion. however. gross profit margin rose until 1991 before falling in 1992.610 1. While the decline in gross profit margin was not as sharp. its high point in 1995 at B3.201 2.301 3.281 832 373 356 482 Due to listing requirements and other reasons.

2 27.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14. and footwear industries also experienced losses.5 52.8 51.7 5. II Table 4.7 80.7 35.2 215.8 5.4 5.0 145.4 12. Thailand’s ROE.9 7.9 7.0 125.4 34.8 5. US.1 120. practice of heavy borrowing.4 24.1 16.7 12. Korea and Thailand had the highest debt-to-equity ratios.0 3.4 139.8 25. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.4 119. They were generally more efficient in managing their assets and .1 242.7 12.2 64. which was particularly significant in the two years preceding the crisis.3 8. Severely affected by global competition throughout the decade.2 10. Among the crisis-hit countries.2 49.7 12. 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 (%) (%) (%) 3.5).3 91.7 5. The downtrend in corporate profitability.6 27. Overall.3 10.4 12.6 7.2 161.3 12.9 8.6 168. was also distinct in the region. clothing.4 28.4 Key Financial Ratios of Publicly Listed Companies. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.1 9.9 27. was felt across industries.0 63.8 11.2 6.8 54.2 10.4 18.7 20.5 30.9 66.7 15.7 34.5 15.6 138. resulting in higher collateral values for borrowers.7 54.5 63.6 41. the textiles.4 3. Despite the availability of the equity market.1 44.5 51.5 50.9 77.9 51. Vol.7 59.3 4.4 7.4 44. these companies opted for debt. clothing.9 14.0 139.4 4.7 4.2 27. which fell from 16 percent in 1991 to just under 6 percent in 1996.238 Corporate Governance and Finance in East Asia.1 52.6 12. Hotels and travel showed the highest ROE of 15 percent while textiles.4 51.4 9.0 29. A major reason for this was the rapid rise in asset prices.5 38.7 12.2 10.6 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 7.8 88.1 16.0 7.4 47.7 5.8 8.6 125. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.1 114.7 27.8 14.7 21.4 26.9 144.5 9.9 39.1 60.2 35.8 151. and footwear had the lowest at 11 percent.6 36.9 140.7 27.0 117.

6 12. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. weaknesses became evident.4 8.7 6. also deteriorated.3 25. it was thought. 4.1 29.4 Legal and Regulatory Framework Before 1992.6 6.3 49.Chapter 4: Thailand 239 Table 4.3 88. For instance.3 49.3 15. could lead to a high turnover in the board.3 176.1 Small Medium Large 5.6 7.3 43.6 30.0 48. the law disallowed cumulative voting.8 47.5 6.6 30. .5 87. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.1 5.6 61.2 12.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. measured by total asset turnover.1 25.3 164.8 6.2 10. 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 6.4 52. total asset turnover declined after 1989.5 7.3 52.3 23. which would be disruptive to company management.0 83.8 142. However. In sum.6 31.0 20.2 121.2 134.8 26.1 6.1 13. the overall activities of listed companies. Cumulative voting.3 135. They also tended to use more financial leverage than small companies as their total DERs show. During the 1990s.6 10.8 62.6 5. although the performance of listed companies in the late 1980s was strong.2 18.8 10. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.7 10. Although stable in the 1980s.9 13. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public. US.5 94.7 14.9 20. capital despite the higher gross margins of small companies.8 6.2.4 116.5 Average Key Financial Ratios by Company Size. by the 1990s.

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

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.3 percent and 18.4 26.1 5. .3 percent.1 4.5 Average for 1990-1998 period.9 52.3 7.3 7.1 3.2 4. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. on average.9 52.6).9 3.China have the least concentrated ownership.3 28.7 11.2 11.0 7. these companies obtained funding solely from banks or from their own retained earnings.4 5.7 6.0 3. In the past.7 12.4 10. China firms have the highest single shareholder ownership concentration at 35.1 percent of control rights.1 12.4 6.1 11.1 5. Unfortunately.6 4.6 68.0 3. there were only slight variations in the pattern. and minority shareholders to stake their claim in the control and regulation of these companies.6 57.4 4.9 52.3 11. Ownership was most concentrated in the packaging.2 56.9 54.2 4.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.9 6. Source: Comprehensive Listed Company Information Database. 56.2 4. Ownership Concentration Between 1990 and 1998.7 7.3 16. with the largest shareholder on average controlling 10.6 27.1 5. with the top three shareholders accounting for almost 50 percent (Table 4.0 56. Stock Exchange of Thailand. Indonesian. In contrast.9 4.9 11. and 28. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28.3. 33.0 5.Chapter 4: Thailand 241 4.9 26. But with their increased reliance on new varieties of equity and debt instruments.8 32. Most large Thai corporations listed on SET started out as family businesses.4 6.4 26.7 percent.4 percent of outstanding shares.1 7.9 percent of shares of a company.8 11.6 28.0 53.3 5.4 26.0 7.5 9. Table 4.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. Thai. the top five shareholders of each of publicly listed Thai companies held. and Hong Kong. creditors.5 28.8 5. this was not the case.9 3.9 55. respectively. Across industries. one would expect the public.

It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. II agribusiness.080 6. founding families maintain effective control of entire groups. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.022*** 0. including those that are publicly listed . 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 4.029 3. * Denotes significance at the 10 percent level. as measured by debt-to-equity and debt-to-asset ratios. Vol.169*** 0. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.647 Note: The regression included dummy variables for industry.7).005** 0. owning 26. US.001*** 0. *** at the 1 percent level.8).072) (0.090 0.533)*** Debt-to-Assets (0. and building and furnishing industries.058* ROE (0.116) Debt-to-Equity (1. Company size is significantly related to ROE and leverage.034*** 0.001) 0.001 0.003 0. and ownership types. year.031 3.115 9. Table 4.242 Corporate Governance and Finance in East Asia.7 Statistical Relationships between Corporate Profitability.037 0. results show a significant positive relationship between ownership concentration and financial leverage. Through these holding companies.7 percent of outstanding shares on average (Table 4. 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. ** at the 5 percent level. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0. Leverage. with a top-five ownership concentration of at least 60 percent. Ownership Concentration. On the other hand. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. Based on a regression analysis.800 0.

5 2.0 3. a NBFIs denotes nonbank financial institutions.1 4.7 1.2 7. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.9 6.3 percent of outstanding shares.2 18.1 0.0 19.5 0.5 Individuals 13.2 1. a joint venture among three families.5 Government Other 0. Established in 1980 with a registered capital of B300 million.1 1. the company increased its registered capital and became a public company listed in SET.3 27. with 29. In addition.5 0.9 7. Source: Comprehensive Listed Company Information Database. Stock Exchange of Thailand.5 1.3 1.5 percent.9 19. averaging about 18.5 5. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.4 1.2 5. Individual family members also hold a significant amount of outstanding shares. the affiliate firms rarely hold shares of their parent companies. These individuals usually hold important management positions in concerned companies.5 NBFIsa 6.6 28.3 1. in SET. operates five of the most successful shopping malls in Thailand.8 23.4 22.3 20.6 1.7 Bank 2. This practice is illustrated by Central Pattana. unlike in Japan where crossshareholding is common.3 0.1 1. Although holding companies set up affiliate firms.7 0.0 17.8 0. one of the founding members.Chapter 4: Thailand 243 Table 4. . owned by the Chirathivat family.7 5. including finance and investment companies.5 26. Typically. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.3 — = not available. The top 10 shareholders include a holding company owned by the Tejapaibul family. The largest shareholder is Central Holdings Company.3 27.3 1.5 1.6 percent of outstanding shares.2 1.6 1. a company listed in the real estate sector of SET.9 0.6 1. In 1994.3 27.4 1. the company.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.4 1.8 1.6 5.9 15.0 18. individual members of the Chirathivat family aggregately hold 25.8 28.6 25. The ADB survey indicated that listed companies held shares in an average of 11 companies.5 0.9 18.4 20.7 — 1.

roles. In such cases. they exercise limited influence in operations because of the restricted size of their shareholdings. and a state bank. has the Ministry of Finance as its only large shareholder with 92. duties.. .5 percent of total outstanding shares. on average. the Petroleum Authority of Thailand. Vol. Only a handful of companies have the Government among their large shareholders. qualification. For example. the Government’s role in public companies is expected to decline. In effect.3.1 percent of total outstanding shares of listed companies. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. II another of the company’s founding members. and responsibilities of directors of public companies. However. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list.244 Corporate Governance and Finance in East Asia. both conducted in 1999. the predominance of individual family members and holding companies in the top shareholder list remains valid. 3 Discussions in this section are based on results of company surveys by SET and ADB. with the envisioned privatization master plan. Together.9 percent of outstanding shares. Although the list of top shareholders of publicly listed companies includes financial institutions. By owning 62 percent of voting shares. the top 10 shareholders consist predominantly of members of founding families and their holding companies. The Government holds. 4. where the top three shareholders are the Ministry of Finance.5 percent of total outstanding shares of listed companies. Except in the hotel and travel service sector. Another example is Bangchak Petroleum Plc. Thai Airways International Plc. Nonbank financial institutions hold an aggregate 5. There was a trend of rising government shareholdings throughout the period 1990 to 1998. Across industries. these shareholders are able to control the company. Moreover.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. only one tenth of listed companies have commercial banks on their top-five shareholder list. On average. they account for 80 percent of total outstanding shares. 1. the Government owns the majority of the shares. commercial banks account for only 1.

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

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

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

the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. 4. But with the ownership concentration of Thai companies. Written law and its enforcement diverge partly because of a provision that shareholders who take action against erring directors must have at least 5 percent of the total number of shares. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. Banks would be obvious candidates to implement these mechanisms. however. . In theory.3. 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. Vol.248 Corporate Governance and Finance in East Asia. In effect. 66 percent of total outstanding shares. and mandatory disclosure of related interests and significant shareholders’ transactions. While stimulating the growth of the sector. Only a small number of shareholders attended the latest AGSMs. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. takeover of the company. it would be difficult for minority shareholders to gather the shares needed to take action. given their importance in providing finance and their stake in companies. did not vote in previous AGSMs. such protection has been insufficient. and insider trading. minority shareholders are assured adequate legal protection. the only group of shareholders that can exercise rights is the top five shareholders. and call an extraordinary session. Almost 82 percent of shareholders. representing only about 28 percent of shareholdings. In practice. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. On paper. they comprised only 8 percent of total shareholders. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. on average. But the exercise of these rights requires even higher shareholding levels. Although the attendees held.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 SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing.

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

Recently. According to the SEA of 1992. 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. SEC was later made responsible for regulating corporate takeovers. only a limited number of successful mergers of public companies have taken place. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. Such efforts would serve to strengthen external discipline on controlling owners.3 billion (Table 4. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. there are two categories of merger and acquisition activities with associated regulatory measures. In 1994 and 1995. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. of shareholders: (i) all shareholders must receive tender offers. In 1996. whether directly or indirectly.250 Corporate Governance and Finance in East Asia.3 billion.9). (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. before the extent to which the bankruptcy framework has been strengthened becomes clear. with a significantly lower total tender offer value of B8. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. there were only six tender offers. there were 41 cases of tender offers. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. Since the introduction of the Public Limited Company Act of 1978. The market for corporate control has not been active in Thailand. The second category is the tender offer. and failed to provide managers with strong incentives to perform efficiently. It will take years. with a total tender offer value of B42. its main role is to ensure transparency and fairness. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. however. Vol. Although merger and acquisi- . The first category is the acquisition of shares in the open market. In this case. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. if the purchase of shares implies a change in the directors or business activities. There are detailed requirements regarding such notification. SEC has no authority to either approve or reject tender offers.

Even when companies offer ESOPs.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.2 6.3 11. Provident funds for government workers and workers in public enterprises have been established only recently. Few companies offer employee stock option plans (ESOPs). trading by mutual funds in SET represented less than 10 percent of total trading. The number of domestic institutional investors rose after the mutual fund industry was established in 1991.1 58.8 81.2 8.3 60.2 6. . employees are even less willing to accept common shares as a form of compensation or benefit.4 23. Eleven of the 46 responding companies in the ADB survey offer ESOPs.0 55. Since 1994. Twenty-nine firms indicated that employees held shares of their companies.1 75.5 6.7 11. Source: Securities and Exchange Commission of Thailand.1 84.9 3. but the average shareholding is smaller than 1 percent of total outstanding shares. Employee Participation in Corporate Governance There has been little.1 19. employee participation in corporate governance in Thailand. they have mostly been concerned with short-term gains. it remains small. But instead of opting for an active role in the market for corporate control.Chapter 4: Thailand 251 Table 4. most of these were forced mergers or related to rescue packages.6 17. tion activities increased after 1997. Pension funds are perhaps even weaker in Thailand.3 6.2 7. employees regard the plans as monetary incentives. not with a view to becoming involved in actual management. but employees have never been represented in the board of directors since their shareholdings are minimal. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. Because of the current crisis. While the Thai mutual fund industry compares well to those in other developing countries in the region.0 B billion 4.7 Purchase Value Number of % of Tender Offer Value Companies 84. if any.9 Merger and Acquisition Activities.

the next four largest banks accounted for 63 percent.5 4. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.133. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.0 424.477.360.171.6 1.5 6.5 trillion.4. Vol. II 4. . there were 29 commercial banks.6 6. although its role increased in the wake of the crisis. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.268. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.4 4.906.325.119.3 5. 15 of which were domestic banks.5 Outstanding Loans from Commercial Banks 2.912.564.2 262.0 339.979.8 941.1 7.5 5.8 3.825.1 Domestic Debt Securities Outstanding 215.4 519.1 3.430.390.1 3.5 4.230. The country’s largest bank.663.4 4.3 1.6 2.037. Bangkok Bank Ltd.1 6.775.300.4 3.0 8.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.1 5. Thai Bond Dealing Centre. The bond market played only a marginal role in corporate financing.4 1.669.0 SET Market Capitalization 1.252 Corporate Governance and Finance in East Asia. The share of domestic banks in the banking system’s total assets was 80 percent.2 2.161.3 546.193. accounted for 28 percent of the banking sector’s total assets. The Banking System Until recently.10) shows that Thailand is a highly bank-dependent economy. total assets of commercial banks amounted to B5.485. Table 4. In 1996.559.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.372.10 Size and Composition of the Thai Financial Sector.0 3. and Bank of Thailand.9 2. the banking sector was highly concentrated..

was set up by 74 members with an initial capital of B500 million. The number of listed companies also quadrupled between 1981 and 1993. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. BIBF banks also enjoyed tax incentives on their operations and profits. SET is organized into 32 major industries. Despite the worldwide market crash in 1987. self-regulatory organization under the . In 1993. finance. The Equity Market During the first few years of its operations. and almost all capital account transactions were deregulated. Some 347 companies were listed in the same year with a total market capitalization of B3. After that. Turnover value reached B2. 12 existing foreign banks. The lack of supply of quality shares was a big problem for SET at that time. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. and 20 new foreign banks. Because borrowers carried the exchange rate risk. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. Benefiting from rapid economic and industrial growth.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. Licenses were granted to 15 Thai banks. SET immediately recovered due to the strength of the Thai economy. SET was not very active. banking.8 in 1998. In contrast. the stock market entered its first boom period in 1986. reaching 355. owning 70 percent of the country’s second largest bank. and property have accounted for the bulk of trading volumes. In the following years. Banking activity peaked in the mid-1990s. BSDC is a nonprofit. an over-the-counter market. Easy access to commercial bank loans by family business groups. the SET index declined.2 trillion. The Government removed controls on capital and dividend repatriation in 1991. Through the years. the market rose steadily and reached a record high in the fourth quarter of 1993.3 trillion. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. due to their close ties. also made it unattractive to raise capital from the equity market. the Bangkok Stock Dealing Center (BSDC). In 1995.

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

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

8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.5 — 0.7 132. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.0 17.11 Offerings of Debt Securities.3 29.4 — 26.8 2.5 — — 32.2 — — 50. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.9 40.7 — — — — — — — 77.5 55.7 5.0 — 5. By 1995.7 5.5 138.1 59.3 22.6 19.3 — 14.2 57.0 33.3 8.7 — — 40.2 2.3 46.3 6. this had climbed to B200.3 13.1 41.9 37. total offshore debt offerings had plunged by 68 percent to a mere B28.4 billion.1 61.8 31.7 0.3 — — 3.5 10.7 538.8 47. II Table 4. by the end of 1997.9 30.0 281.8 191.0 333.0 0.8 55.6 billion.9 5.1 141.1 107.7 7.7 95.9 37.0 — 26.1 — — 6.1 10.3 50.3 3.7 821. However.5 5.8 167. the year the crisis unraveled and the baht was floated.4 110.4 57. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996. turnover value had reached B51.7 — — — — — 4.9 20. Total offshore debt offerings peaked in the run-up to the financial crisis.6 — — 0.0 26.5 — — — — 1.0 7.2 45.1 289. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992. a surge attributed to capital inflows encouraged by high returns on Thai bonds.1 12. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.7 28.1 — — — 29. .6 — 0.7 0.1 55.0 60.9 0. 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 — — — — — — 400.1 21.0 86.1 6.5 43.0 27.2 89.7 90.4 — — — 1.4 — 9.256 Corporate Governance and Finance in East Asia. then declined substantially in 1996 and 1997. The following year.5 billion.2 39.1 8.4 49.3 46.1 121.0 — 5.4 7.0 5.2 43.3 140.2 28.5 — — — 3.5 37.9 329. Vol.5 — 39.1 315.

In the same year. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. steadily easing up between 1990 and 1996.4. Turnover fell further to B72. they also had a relatively small proportion of equity and . these accounted for 33 percent of total liabilities. 4. There was also little change in the trend in retained earnings within the seven-year period.12). In 1997. In addition. and marketable securities holdings. Construction and property development industries tended to have high proportions of long-term loans and debentures. The average for all industries was only 22 percent. while for the property development industry. At lower than 5 percent of total liabilities.1 billion in 1998. significant variations can be noted. cash balances. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. short-term loans accounted for more than 40 percent of total liabilities. a trend most apparent in the leap between 1991 and 1992. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. Longterm loans accounted for about 20 percent of total liabilities. For the construction industry. Companies in construction and property development seemed unable to generate internal funds. these comprised 31 percent. Retained earnings accounted for about 30 percent of total equity financing.2 billion as a result of the default of debentures due to the Asian crisis. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth.Chapter 4: Thailand 257 compared with investment in equities. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. with equity levels remaining high despite an increase in debt. In any case. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. Equity financing remains an important part of listed companies’ long-term financing. turnover value plummeted to B106. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. Across industries. The proportion of accounts receivable also declined steadily. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. From 1990 to 1996. judging by their relatively low levels of retained earnings.

9 10.2 12.2 45.5 1.0 100.7 1.6 15.4 8.6 18.2 42.8 34.6 100.9 2.4 43.9 17.4 17.3 14.6 14.3 12.0 100.0 100.0 100.8 37.8 3.8 46.3 50.2 1.0 100.0 7.5 9.13).0 10.0 15.6 6.0 100.3 18.1 2.1 5.5 43.8 9.6 100.2 17.6 0.3 18.6 50.8 35.7 7.2 2.2 2.2 2.0 14.9 17.8 8.8 17.2 15.9 14.1 49.5 9.9 0. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.1 18.9 14.9 14.2 1.8 21.2 17.9 6.0 13.258 Corporate Governance and Finance in East Asia.6 2.6 8.4 48.9 18.1 36.2 17.8 20.4 7.3 48.2 1.3 1.6 0.3 21.8 1.8 10.9 12. US.0 100.7 15.6 0.0 6.3 17.0 100.0 100.3 25.9 14.2 43.3 1.7 16. Vol.9 49.5 11.2 16.0 51.0 2.7 14.0 10.8 9. The level of total liabilities for the group characterized by high ownership concentration .7 18.3 2.3 6.4 2.7 16.2 22.2 16.0 12.7 50.7 9. Printing and publishing companies had lower financial leverage than companies in other industries.8 25.2 3.2 17.4 17.1 50.6 0.0 100.8 7.4 21.7 52.1 17.12 Common-Size Statements for Companies Listed in SET.8 6.0 1.5 37. were highly leveraged.0 100.3 34.7 36. II Table 4.3 38.3 14.5 1.9 6.2 43.4 49.2 35. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.6 51.7 17.6 22. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.1 7.3 49.4 49.9 43.9 16.1 13.3 34.8 19.0 100. compared with the 44 percent general average.8 14. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.0 100.4 6.2 34.6 21.2 2.9 3.9 14.0 48.9 20.9 50.5 1.9 38.5 14. medium.4 14.6 12.9 40.6 38.5 0.6 36.6 11.9 15.0 Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.0 100.8 37.7 0.6 13.6 10.

5 13.0 Low 1. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.9 50.0 16. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.8 37.Chapter 4: Thailand 259 Table 4.0 6.5 100.9 0.4 13.4 50. US.6 47.1 18.3 1.9 2.0 100.1 53.1 36.7 percent for medium ownership concentration companies and 49. 1990-1996 Degree of Ownership Concentration Item Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity High 2.0 100.5 21.13 Common-Size Statements of Public Companies by Ownership Concentration.6 2.3 1.0 7.2 45.0 6.9 36.1 44.0 Medium 2.7 12.4 49.2 22.4 7.5 percent for low ownership concentration companies.9 100.4 3.6 22.0 14.7 19.6 15.6 0.2 0.8 12.2 11. .3 16.3 35.8 13.4 37.8 13.4 18.9 16.6 9. For the high ownership concentration group.6 100. was 53 percent of total assets compared with 49.5 11.9 7.4 35.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 1.7 17.3 100.2 14.0 19.1 49. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.0 41.2 8.5 18.9 21.6 14.3 8.

however.6 125.1 16.8 151.8 5.4 44.4 51. 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 8.2 35. bond issues.4 7.7 in 1994 to 5. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.4 12.8 51.9 51. thus rendering them more vulnerable.2 68.0 50.7 66.1 31.7 34. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. especially from 1994 to 1996.8 65. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.9 7.4 5.1 64. The TIE ratio declined from its peak of 7.9 14. minimization of transaction and interest costs. Vol.7 percent in 1996.7 28.7 12. Short-term debt accounted for most of the increase.14 Financial Ratios of All Listed Firms.4 139.9 63.1 31. US. Table 4. More important. As a result. bond issues overtook loans from commercial banks as the second preference. these firms more easily increased their leverage.15. Such deterioration of financial positions during the period was a common feature of listed companies.7 12.7 11.8 65.260 Corporate Governance and Finance in East Asia. and rights issues.8 percent in 1990 to 52.14).6 7. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.9 140. was the headlong deterioration of firms’ ability to meet their interest payment obligations. followed by bank loans. . After the crisis. While further detailed investigations are necessary.6 41.3 61.1 144.1 16.2 49.1 23.1 44.1 in 1996.7 34.0 28. however.0 25. The ratio of total debt to total assets increased from 50.1 52. Public companies relied more on short-term debt financing in the period before the financial crisis. Generally. the choice of financing is determined by the company’s liquidity considerations. and maintenance of the existing ownership structure. 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 4.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.0 145.5 52.7 5.5 38.6 138.3 31.

Nonbank private debt increased from 27. 4.8 percent in 1986 to 52 percent in 1995. .4 52.8 66.2 124.4 percent to 46 percent during the same period. however.1 High 6. unhedged foreign exchange liabilities. The proportion of external debt as a percentage of GDP consequently increased from 42.0 64.8 14.1 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. From 45 percent of total net capital movements in 1985.8 29. on the other hand. is even more telling. Their average annual growth rate declined from 28. the proportion of short-term debt increased from 15. Additionally.8 49. and a preponderance of short-term debt liabilities.5 34.4 63.3 42.5 percent of external debt in 1996 (Table 4. such as direct equity and portfolio investment. The proportion of nondebt-creating capital flows.5 148. 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. US. The composition and term-structure of this debt.2 49.4 13.2 percent in 1986 to 251. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. private debt accounted for 84. This decline was accompanied.16).8 28.8 Medium 7.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.7 percent from 1991 to 1996.15 Financial Ratios of Listed Companies by Ownership Concentration.5 percent between 1985 and 1990 to 8.5 126.9 percent in 1997. From only 34 percent in 1986.6 11. continued to slide from 1985 to 1997. debt-creating capital inflows rose to 65 percent in 1990. by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF.5.6 30.5 4.Chapter 4: Thailand 261 Table 4. peaking in 1994 at 84 percent.4 27.

1 Source: Bank of Thailand.6 — 0.1 30.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.1 64.2 14.5 14.4 2.3 105.3 0.9 100.1 34.8 0.3 3.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.2 10.1 0.3 0.8 3.7 13.4 10.2 0.3 — — — — — — — 6.1 5.1 2.1 0.5 16.3 16.2 15.9 43.0 11.0 13.3 7.0 6.7 10.8 3.5 1.9 10.5 12.9 13.8 31.7 1.6 1.9 3.2 0.9 35.5 19.8 108.2 2.9 31.7 24.9 6.9 3.1 0.6 7.4 5.7 23.9 0.4 15.9 29.1 95.3 0.16 External Debt. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.0 11.9 4.6 52.0 8.5 4.1 0.3 0.1 12.3 37.5 12.6 Total 18.3 0.4 18.2 0.3 3.3 0.7 109.8 10.0 4.2 32.3 0.4 — — — — — — — 1.7 20.5 4.0 21.0 0.1 22. .Table 4.9 1.8 13.9 5.3 10.9 10.2 2.7 0.9 7.3 12.4 3.9 1.7 2.3 0.3 2.2 2.6 18.1 23.0 3.9 6.8 12.3 20.9 11.

The value of public offerings sank in 1997 to B56. the index declined to 1. and poor business confidence on the other. It hit a 10-year low in the second quarter of 1998. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. outstanding credit also declined throughout the second half of 1998.6 billion from the 1996 level of B201 billion. and drastic decline in the number and capital of newly registered companies. based on the three-month past due definition. 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. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. reaching 45 percent of total outstanding credit in December. leaving domestic investors with large capital losses. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. closures. With easy access to foreign funds. Most of these foreign debts were not properly hedged. Even before the crisis. At the end of 1994. according to the Bank of Thailand. exposing the companies to disaster when the baht started tumbling on 2 July 1997. suggesting that serious investors have not returned to the market. If lending rates remained high. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. the SET Index stood at 1. from its peak in 1995. Due in part to liquidity problems on the one hand. Meanwhile. . SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. Foreign investors retreated from the market. the liquidity problems faced by the corporate sector are likely to continue for some time. banks would be recording more of such NPLs. trading activity at SET had been on the downturn. The effects of the crisis were felt across all industry sectors.17). 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. After that.6 in December 1996. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. Trading volume has since been thin. On average. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. Similarly.360.281 in December 1995 and to 831.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. and (iii) bankruptcies.

410 5. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.052 36. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.2 Responses to the Crisis Initially. .695 3. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.409 6. Ministry of Commerce.797 4.134 31. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.902 3.080 9. It also explains the higher dividend yield ratio.904 20.5. A steady price decline over the past few years has dragged down the ratio of market price to book value.288 35.312 25.977 Source: Department of Commercial Registration.5 at the end of 1994 to 12 in 1996 and further to 6. The price-to-earnings (P/E) ratio deteriorated from 19.096 22. 4.407 28. II Table 4. But when assistance from other sources did not materialize. The IMF financial package was a credit facility of $17.677 Bankrupted/Closed 2.066 19.2 billion for balance of payments support and buildup of the country’s reserves. As part of the assistance package.410 37.201 24.933 25.307 4.224 4.17 Number of Newly Registered and Bankrupted/Closed Companies.095 14.915 37.105 4.264 Corporate Governance and Finance in East Asia.218 3.792 7.6 in 1997.925 12. Thailand. Vol. the Government was left with no choice.777 11.112 9.334 4.

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

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

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

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

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

6.270 Corporate Governance and Finance in East Asia. Thailand is coming from a situation where excessively high leverage became the norm because firms could obtain finance without having to concede a measure of control to outsiders. 4. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. 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 1997.1 Summary. and promoted key industries through incentives. Examination of corporate ownership. Such improvements in disclosure standards are part of the efforts of SET and SEC. Conclusions. behavior. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. For this reason. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. the Government protected certain corporate sectors through tariffs and regulation. Vol. despite the weakness of their disciplinary powers. 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. and even Indonesia. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Philippines. The study covers the period 1985 to 1996. Financial information from listed companies will also soon be required to conform to International Accounting Standards. The . It required listed companies to establish their own audit committees by the end of 1999. to push companies to harmonize their accounting with international standards. and performance during this period helps understand the causes of the crisis.6 4. In the next three decades. II Malaysia.

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

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

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

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

The slow improvement in the legal framework has likewise obstructed progress in this area. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992.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. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. The Government does not have an effective way of monitoring the financial activities of these companies even as it is widely believed that a large amount of funds is being channeled through them. The situation prompts two specific recommendations. requiring cumulative voting for the election of directors. there has been much progress in this area. But weaknesses in accounting and auditing practices have been inhibiting the development of capital markets. increasing penalties for directors engaged in misconduct. and . the Government can change the shareholding limit for controlling shareholders. accountability. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. There is also a need for legislation dealing with nominee or holding companies because they are the institutional means that founding family members use to maintain control. they should be monitored and regulated. and a prohibition of connected transactions by directors or management. The second recommendation is to dilute ownership concentration through the use of regulatory power. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. regulators must increase transparency and step up enforcement. Through an amendment in the Public Company Act. This move is expected to be unpopular among founding family members and original owners. To ensure a level playing field. transparency. Since the Asian financial crisis. Because these holding companies control a number of large public companies in Thailand. SEC is exploring the possibility of amending the law toward this direction.

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

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

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