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

1986-1996 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 . 1990-1998 Table 1.2 Foreign Capital Flows.3 Subsidiaries of the 30 Largest Chaebols Table 2.1 Growth of the Banking Sector.4 Growth Performance of Publicly Listed Companies by Sector.4 Development of the Stock Market.19 DER and ROE of Publicly Listed Companies by Sector. Republic of Korea Table 2. 1993-1999 Table List of Tables 1. Indonesia Table 1.20 ROE of the Banking Sector.11 CharacteristicsoftheBoardofCommissioners Table 1.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.10 Anatomy of the Top 300 Indonesian Conglomerates.17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1996-1998 2.1 Listed Firms with Positive Economic V alueAdded. 1996-1999 Table 1.13 Presence of Board Committees in Listed Companies Table 1. 1996-1998 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization.8 OwnershipConcentrationofPubliclyListedCompanies.6 GrowthandFinancialPerformanceofState-Owned Companies. 1997 Table 1.7 Growth Performance of the Top 300 Conglomerates.12 CharacteristicsoftheBoardofDirectors Table 1.2 KeyMacroeconomicIndicators Table 2. 1992-1995 Table 1.5 Financial Performance of Publicly Listed Companies by Sector. 1992-1997 Table 1. 1988-1996 Table 1. 1992-1997 Table 1. 1992-1997 Table 1. 1992-1998 Table 2. 1993-1997 Table 1.18 GDP Growth by Sector. 1992-1997 Table 1.16 FinancingPatternsofPubliclyListedNonfinancial Companies.14 Banking Sector Outstanding Loans.21 Nonperforming Loans by Type of Bank.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 1992-1999 Table 1. 1992-1999 Table 1.

6 Table 2.5 Table 2.13 Table 2. 1997 Ownership Concentration ofAll Listed Firms.22 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.24 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 .12 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio.9 Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.14 Table 2.17 Table 2.15 Table 2.vii Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.11 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.7 Table 2.10 Table 2.20 Table 2.29 Table 2.8 Table 2. 1995-1997 Ownership Composition of Listed Companies. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.28 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.27 Table 2.21 Table 2.25 Table 2.19 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.16 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies.30 Private Capital Flows to Korea. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1997 Ownership Composition of Listed Firms in Selected Countries.18 Table 2.23 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.26 Table 2.

Leverage Table 3. 1997 Table 3.1989-1997 Table 3. 1988-1997 Table 3.11 TotalandPerCompanySales. 1983-1997 Table 3.19 Financing Patterns by Firm Size. 1995-1998 4. 1989-1997 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 3.21 OwnershipConcentration.14 Philippine Stock Market Performance.31 Table 2. 1988-1997 Table 3.15 Financing Patterns of the Corporate Sector. 1989-1997 Table 3. 1992-1999 . The Philippines Table 3. andAffiliated Banks of Selected Business Groups.3 TheCorporateSectorandGrossDomesticProduct.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.13 ADB Survey Results on Shareholder Rights Table 3.12 Control Structure of the Top 50 Corporate Entities. 1985-1997 Number of Firms with Dishonored Checks. 1988-1997 Table 3.22 Foreign Investment Flows. 1997 Table 3.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1997 Table 3.000 Companies.32 Table 2.17 Composition ofAssets and Financing of the Publicly Listed Sector.33 Net Profit Margins of Chaebols. 1990-1999 Table 3. Thailand Table 4.20 Financing Patterns by Industry.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. 1978-2000 Table 4. 1989-1997 Table 3. 1989-1997 Table 3.16 CorporateFinancing PatternsbyOwnershipType. 1997 Table 3. 1988-1997 Table 3.2 Public Offerings of Securities. 1986-1998 Nonperforming Loans of General Banks.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry. 1992-1996 Table 3. 1988-1997 Table 3.2 Growth and Financial Performance of the Top 1. 1988-1997 Table 3.18 Financing Patterns by Control Structure.Profitability andFinancial . 1997 Table 3. Flagship Company.1 Public Companies Registered.viii Table 2.8 Ownership Composition of Philippine Publicly Listed Companies by Sector.SectorOrientation.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.1 GDP Growth of SoutheastAsian Countries.

11 Table 4. Leverage. Ownership Concentration.5 Table 4.9 Table 4.12 Table 4.16 Table 4.ix Table 4. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.1 Figure 1. 1992-1999 Offerings of Debt Securities.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.14 Table 4.15 Table 4.1 Figure 3. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.17 StatisticalHighlightsoftheStockExchangeofThailand.10 Table 4. 1985-1996 Average Key Financial Ratios by Company Size.7 Table 4.13 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.3 Table 4. 1990-1998 Merger and Acquisition Activities. 1990-1996 Financial Ratios of All Listed Firms. 1993-1999 Size and Composition of the Thai Financial Sector. 1990-1996 External Debt.8 Table 4. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.6 Table 4. 1993-1999 Key Financial Ratios of Publicly Listed Companies. 1992-1999 Common-Size Statements for Companies Listed in SET.2 Figure 3.4 Table 4.


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

Arvind Panagariya ChiefEconomist


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


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

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

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

1 Indonesia
Saud Husnan1



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

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

the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. patterns of financing. this left the Indonesian economy extremely vulnerable. followed by finance (-26. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. highly leveraged companies.5 percent. Vol. regulatory framework. 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.2 Corporate Governance and Finance in East Asia. It analyzes the weaknesses of corporate governance in Indonesia. patterns of ownership and control. how it has affected corporate financial performance and financing.5 percent. To facilitate even easier access to credit. When the crisis hit the country. the Indonesian economy seemed to be in generally good shape. In many instances.3 looks at patterns of corporate ownership and control. except utilities. no doubt. The construction sector was the worst hit. All sectors. These banks were allowed to operate even if they violated minimum capital adequacy requirements. The study also identifies family-based companies and corporate groups. placed a high premium on these political connections in assessing the chances of being repaid. and analyzes their importance to the corporate sector in Indonesia. and . Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. In this setup. Although as a percent of GDP the stock of outstanding foreign debt owed directly by the private sector was smaller than that of the Republic of Korea. or Thailand. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. On the other hand. II rate reached 58. Section 1. posted negative growth. However. and how it contributed to the crisis. particularly those with large foreign loans. contracting by 36.2 presents an overview of the Indonesian corporate sector. these controlling families had political connections that allowed their companies to enjoy special privileges. This study reviews the Indonesian corporate sector’s historical development.6 percent) and trade (-18 percent). Foreign debt reached more than $100 billion. were the ones most affected. the currency composition and term structure of corporate foreign indebtedness were causes for concern. short-term loans were used to finance long-term investments. Section 1. prior to the financial crisis. The highly concentrated and family-based ownership structure of corporate groups and companies resulted in a governance structure where corporate decisions lie in the hands of controlling families. Foreign creditors. Malaysia. and responses to the financial crisis.

2 1. a gradual shift in public investment away from manufacturing took place. textiles. . and its response.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. It also examines the statistical relationship between corporate performance and corporate governance characteristics. and tobacco industries. Subsequently. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies.2 Section 1. Despite the oil revenues.4 analyzes corporate financing patterns. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. The industries that emerged were highly import-dependent and reliant on tariff protection. Section 1. 1.1 Overview of the Corporate Sector Historical Development The marked permeability between the State and business in Indonesia goes back to the country’s struggle for independence.2.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. Not all items in the questionnaires were answered by the respondents. medium. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. Up until the mid-1960s. However. Section 1. how it was affected by the crisis.5 examines the corporate sector during the financial crisis in terms of its role. substantial volumes of private investment entered the scene. in the course of the fight for nationhood from 1942 to 1950. In the early 1970s.and large-scale companies were dominated by state-run industrial concerns. while Chinese and indigenous entrepreneurs ran some large businesses in trading.

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

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

8 29 6.6 240 1996 1997 1998 1999 141. Of these. II Table 1.5 27 88. Bank Danamon.8 10 37.5 27 66. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).8 27 200. But the banking system proved incapable of performing its intermediation function. In terms of assets. The other banks among the top 10 were state banks. and Bank International Indonesia (ranked 9th).5 165 308.9 31 9. 1993 100.2 10 14.3 30 7.7 27 37.2 161 214.9 39 18.8 166 248.4 10 35.6 7 7.9 27 113.7 351.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.9 248.8 31 10.1 240 1995 122.3 201.5 7 9. Bank Danamon (ranked 7th). Among private domestic banks.8 10 19. Both BCA and BUN have shareholders linked to the former President Suharto. BCA. 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.3 27 51.9 304.1 Growth of the Banking Sector. Because regulation was weak. the 10 largest were all affiliated with major business groups.6 34 14.6 7 12.4 34 12.9 10 11. 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.3 10 17. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).9 762.9 291.8 27 147.6 164 144 130 92 387. Vol.5 7 7 7 5 15. .0 234 1994 104. while BUN has been closed down by the Government.4 789.5 528.1 10 47.6 Corporate Governance and Finance in East Asia. banks could earn profits even when they did not gather and process information about risk.8 391.

when the financial crisis hit Indonesia. foreign creditors were eager to provide financing to Indonesia. such as metal goods. . FDI flows were strong. Between 1990 and 1996. and footwear. Indonesia received capital inflows averaging about 4 percent of GDP. Joint BIS-IMF-OECD-World Bank Statistics on External Debt.10 5. Source: IFS CD-ROM. Until the onset of the crisis.63) (1.01) (0. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).74 5. Most FDIs came in through joint ventures with business groups having strong political connections.09) (0.40) (0.50 (0.09 1. the Government allowed foreign investors to own 100 percent of an Indonesian company. In the 1990s. except in certain strategic sectors. 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. initially from Japan and the Republic of Korea.2. Table 1.59 billion in 1996.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.33 (13. November 2000.00 2.48 1. IMF.88 4. there was a phenomenal growth in direct borrowings by Indonesian corporations. September 2000.11 3.15) — = not available.09) 1. But FDIs were only one form of foreign capital inflows to Indonesia.78 2. In 1994.2. as shown in Table 1.2 Foreign Capital Flows.81 3. Successive policy deregulation facilitated FDIs in various light manufacturing industries. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.59 4. From the mid-1980s until July 1997. textiles. In effect.87 7. they still amounted to a large sum for the economy to absorb. Increasingly. Net FDI flows increased to $5. foreign investment also had a strong presence in the services and infrastructure sectors. especially through bank loans.88) — — — — — — 8.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).01 (2. 1.

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

8 220. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines. there were 204 firms. although the contribution increased over time. b Asset turnover is defined as sales over assets. and 1992. 1994. 1995.7 — 250.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.0 1.2 30.6 48. During 1992-1997.1 220. but fell to 24.9 310. 1996.4 38.2 7.8 230. total sales of listed companies grew at an annual average rate of 31 percent.0 12. Despite such rapid growth. but declined to 0.6 24. Source: JSX Monthly (several publications). Table 1.4 1997 7. 250 firms. while total assets grew at 43 percent.5 37.0 12.0 3.8 6.2 1995 37.0 10.4 1996 18.1 0. Return on assets (ROA) was also relatively stable during 1992-1996. the average DER increased to 310 percent from 230 percent the .6 3.3 shows the growth and financial performance of Indonesian publicly listed companies.8 percent between 1992 and 1996.7 3. When the crisis battered Indonesia in 1997. 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 — 3.9 37. In 1997.4 percent.7 percent in 1997.0 12.3 3.1 4. The growth of listed companies was sustained by continuing investments.0 6. Average return on equity (ROE) of listed firms was 11. 174 firms.5 34. publicly listed companies as a group contributed less than 10 percent to GDP.0 11.3 Growth and Financial Performance of Publicly Listed Companies. averaging 3. 226 firms. 1993.6 percent in 1997.4 1993 45. 248 firms.4 31. 246 firms. but turned negative in 1997. a Value added was assumed to be 30 percent of total sales.1 percent in 1997 when the crisis began to buffet Indonesia. Asset turnover was above 30 percent until 1996.0 64.3 6.5 240.5 3. but dropped to 1. Note: The number of firms is not identical for each year.6 1994 50. ranging from 220 to 250 percent between 1992 and 1996.0 33.5 34.7 — = not available.

The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. For instance. and building construction.7 percent during 1992-1996. ROA of all sectors dropped in 1997. Also. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. real estate. the mining sector had the highest ROE. basic industry and chemicals. From 1995. and services. ROE fell drastically because the sector had one of the highest DERs. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. only two sectors (mining and finance) showed a consistently increasing trend from 1992.2 in 1997. But the sector’s ROE fluctuated a lot. the mining sector ranked first. The finance.10 Corporate Governance and Finance in East Asia. which operated in nickel and copper mining in 1992 and 1993. and property. Four sectors (basic industry and chemicals. Overall. when the property sector was booming during 1993-1997. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. property. This sector was less affected by the crisis. Meanwhile. averaging 21. still posting a positive but lower ROE. mining. with ROE falling to -11. II previous year.73 percent in 1992 to 1. The finance sector’s contribution to GDP. meanwhile. the mining sector had the lowest DER. and services. and trade) even posted . the dominant sector was the finance sector. although asset turnover was slow. helped in part by the relatively strong demand for consumer goods. In terms of share of value added to GDP. real estate. in terms of growth of sales and assets. However. the banks eagerly provided credit to property development companies. the property sector was severely affected by the crisis. The same applied to the trade sector. The consumer goods sector ranked second in terms of ROE. When interest rates increased. Vol. Before the crisis.64 percent in 1997. indicating its reliance on equity to support growth. miscellaneous industry. investment. During those years. trade.5 presents the financial performance of listed companies by sector. finance. Table 1. property. the companies in the sector did not operate with a high leverage. consumer goods.3 percent between 1992 and 1996. due mainly to the domination of the International Nickel Company of Canada. and trade. In terms of sales and asset levels in 1997. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. increased from 0. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. averaging 17. infrastructure. miscellaneous industry. followed by agriculture (Table 1. investment.4).

0 16.6 0..4 1993 155.Table 1.4 64. and Services — = not available.3 51.0 64.4 1.9 53.1 0.4 43.5 45.7) (27.4 (149.4 0.8 (76.. Infrastructure Finance Trade. Investment.7) 26. and Bldg.5 9.3 1.3 0. Industry Consumer Goods Industry Prop.7 — — 11.6 0.5 1.9 59.1 71.1 1.4 103.8 1.5 53.0 22. Industry Consumer Goods Industry Prop.5 1.1 67.0) 46.8) (12. Source: JSX Monthly (several publications).5 68.6 15.4 1.7 34.8 0..1 32. Real Estate.7 43.3 92. Constn. Real Estate. Investment.8) 0.7) 17.3 0.1 0.6) 19.6 83.5 23.3 0.0 0.8 24.2 5.0 0. and Bldg.3) 53.6) 119.7 1995 51.7 (82.9 14.1 16.9 8.1 42.1 0.6 22.6 133.5 61. Industry Consumer Goods Industry Prop.0 31.7) (113.1 35.0 0.9 31.0 (192.9 0.6) 25.7 62. and Bldg.1 23.0 1.2 14.7 40.3 0.5 (8.4) 8.7 — 36.4 38.2 0.1 0.3 340.6 24.1 1.1 0.2) 0.0 1996 1997 58.1 0.5 1.8 32. Infrastructure Finance Trade.9 64.2 13.0 (28.2 0.3 17.1 1.2 35.1 0.0 0. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.8 28.4 1.5) 6.0 24.. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.9 123.5 (11.6 1994 (75.7 17.6 26.5 95.8 1.6 0.3 0.9 1. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.4 77.6 (41. Infrastructure Finance Trade.6 0.8 62.0 68. Investment.1 0. Investment.7 0.5 0.1 0.1 28.0 18.1 0.7 0.9 54.9 (7. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.7 54.8 51.6 85.7 90.4 30.1 — 39.5) 49.9 25.9 36.3 31.0 (20.4) 6.8 29.9 .5) 13.1 (41.5 28.9 0.7 21.8 66.4 31.4 21.1 1.5 0.3) 39. and Bldg.2 59. Real Estate.7 112.4 44.2 41.6 51.1 (11. Constn.4 Growth Performance of Publicly Listed Companies by Sector.6 1.0 0. Industry Consumer Goods Industry Prop.2 41.0 43. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.6 (0.8 50.8 27.5 13.6 135. Constn.4 170. Constn.5 92.4 30.3 (203.9 54.3 31.7 28.7 24.1 1. Real Estate. Infrastructure Finance Trade.7 133.6 28.0 0.2 11.

6 74.0 150.8 168.3 17.9 7.0 70.2 11.2 39. and Bldg. Constn.7 1.0 80.0 560.4) (1.7 13. Industry Consumer Goods Industry Prop.9 10.4 35.0 9.0 11.0 110. and Bldg.1 13.0 190.8 20.7 4.6 23.7 5.6 18.5 17. Infrastructure Finance Trade.0 160..0 190.0 110.0 210.2) 7.0 69.5 19.8 5.1 9.5 11.1 11.5 5.7 10. Industry Consumer Goods Industry Prop.7 4.5 Financial Performance of Publicly Listed Companies by Sector..2 1993 130.5 4.0 120.8) 8.6 8.1 89.0 80.3) 5. Real Estate.7 46.1 6.6 8.4 5.5 13.0 100. and Bldg. Real Estate.5 4.6 13.0 3.5 56.0 8.8 3.0 110.0 110.0 110. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc. Investment.0 39.0 140.7 8.1 63.0 66.0 15.4 79.1 2.4 4.8 25.1 10.7 71.1 10.Table 1.7 4.2) 15.7 26.6) 36.2 3.0 8.2 30.0 80.8 44.0 160.1 1996 100.3 13.0 160.3 17.0 110.9 4.4 35.7 8.6 14.4 13. Infrastructure Finance Trade.6 (2.7 10.6 13.7 12.1 10. Industry Consumer Goods Industry Prop.2 13. Industry Consumer Goods Industry Prop.3 64.0 90.2 53.7 12.9 38.0 220.5 7.2 7. Constn.7 5.3 18.7 1.9 42.3 73. Real Estate.4 46.0 700. Constn.4 1.7 61.0) 7.0 14.2 7..8 67. and Bldg.4 6.0 70.3 7.3 1.2 8.1 1994 80.0 70.2 (4.4 20.8 8.3 5.0 150. and Services Source: JSX Monthly (several publications).8 382.0 60.1 4.0 19.8 11.0 180.8 479.0 190.3 38. Infrastructure Finance Trade. Investment.0 (0.4 71.1 7.4 6..9 40. Investment.1 (3.0 100.0 650. Real Estate.0 46.0 100.8 81.9 87.3 7.0 150.0 50.3 33. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.2 15. Investment. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 650.0 100.8 9.4 46.0 120. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.9 29.7 10.7 9. Constn.4 13.9 14.0 180.7 12.3 0.1 9.0 110.0 170.6) 18.9 17.0 630.1 (5.0 120.5 1995 80. Infrastructure Finance Trade.1 3.9 41.1 8.4 17.2 111.0 180.1 4.1 1.8 16.9 38.1 4.0 1997 230.2 23.0 3.5 14. 1992 20.6 (11.0 86.2 3.0 17.7 (3.0 140.0 380.5 43.0 680.0 120.1 65.4 .0 12.6 19.6 1.0 130.8 11.2 6.

This was relatively high compared to the 3. and basic industry and chemicals sectors had relatively stable ROA before the crisis. much lower than that of companies listed in the stock exchange. Similarly.8 percent between 1992 and 1995 (Table 1. respectively. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. Six SOCs were listed in the Jakarta Stock Exchange. State-Owned Companies At the end of 1995.Chapter 1: Indonesia 13 negative ROA. Trade had the highest ROA of 39. between 1993 and 1995. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. banks (seven companies).6). but dropped dramatically to 4. These growth rates were low compared to those for listed companies during the same period.4 percent the following year. there were 58 SOCs with subsidiaries and affiliates. Asset turnover rates were lower relative to those of publicly listed companies. the subsidiaries and affiliates number 459 with total assets of Rp343. insurance (11 companies). While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. the Department of Finance supervised 30 SOCs. and finance company (four companies). Assuming a fixed ratio of value added to sales. indicating SOCs’ declining contribution to GDP. SOCs diversified into many businesses. ROA had been at high levels from 1992 to 1995. increasing from 21. The DER was slightly higher than for listed companies. which collectively had the largest assets. the ratio decreased from 8.7 percent in 1990 to 6 percent in 1996. Just like private companies. averaging 24 and 31 percent. registering an average annual rate of 10 percent. By 1995. Taken together. SOCs actively operated in various sectors4 under the supervision of “technical” departments. growth of net profits and assets was erratic. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.3 percent in 1995. The finance and miscellaneous industry. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. For instance. SOCs’ ROE ranged from 6. However.3 trillion.1 percent in 1993. This was due to large sales by the National Oil Company (Pertamina). The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies).6 to 8. . there were 165 state-owned companies (SOCs)3 in Indonesia.7 to 7 percent for publicly listed companies. SOCs’ sales growth fluctuated during 1990-1996.7 percent.1 percent in 1992 to 28.

766 business units. a Value added was assumed to be 30 percent of total sales.7 Growth Performance of the Top 300 Conglomerates.7 13. Their total sales increased from Rp90.7 1994 (9.3 30. SOCs’ asset turnover rates showed a downward trend from 32.2 18.7).8 11. but climbed to 30.1 trillion in 1990 to Rp234 trillion in 1997. In 1997.7 (2.2 — = not available.8 12.14 Corporate Governance and Finance in East Asia.4 7.6) 260.4 13.0 8. mostly private companies.1 19.5 percent in 1995. but dropped to 11.1) 5.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia. these conglomerates owned 9.1 12.8 percent in 1990 to 13.4 16. Table 1.4 percent in 1992 to 28.6 28. Table 1.1 310.2 — 370.4 13.4 1993 16. 1992-1995 (percent) Indicator Growth Indicators Sales Growth Share of Value Added in GDPa Assets Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb — = not available. a Value added was assumed to be 30 percent of total sales.0 7.3 12.2 percent in 1997 (Table 1.1 32.6 percent in 1994.1 30. Vol. II companies consistently declined over time.0 12.3 250. the contribution of conglomerates to GDP increased from 12. Source: Indonesian Data Business Center.6 28.0 28.6 Growth and Financial Performance of State-Owned Companies.0 17.2 23. Assuming a constant ratio of value added to sales.4 13.8 21.0 24. 1992 — 7.1 6.5 3. . 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17. b Asset turnover is defined as sales over assets. Source: Indonesian Data Business Center.0 8.7 16.6 1995 25.4 percent in 1994.0 6.

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

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

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

6 percent.0 1.6 3. 2.2 11. Rig Tenders Indonesia (shipping services) issued 51.6 4.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). mining.5 1997 48.1 4.8 1.5 16. Table 1.5 12.7 1996 48.9 2.9 percent of total outstanding shares. 13.9 14. Table 1. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.6 68. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997. the founder usually continues to own the majority of shares through a .6.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.5 Average 48. and basic industry and chemicals sectors than in others.3 1995 47.6 3.9 0.5 percent. Meanwhile.7 3. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.8 Ownership Concentration of Publicly Listed Companies.1 13. Vol.1 1.18 Corporate Governance and Finance in East Asia. for instance. issued 93.0 0. This is because a few companies in the transportation sector issued high proportions of shares to the public.0 2.7 1994 48. Zebra Nusantara (taxi services).2 1.4 percent.0 0.4 2. the controlling shareholders usually act as standby buyers.8.1 0. and 0.0 67.9. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.0 4. respectively.9 Source: The Indonesian Capital Market Directory.6. consumer goods.9 2. This preserves the pro rata share of existing shareholders. The pattern of ownership concentration changed little over this period. 3. On average. When a company goes public.5 72. the five largest shareholders owned 68. II Publicly Listed Companies Table 1.8 68. When a company makes a rights issue.2 67.6 13. The percentage owned by each of the five largest shareholders was 48.8 68.

1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.3 2.8 14.5 1. Indonesia has the largest number of companies controlled by a single family.6 percent of total market capitalization while the top 15 families control 61. the rule of law.1 0. (1999). In terms of capitalization. which shows that in 1996. and only 0. In fact.4 1.1 11.9 44.1 13. two thirds (67.1 0.1 2.1 1.4 6. and Services Average Source: The Indonesian Capital Market Directory.1 percent) of Indonesian publicly listed companies were in family hands. on the other.1 2. Table 1.2 10. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.2 15.1 1. that the correlation between the share of the largest 15 families in total market capitalization.7 6.7 13. and Transportation Finance Trade.6 percent were widely held. the top family controls 16.9 44.9 1. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. Claessens et al.3 48. Infrastructure. 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.7 1.4 4.9 50.6 9.2 2.4 11.7 4.9 3.6 1. on the one hand.4 54. as well as the existence of corruption. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.2 46.2 0.1 2.6 2.5 58. Investment. in a cross-country study. and the efficiency of the judicial system.3 36. (1999) also found.5 4. Industry Consumer Goods Industry Prop. Constn. is strong.1 1.7 percent of the market.6 0.3 0.3 14. Util.4 44. and corruption.1 1.3 0. Real Estate.2 This is confirmed in Claessens et al.0 5.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). and Bldg. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in ..9 0.7 9.6 8. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals..9 Ownership Concentration of Publicly Listed Companies by Sector.

Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. ethnicity. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. The nonindigenous businesspeople are usually Chinese. most were established during the New Order Government. the legal system is less likely to evolve in a manner that protects minority shareholders. Coordination is easier because informal communication channels exist. Vol. However. their number increased to 5 In 1997. conglomerates established before 1969 dominated in terms of sales. In Indonesia.20 Corporate Governance and Finance in East Asia. and family origin. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. accounting for 64 percent of total conglomerate sales in 1988-1996.5 Conglomerates Table 1. This may indicate that the New Order Government. the Government allowed foreign investors to buy up to 100 percent of listed shares. with all its regulations. However. In September 1997. the proportion of foreign ownership declined from 27. II the small number of families and the tight links between companies and the Government. and Padang. numbering 162 in 1988 and 170 in 1996.55 percent in August to 25. 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. or other ethnic groups. During 1988-1996. political affiliation. From 193 in 1988.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. Indian. . there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. Indigenous businesspeople include the Javanese. the onset of the crisis negated this development. foreign ownership increased to 21 percent. was able to create a favorable environment for business development. Batak. resulting instead in a decline in the proportion of foreign investor ownership. But these benefits are few and often dubious compared to the high costs of concentration. Among the top 300 conglomerates. In 1993.42 percent in December. it rose to 30 percent. Sundanese. but later declined and steadied at around 25 percent.

9 47.4 81.7 89.2 33.9 billion. Meanwhile.8 25.4 59. sales of the Bakrie group before it went public in 1990 were only Rp369.3 80.8 57.6 trillion in 1988 to Rp137.1 103.2 29.5 120.1 87.4 37.5 106.10 Anatomy of the Top 300 Indonesian Conglomerates.8 68.4 31.3 134.4 15.7 28. In 1996.3 43.8 Source: Indonesian Business Data Centre.8 28.1 33.6 12.0 15. 204 in 1996. For instance.4 59. 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 9.8 49.0 28.9 14.7 106.1 41.4 trillion in 1996.1 46. its sales reached Rp1. the number of mixed groups declined from 86 in 1988 to 68 in 1996.1 46.5 21.9 73.0 58.4 32.5 22.2 159.4 86.7 24.0 18.0 116.3 120.4 16.7 49.1 25.1 58.4 19. more than five times its 1988 level.1 percent of total .7 40.2 23.8 12.Chapter 1: Indonesia 21 Table 1.4 69.3 101.2 30. Their total sales also increased from Rp38.8 38.9 13.4 31.4 22.1 21. due to their “go public” activities.6 54.6 95.6 114.7 95.3 36.1 42.2 48.6 17.9 42.1 52.9 trillion. While they supplied 20.4 18.0 58.0 31.8 30.3 20.9 77.9 35. Conglomeration Indonesia 1997.4 48.6 77.9 137.8 36.6 34.4 57.2 12.2 76.0 44.4 52.7 64.1 179.4 68.

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

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

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

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


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

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

7 112. the share of private national banks in outstanding total loans increased to 44.0 93. stocks.2 5.1 Equities In 1977.14 Banking Sector Outstanding Loans.3 9. when the Government reactivated the stock exchange.4 86. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).32 Corporate Governance and Finance in East Asia.0 6. Bank Credit As shown in Table 1. Table 1. including bonds. remain the major financing instrument for the corporate sector.3 66. jointly providing almost 90 percent of loans until 1997. and others offered by nonbank financial institutions or finance companies. however.6 150.1 Corporate Financing Financial Market Instruments Prior to 1977.9 153.4 225.3 60. However.3 14. because of the restrictions discussed below.2 71.6 4. 1992 1993 1994 1995 1996 1997 1998 1999 68.3 188. II 1.5 80. equities became available to the corporate sector.0 3.5 7. Since then.6 48. From 34. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.5 108.4 1.6 6.9 234.4. Data from Bank Indonesia show that from 1994 to 1997.9 trillion in 1992 to Rp487.0 487. . Private national banks and state-owned banks were the biggest domestic creditors.9 378.6 percent in 1997.2 27. Vol.7 50.8 193.1 220.6 3.14. bank credit surged from Rp122. companies considered alternatives to bank loans. Bank loans.5 42. new instruments have been introduced to the corporate sector.2 6.4 56.7 18.4 24.0 168. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.9 150.6 292.4 trillion in 1998.4 percent in 1992.3 111. private national banks overtook state banks as the dominant credit source. this market was not well developed.7 122.

15 Value of Stocks Issued and Stock Market Capitalization.0 206.9 1999 76. offering services such as leasing.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.1 17. It gradually increased again starting in 1991.6 301. the stock market has gained a bigger role in corporate sector financing (Table 1.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares. shooting up to 18. . The ratio reached 8.4 207.8 48.6 859.e. The ratio of funds raised by finance companies to credit disbursed by the banking sector has been increasing from about 5 percent in 1992 to 13 percent in 1996. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.1 18. when foreign investors were not yet allowed to purchase listed shares.7 9.5 333. legal lending limit.9 406.g. the Government issued regulations to supervise and promote prudential practices in finance companies. and consumer credit.15).2 16. capital adequacy ratio.5 1995 35.1 10. thus increasing the role of the capital market in raising long-term funds. Overall. They were not. In 1988. factoring. allowed to accept deposit accounts from the public. Prior to 1995.6 310.0 70. 1992 1993 11. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. credit cards.7 14..4 1996 1997 1998 50.. finance companies were increasingly used as channels for the inflow of foreign loans.Chapter 1: Indonesia 33 Some companies went public. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.1 1994 26.7 15.7 percent in 1997. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. and net open position).6 123. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. In 1995.6 91. however. i. During the 1990s.0 15. Table 1.

3 14. PACAP Research Center.0 100.5 21.6 100.0 1986-1996 17.8 17.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.5 percent and 36. respectively.0 39. 1996. Thus in November 1995. have been popular in Indonesia since 1990.2 Patterns of Corporate Financing Table 1.6 12. averaging 26.4 13. II Commercial Papers Commercial papers.1) 23. This is in contrast to the lower share of borrowings during the same period.2 26. they were not rated by a rating agency. In the second half of the 1980s. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. otherwise it would be classified as a loss in the banks’ books.6 23.0 3.7 22.6 100. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. at 81 percent of total borrowings. Vol.3 16.9 16.4. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents.34 Corporate Governance and Finance in East Asia. short-term borrowings were greater than long-term debts.3 37.1) 23.3 (0.0 1991-1996 16.4 8. In terms of composition. Table 1.5 11.16 Financing Patterns of Publicly Listed Nonfinancial Companies. 1. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings). .8 percent. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.6 8.4 23. While banks had some exposure to these instruments.8 7. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments).5 — 26.0 — = not available.5 (0.

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

the borrowings swelled. II However. 1. The test of the difference between the two means found the t-value of 1. to maintain control of the company. since commissioners represent the controlling party. the private sector borrowed heavily in unhedged dollars. In addition. As a result. aided .0 1. decisions on debt are made with the implicit endorsement of owners.56 significant at the 10 percent level.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. Controlling parties rely on external financing to maintain their equity share and.5 1. 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. ultimately. 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. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. Vol.0 386.17 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. and high ownership concentration among families with political affiliation.358. Source: Author’s estimates.5. Table 1. the free capital flow system allowed private companies to borrow dollars offshore without any restriction.0 351. Between 1987 and 1996. heavy reliance of companies on bank credits to finance investments.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.36 Corporate Governance and Finance in East Asia.

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

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

0 5.4 7.1 5.9 3.8) (13. much higher than the 307 percent registered in December 1997. and 128 companies reported a total loss of Rp46. The construction sector was the worst hit. followed by the finance and trade sectors. BPS).6) (3.18 GDP Growth by Sector.1) (26.7) 2.1) 1.4) 2. and Water Supply Construction Trade.0) 1999 2. and Fisheries Mining and Quarrying Manufacturing Electricity. The consumer goods industry reported the lowest ROE.7) (2.58 trillion (meaning their losses were greater than the paid-up capital).3 11. Forestry. The average DER was found to be 1.7) (8.7 6.8 8.5. real estate.8 1997 1.52 trillion. Only 86 companies reported profits.8) (11.0) (15. posted negative growth rates.18 shows that growth in most sectors significantly fell in 1997.4 7. and Business Services Other Services GDP 1996 3.3 12.8 0.2 8.4 5. This continued in 1998. Gas. as shown in Table 1.6 (36. indicating a rapid rise in .370 percent. and Restaurants Transport and Communications Financial. 53 companies reported negative equity of Rp6. Livestock.19.6 12. and building construction. followed by property.Chapter 1: Indonesia 39 1.8 7.4) (0. Real Estate. DER and ROE were calculated per sector. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.1 6.6 13. Sectors with lower ROE generally had higher DER. Table 1.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1. 1996-1999 (percent) Sector Agriculture.6 8. Most sectors showed significant increases in leverage. Hotels.0 2. when all sectors. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39.2 (1.24 trillion for the first six months of 1998.6) (0.3 Source: Central Bureau of Statistics (Biro Pusat Statistik.6 4.0 3. except utilities.1 (1.7 1998 (0.5) (18.

0 111. Vol.7 percent in July 1998.0 631.0 163.0 1.8 (373.0 2.0 205.625.4) 8.4 (6. losses in operation were due to declines in sales and increases in the cost of imported inputs. Second. the NPL ratio rose to 25. The huge losses suffered by most companies were caused by three factors.0 229. small foreign banks enjoyed the highest profits.4) 18.7 1.0 2. Financial and banking analysts estimate that by September 1998.40 Corporate Governance and Finance in East Asia.2 23.0 12.2) (264.395. several publications.0 65.21.0 635.0 697.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 a ROE 1996 1997 1998a 14.1) 7.0 72.8) 36.9 12.8 percent in 1996. Third.1 (92. and would have kept on increasing if interest rates had not declined. Impact on the Banking Sector Table 1.370.1 1. Mostly suffering from a liquidity squeeze. the NPL ratio had reached more than 60 percent.6) (115.0 158. This figure further increased to 47.0 105.0 108.0 92. First.3 7.271.0 193.0) (78. as shown in Table 1.0 191.0 864. a Actual data for 1st semester only. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.097. .5 8.0 97.20 reveals that the banking sector’s ROE decreased significantly in 1997.6 (11.0 1.0 307.8 17.4 5. II Table 1. As the rupiah weakened and interest rates increased.7) 6. from only 8.0 177. foreign exchange losses came about with the use of unhedged foreign debt.2 13. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.1 30.0 1997 234.19 DER and ROE of Publicly Listed Companies by Sector.0 108.0) 10.0 1.0 1998 186. private banks posted negative ROEs in the same year.1 (124.0 219. Source: JSX Monthly. but annualized to approximate full year values. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.5 percent in April 1998.1 (3.2 (4. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.1 (5.6) 15.0 177.

86 11.25 22. put pressure on the banking sector.30 5.45 21.89 27. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.9 — 11.0 129.8 187.21 Nonperforming Loans by Type of Bank. 230/1998.1 1.3 Private National Banks — 179.70 1995 7. 1996-1998 (Rp trillion) State-Owned Banks — 140.8 11.8 14.6 — 4.2 8.1 30.34 16.5 222.2 10.0 622.6 6.2 37.3 361.09 11.39 13.8 3.20) Table 1.7 — = not available.91 21.73 30.50 9.1 47.4 7.07 1994 14. 227/1998 and October No.7 29.2 8. Source: Infobank. In July 1998.0 — 4.2 48. private national banks overtook State-owned banks when their NPL ratio jumped to 57.6 — 13.28 5.2 — 19.7 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 331.43 10.2 — 8.2 1.20 ROE of the Banking Sector.1 198. 1992 7.15 20.9 Regional Foreign and Development Joint Venture Banks Banks — 9.Chapter 1: Indonesia 41 Table 1.8 8. The high and increasing NPLs.72 16.5 31.1 13. July No.07 13. State-owned banks initially had the highest NPL ratio.3 22.06 20.47 20.09 (11.68 1996 1997 8.67 8.5 2.0 — 32.69 14. coupled with negative spreads (deposit rate was higher than the credit rate).1 274.7 — 1.9 11.7 106.24 (4.45 — 1993 15.9 percent.12 15. Source: The National Banking Association.37 19.5 34. .81 13.24 15.7 4.2 47.3 445.44 15. however.38) 11.5 57.5 128.6 — 1.84 27.9 297.

and Ciputra (property business).7 percent ($64.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. a more comprehensive scheme to tackle domestic and foreign corporate debt. In November. by mid-September 1998. Vol. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. assembling the legal and policy framework to facilitate corporate restructuring.7 billion of foreign exchange debt. the committee launched the Jakarta Initiative. Aside from being described as overly complicated. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). Corporate debt accounted for 46. II 1. Thus.000/$1) in debt from domestic commercial banks. 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. few companies were in a position to resume interest payments.5. particularly in terms of debt resolution. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. 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. have been subject to restructuring deals under the initiative. Astra International (automotive). such as Garuda (a national flag carrier).6 billion) of Indonesia’s total external debt in March 1998. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. companies were not servicing their debts.2 billion debt. only a . The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.000 eligible firms had signed up for the scheme. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. a number of prominent companies. While the process of restructuring was in progress. In addition. none of the 2. However. the scheme failed.4 trillion of domestic debt and $6. On 9 September 1998. The scheme encourages negotiation between creditors and debtors.42 Corporate Governance and Finance in East Asia. about 80 percent of which was private. Unfortunately. Since September 1998. By end-November. In June 1998. the Government and private sector formed a committee to help corporates deal with the crisis.

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

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

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

On average. These figures show the extent of power wielded over the corporate sector by a small number of families. the majority remains family-controlled. II 53 percent of total assets of the top 300 Indonesian conglomerates. As a result. retain ownership control of companies. The restructuring and resolution of financial distress may. lacked the information necessary to allow them to assess projects’ risks and chances for success. Foreign creditors. Therefore. when barriers to entry in the banking sector were lifted. Indonesian companies borrowed short term. Among those listed in the Jakarta Stock Exchange. however. Vol. Rapid growth in investments masked the corporate sector’s increasing leverage. banks were unwilling to provide credit to highly leveraged companies. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion . thus. allowing them to maintain their equity shares and. while a single family controlled 16. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. families control 67. When the Government regulated the legal lending limit and the net open position of banks. conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. Companies relied heavily on bank credit. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. However. These banks also obtained cheap offshore funds.46 Corporate Governance and Finance in East Asia. Financing Patterns Controlling shareholders opted to use debts to finance expansion. On the one hand. 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.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61.7 percent.1 percent of publicly listed companies in Indonesia. corporate debts grew over time. not all of the conglomerate-affiliated companies are publicly listed. However. But because foreign creditors were reluctant to lend long term. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. meanwhile.

Bank Indonesia extended emergency loans to many banks. the consumer goods industry was the worst hit. DER increased to 307 percent in 1997 and further surged to 1. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. NPLs rose and capital adequacy ratios fell. corporate-initiated debt restructuring . The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. and strengthen prudential regulations and supervision of the financial sector. the highly leveraged companies. Sales of conglomerates as well as those of publicly listed companies were increasing. facilitate debt restructuring. and the rapid decline in equity due to losses. As the rupiah weakened and interest rates increased. particularly those with large short-term foreign loans. Meanwhile. although at a declining rate.370 percent in 1998.21 trillion in 1996. On the other hand.1 percent in 1997 to -124.24 trillion in the first half of 1998. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. The Government and the private sector responded with measures to mitigate the negative effects.1 percent in 1998.Chapter 1: Indonesia 47 without diluting their control. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. At the height of the crisis. The Government introduced reforms to improve bankruptcy procedures. The financial crisis led to the closure of several dozen banks. and registered a net loss of Rp39. Impact of the Financial Crisis Prior to the crisis.1 trillion in 1997 from Rp13. ROE dropped from 1. financed by issuing nearly $80 billion worth of bank restructuring bonds. To restructure the corporate sector. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. the corporate sector was in quite good shape in terms of growth and profitability. the high domestic interest rates that prevailed from 1998. followed by the property sector. When the crisis hit Indonesia. were the most adversely affected. Total profits of publicly listed companies dropped to Rp3.

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

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

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. II explaining the greater depth of the crisis in Indonesia. despite the smaller level of capital inflows (as a percentage of GDP). Vol. .50 Corporate Governance and Finance in East Asia.

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

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

Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. Government reform goals for the corporate sector include enhancement of corporate transparency. T. II Table 2. and J Murrin (1995). The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. The EVAs are the same as the economic profit as explained in T.1 1997 518 104 20. Koller. Source: Korea Stock Exchange.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. This study collects and analyzes data on the Korean economy.4 1993 513 174 33. 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. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital. accountability of controlling shareholders and boards of directors. capital market discipline. and individual companies. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. June 1999.1 1996 561 163 29. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. the corporate sector. 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. which distributed and collected the questionnaire.54 Corporate Governance and Finance in East Asia. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.1 Listed Firms with Positive Economic Value Added. and improvement of bankruptcy procedures. Copeland.9 1994 531 165 31. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. Many firms left some questions unanswered.1 1995 560 163 29.1 1998 490 164 33. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. Weaknesses in the overall corporate governance system in Korea had many ramifications. especially chaebols.

clothing. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. and naturally adopted an import substitution policy. From 1948 to 1961.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. which account for a substantial portion of the Korean economy. 2. The Government tried to produce food. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn.4 contains analyses of corporate financing and its relationship to performance. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. Section 2. Section 2.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. Major economic indicators for some of these periods are shown in Table 2.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. . and employees and their role in shaping corporate governance practices. This chapter is composed of six sections. Yang. the board of directors system. creditors.2 presents an overview of the corporate sector. In the period 19481961. and Yim (1998).2.2. reviewing government policies responsible for the development of the modern corporate sector. It reviews such elements as shareholders’ rights.2 2. The evolution of the modern Korean economy can be divided into four periods. It traces the country’s economic development. It then presents recommendations for further reform in corporate governance and financing.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. corporate control by the Government. Section 2. Section 2. Section 2. and other necessities domestically.

and implementing new budget and tax measures.8 (8. This goal required very high savings and investment rates. lack of strong drive. c Refers to 1989.2 757. The Government tried .1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries. International Financial Statistics.4 1990-1997 7. However.4 29.0 41. Export Drive: 1962-1971 Between 1962 and 1971. Source: Bank of Korea.7 37. and inconsistent economic policies. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).9b 15.2 1980-1989 8. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.855. IMF.0) 492.9 794.753.2 Key Macroeconomic Indicators Annual Average (percent.265.5) 8. b Refers to 1979.1 — = not available. Economic Statistics Yearbook.8 15.1 35.4 (1. high unemployment and inflation.2 452. Vol.7 30.6 11. and large current account deficits. a Refers to 1971.2 6.56 Corporate Governance and Finance in East Asia. 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 27.4 29.2 30. d Refers to 1997.102.9 — — 21.8 12.2 1.4 10.8 24.1 29.949.1a 21.5 250. the Government was not successful in solving the problems of slow growth. In the Plan. e For maturities of one year or more.9) 1.8 (724.7 14.447.1 9.3 8.332.5 38.1d 9.2 314. the Government called for an unprecedented average annual economic growth rate of 7.2 32. 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.5) (1.2 31.1 15. II Table 2.7c 11.0) (297.4 24. modernizing the industrial structure.9) (7. largely because of political instability.

boosting internal investment resources. During this period.5 percent. abundant. The exchange rate system was a kind of crawling peg until 1974.2 billion in 1972. The average growth rate of the economy from 1960 to 1964 was 5. up from 30 percent in the late 1950s. the import liberalization rate was 55 percent. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. In 1971. but tariff rates were raised to 40 percent in the 1960s. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. which laid a solid foundation for a steady growth path. channeling funds from curb markets into the banking sector. However. Also. This change raised the import liberalization rate from 9. Exports increased sharply from $41 million in 1961 to $2.3 percent average between 1954 and 1959. But the liberalization trend turned out to be short lived as current account deficits continued. a modest improvement over the 4. due to continuous current account deficits. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. The interest rate reform enabled banks to allocate large funds to the industrial sector and reduced the high inflationary pressure that had built up in the economy. imports of consumer goods and luxury items were highly restricted. and cheap labor force was well utilized by the export-led growth strategy. During the first five-year plan period. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. the growth of gross domestic product (GDP) raised domestic savings. . In 1963-1964. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. The well-educated. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). but the average growth rate for 1965-1969 shot up to 10 percent. and maximizing mobilization of domestic savings on the other. In 1964. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent.3 percent to 60. while the average tariff rate was 39 percent. the Government tried to provide exporting firms with a free trade environment. Bank deposits increased rapidly.4 percent. resulting in high real interest rates.

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

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

9 percent. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. Korea adopted a market average exchange rate system. 13. 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. In 1990. The most important element characterizing chaebols is the concentration of ownership. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. which gradually widened. the importance of chaebols was increasing.9 percent. The Government tried to adjust economic policies and regulations to meet global standards. 46. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups.1 percent. Meanwhile.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. the import liberalization ratio reached 98. The low value of the dollar led to a low won and high yen. the Government committed itself to further liberalization of the goods and capital markets. and total workforce.2. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. while continuous and large current account surpluses saved Korea from the foreign debt problem. . further increasing its pace of import liberalization. total sales. whose business activities are controlled by an identical person. 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). In 1988. and acceded to the World Trade Organization (WTO) in 1994.2 percent. giving up its foreign exchange controls related to the current account. Vol.3 percent. Industrial and trade policies were modified to be consistent with WTO. with the 30 largest in the total economy in 1997 standing as follows: value-added.60 Corporate Governance and Finance in East Asia.9 percent. 47. 2. In 1993. II world interest rates. 4.1 percent and average tariff rates 8. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. 45. The official rate fluctuated within a band. total assets. and low oil prices. total debts. Korea began participating in many multilateral trade negotiations during the Uruguay Round. and declaring that it would follow Article XI of GATT. but it chose to liberalize gradually.” A large-scale business group is called a chaebol.

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

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

1 16. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. Korean firms were allowed for the first time to issue in international financial markets equity-related securities such as convertible bonds (CBs) and depository receipts. Beginning 1990. As shown in Table 2.Chapter 2: Korea 63 During the 1980s and 1990s.9 34. the stock market grew rapidly during the 1980s. was established to invest in domestic shares beginning in September 1985. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. especially those paying small or no dividends. continued until 1989.6 747. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. The policy to expand the size of the stock market.020 151. several important policy measures were implemented to promote the development of the stock market. the Government announced the gradual opening of the capital market to foreign investors in January 1981.5 406.0 79.4 Development of the Stock Market. Third.9 833. Also that year.9 918. The Korea Fund.0 965.151 117.217 141. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues. a country fund. Inc.570 95. however. . the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.798 Market Capitalization as a Ratio to GDP (%) 8.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. First.370 70. 1985-1998 No.4 40.0 49. Because of government policies and the booming economy.4 654..1 30. Second. In this regard. The aggregate Table 2.1 Market Capitalization (W billion) 6.2 44.989 137.476 79.7 934.4. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. 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).

trade credits. . Bank of Korea.339) (9. currency and deposits.875 21.59 percent in 1998 and to more than 50 percent in the early months of 1999. Table 2.5 Private Capital Flows to Korea.433) (9. Source: Balance of Payments. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.123 3. The aggregate market value of listed shares bottomed at 16.800 (7.326 1. and 1993. but increased sharply to 79.352 471 3.347 3.714 1.534) 1.008) (3.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.817 16.338 4.382 Permit basis. and other liabilities.085 2.86 percent of GDP in 1997.858 4.944) 8.287 (340) 73.500 7.852) (2.868 (518) (418) 63 1.450 24. Other investments include loans.413) 56.001 4.642 21.414) 5.953 10.650 (1.255 2. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.455) 13. II market value of all listed firms represented only 8 percent of GDP in 1985.440 1.546 (2. and stayed at the 30-40 percent level up to 1996.870) (1. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.583 25 10.296) (6.924 (1.737 (333) (297) (607) (2) 218 2.2 percent by 1989.150 5.785 (1.910) 2. due to declining stock prices.183 12.658) (3. The relative size of the stock market diminished to 44 percent in 1990.264) (3. However.239 19.571 2.64 Corporate Governance and Finance in East Asia.742 (3.453 (2. 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 1986-1989.553 8.149 13.126 (1. but rose again to 34.141 4. Table 2.017) 1.542) (1.694) 2.942) 42. Vol. 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. The growth in the number of listed firms also slowed in the 1990s.

increasing to 76 percent in 1997. portfolio investments amounted to $73. Table 2. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. This would lay the foundation for evaluating the effect of corporate governance on performance. but between 1988 and 1993.2 percent in 1987. Korea had substantial current account surpluses and experienced net private capital outflow.Chapter 2: Korea 65 Complicated government regulations. and US. The ratio is generally in the same range for Japan and Korea. The contribution of the corporate sector to GDP was 73. Corporate sector net proft margins increased from 1993 to 1995. Between 1986 and 1989.6 percent in 1997.2.7 billion and loans $42.9 billion.6).China and the US. other net private capital inflows amounted to $130 billion during 1985-1998.5). 2. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. Of this.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Net private capital inflow. and high production costs were the main reasons for low FDI in Korea. The growth rates of total assets. Taipei. The dismal performance of the Korean corporate sector compared to the . equity. weak incentives for attracting FDI. (ii) listed firms. The same categories will be analyzed in later sections. following the sharp depreciation of the won. excluding FDI. and sales of the aggregate sector during this period were very high (Table 2. but dropped in 1996 and were negative by 1997.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. and (iii) chaebols. However. Japan’s was consistently higher. the growth rates of equity and sales dropped sharply in 1996 and 1997. This indicates that a substantial proportion of debt was denominated in dollars.China. Return on equity (ROE) and return on assets (ROA) showed similar patterns. In addition to FDI. Profit rates of Korean firms were relatively low compared to those of Taipei.

4 10.8 1.3 3.6 424.0 (0.0 8.7 325.1 5.7 15.3 6.0 305.5 1.9 2. .9 2.8 22.9 5.8 21.1 2.2 13.2 1.2 1.5 0.0 6.5 2. Financial Statement Analysis Yearbook. ROE = return on equity (ratio of net income to stockholders’ equity).6 4. ROA = return on assets (ratio of net income to total assets).4 2.8 3. Net profit margin = ratio of net income to sales.1 6.5 3.2 13.4 1.9 2.5 4.0 4.2 18.Table 2. 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. Source: Bank of Korea.3 312.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.9 4.9 5.2 1.3 308.2) (0.5 (0.8 2.7 3.2 19.5 4.7 4.3 21. Table 2.6 3.8 1.9 16.0 13.7 2.9 18.3 1. Financial Statement Analysis Yearbook.3) 5.4 1.9 5.6 13.3 14.6 2.0 0.0 3.8 8.4 — 6.7 3.3 17.1 2.9 3.0 13.7 4.9) DER = debt-to-equity ratio.9 8.4 2.3 — 3.2 9.0 10.3 11.6 (4.7 4.5 7.4 4.9 3.1 — — — = not available.4 2. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).3 21.1 8.6 1.6 9. Source: Bank of Korea.1 2.3 335. Note: Ratio of ordinary income to sales = (ordinary income/sales).6 1.4 19.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.9 18.8) 297.7 15.5 1.0 7.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.9 13.7 1.4 1.6 318.5 1.9 16.

the exception being the electricity.9). both ROA and ROE were lower for the listed firms compared to the latter. . Small listed firms were hardest hit by the financial crisis. while their average net profit margin was lower than that of medium firms. and steam supply industry. a year ahead of the other industries. the average ROE was lowest for large firms. this may be an indication of the bias toward large firms in terms of access to credit. It is notable that the construction sector’s profit rate began its decline in 1995. sales of listed firms grew 18. However. Profit rates of most industries are also quite low.5 percent while the aggregate sector recorded only 13. with the wholesale and retail trade sector and the construction sector having the highest figures. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. Performance followed similar patterns across different industries (Table 2. and transport sectors recorded negative profit rates in 1997. Growth rates of total assets are generally high. Net profit margins. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. All sectors experienced a sharp decline in equity and sales growth in 1997. This preference of Korean firms has its roots in the structure of corporate governance. 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. The other financial ratios follow the general pattern of the aggregate corporate sector. A comparison of performance by firm size reveals some interesting results. The growth performance of large firms for the 1988-1997 period was better than that of medium. However. In 1997. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. The manufacturing. but higher than that of small firms. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. gas. In most years. ROEs.10).and small-scale firms (Table 2.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. Again.4 percent. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2.8). trade.6). construction. followed by mediumsized firms and large ones. with equity in wholesale and retail trade even contracting. This may be related to its having the lowest DER.

1 1.9 9.8 22.4 3.8 1.5 6.4 0.0 2.5 239.4 1.2 0.5 1.2) 22.6 11.9 13.0 1.1 21.6 14.6 15.9 (0.8 Real Estate.3 15.6 6.4 2.4 5.9 10.7 5.6 12.5 1.8 34.0 245.5 4.7 17.3 1.8) 0.2 18.2 (1.8 2.7 10.8 616.4 740.9 3.1 16.0 1.9 538.3 11.1 290.5 5.4 2.5 23.1 1.2 5.1) 3.8 14.7 520.0 15.0 5.5 (1.4 (0.9 10.3 288.8 302.4 9.6 0.8 0.9 19.3) (1.4 5.4 10.0 22.8 24.6 655.6 14.8 35.6 5.4 12.9 25.3 10.0 1.7 (3.2 7.5 16.6 17.0 (0.0 (4.8 16.0 15.2 6.6 2.9 16.6) (6.5 473.2 6.2 12.5 270.2 241.2 24.4 348.8 12.8 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 13.0 21.6 7.4 2.5 1.8 3.0 16.0) 4.4 10.7 0.4 10.9) 1.5 286.0) 0.0 1.1 0.1 2.0) 1.8 10.9 29.3 10.9 5.4 350.8 2.5 306.2 16.1 28.5 28.8 526.9 31.7 16. Renting.4 458.5 (5.3 14.9 1.9 16.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.8 22.7 30.5 1.0 18.6 318.1 296.7 7.5 30.0 (0.8 7.0 1.0 24.3 15.0 19.5 6.1 0.3 1.4 10.0 2.1 396.9 14.7 4.7 21.4 15.4 1.8 2.2 20.4 4.1 (0.9 2.4 17.0 2.8 12.4 0.1 0.0 5.3 11.1 22.3 8.0 22.6 3.3 18.3 8.4 291.4) 0.0 3.7 317.1 1.6) 3.3 15.8 461.8 32.6 1.2 423.6 17.3 14.4 2.5 432.8 1.6 16.8 3.8 23.2) (0.3 25.6 12.4 2.7 9.1 10.6 375.5 483.6 3.6 1.3 31.7 228.4 5.0 16.8 0.2 315.1 17.2) 6.9 (0.4 14.9 16.0 2.3 2.8 10.8 345.1 2.2 5.3 8.8 13.5 5.2 0.9 0.1 7.1 1.7 22.9 428.8 16.5 14.3 2.5) 0.9 2.3 13.3 15.0 1.Table 2.4 .0 23.5 (0.0 24.2 20.8 24.2 5.5 27.0 1. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.3 8.7 (0.9 (0.1 (0.5 1.1 20.2 25.7 294.5 338.5 3.5 1.0 9.5 569.0 22.1 27.0 37.2 16.7 1.6 0.5 13.2 0.2 36.6 24.7 514.0 18.8 16.8 17.6 14.1) 0.2 2.0 254.5 19.1) (3.4 474.2) 15.7) 2.0 7.9 340.0 12.8 14.2 15.8 562.3 285.0) 0.

4 12.6 9.6 18.9) (8.7 12.6 12.4 6.5 539.9 9.0 1.3 8.8 (Cont’d) Growth Performance Year Assets Equitya Sales NPMb Financial Performance DER ROE ROA Wholesale/Retail Trade 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average — — — — — 31.2 3.5 4.1 8.1 6.2 10.6 — — — — — 17.7 2.1 16.6 2.1 15.5 462.5 16.9 18.9 8.4 9.1 15.5 612.3 0.6 (2.8 529.6 1.5 15.4 633.9 4.3 9.062.4 0.2) 0.3 (2.0) 1.8 7.8 8.5 482. Source: Calculated using data from Bank of Korea. b NPM denotes net profit margin.4 10.5 26.6 4.2) 13.0 14.8 6.0 14.8 0.0 2.3 12.6 512.5 13.6 21.0 21.1 15.3 18.9 10.6 (2.7 510.9 321.4 0.4 16.8 0.9 6.7 11.1 17.7 16.0 5.0 Transport.1 11.0) (0.9 10.5 14.6 34.3 19.3 4.4 7.0 7.2) 9.8 14.5 14. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.4 3.1 21.9 4.3 0.8 14.4 1.6 8.4 1.5 47.9 12.8 12.8) 1. Storage.6 6.8) (12. a New equity does not include capital surplus.4 13.9 7.4 2.7 187.1 (2.1 14.7 7.9 8. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.8 12.3 34.7 2.4 169.3 1.4 — — — — — 448.1 (11.3 543.2 7.4 1.5 11.3 23.9 18.3 524.3) (1.9 332.6 — — — — — 0.3 4.5 0.2 1.4 2.7 20.6 8.5 12.8 15.3 2.2 90.6 16.3 740.4 12.4 367.6 12.0 106.0) 1.3) 4.5 30.7 116.3 112.8 11.6 14.6 9.3) 15.1) (0.8 4.0 5.8 111.2 122.3 17.7) (4.0 (15.4 15.2 10.7) 0.5 14.5 307.7 15.5 14.3 1.2 698.9 17.7 14.0 1.6 6.6 19.9 1.2 18.2 10.9 17.4 7.4 3.8 9.3 4.4 11.7 0.3) 11.6 8.8 3.7 11.4 0.0 1.5 117.6 9.4 3.4 21. Financial Statement Analysis Yearbooks.0 921.1) 1.5 11.6 20.1 11.5 8.3 125.7 0.4 14.6 6.9 (11.7 7.7 19.5 (2.0 (1.5) 22.3 8.6 1.2 18.6 0.3 — — — — — 10.7 — = not available.0 89.2 11.7 — — — — — 14.9 456.9 (10.1 (0.2 14.4 30.1 12.2 14.9 3.6 4.0 2.7 11.2 15.5 344. .3 18.5 2.6 3.2 143.4 (0.1 323.2 — — — — — 2.0 13.1 1.3 3.9 12.1 2.9 9.6 15.Table 2.4 341.8 3.1) (0.4) (1.6 172.2 2.4 (2.0 98.1 3.8 6.4 6.1 4.2 18.6 19.9 Electricity. Gas.1) 5.5 15.

but the number of designated groups has been fixed at 30 since 1993.4 22.9 Source: Constructed using data from Korea Investors Service.2 9.1 6.3 (0. the top 11-30 chaebols experienced a decline of .5 19.6 22. followed by the top 6-10 (Table 2.5 19. had 46 member companies.3 0. Between 1993 and 1997.8 0.9 26.0 0. II Table 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.12).12).8 6. It should also be noted that when the financial crisis struck in 1997.9 percent).6 0.2 2. of which four were listed.9 Growth and Financial Performance of Listed Companies.5 ROA 0. The criteria for selection of largest chaebols have changed a few times.4) 1.0 18.7) 0.8 24. debts (47. The top five chaebols registered the highest growth rates. Chaebols have been the most important actors and engines of growth in the Korean economy. Vol.7 (5.70 Corporate Governance and Finance in East Asia.3 2.8 5.3 15.6 1.4 1.7 1. Kis-Fas. 1985-1997 (percent.3 4.7 Net Profit Margin 0.3 20. The smallest group had 16 members in 1995. the 30 largest chaebols accounted for 13.4 2.0 3.6 2.5 0.6 23.2 6.9 2. The number of Hyundai member companies rose to 57 in 1997.9 6.7 1.1) 4. In 1995.5 5.11).4 1.9 21.4 0. it is the chaebols’ large firms that are listed.9 1.5 ROE 3.1 1.6 and 2.1 percent of the economy’s total value added (excluding the financial sector). Generally. the largest chaebol.6 (1. Performance of Chaebols This section uses available data on the top 30 chaebols.4 1. and close to half of total assets (46.9 0.1 1.9 11.2 0. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. Hyundai Group. sales (45.9 percent). In 1997. and net profits (46.7 percent) of the corporate sector.3 percent).6 3.9 2. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. 1998. of which 16 were publicly listed (Table 2.2 9.

3 6.7 2.1 1.2 2.4 1.6 1.7 2.0 4.2 3.3 9.9) (6.0) 1. Kis-Fas.2 0.6 7.5 17.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.3 (0. 1988-1997 (percent) ROE Large 9.6 3.2 13.3 Medium 14.9 1.9 2.5 3.0 17.6 0.3 11.Table 2.6 (0.3 (0.3 3.5 5.9 6.6) 0.0 16.6 5.2 13.7 18.1) 5.10 Growth and Financial Performance of Listed Companies by Size.4 Medium Small Large Medium Small ROA Growth Performance Large 17.4 16.5 2.0 19.5 0.8 17.3 15.2 10.9 25.4 5.8 0.7 (1.0 1.4 11.4 6.9 22.9 0. Others are medium firms.9 5.9 3.6 9.2) 0.6 2.7 (1.8 0.0 1.3 1.6 6.8 0.0) 0.6 8.0 (4.5 (1.3) 0.0 10. Source: Korea Investors Service.5 1.2 1.3) 5.5) 1.9 1.6 13.2) (1.5) 1.0 1.0 1.2 7.8 7.8 6.4 3.8) 6.9 2.6 0.5 25.2 2.7 1.7 (0.8 0.4 3.7 3.2) (1.1 2.6 2.2 12.1 8.6 1.9 2.6 1.1 0.6 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.4) 1.0 6.8 1.8) 1.2 (0.8 10.8 3.3 15.1 2.6 3.6 (1.9 14.0 15.4 1.9 0.2 Small 13.1 11.9 0.8 6. 1998.8 (5.9 (0. .5 5.7 4.8 16.9 6.4 2.

873 2.376 35.131 3.427 9.756 5.313 14.927 16.597 351.147 5.11 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 43.761 31.180 2.475 2.910 3.445 4.798 — No.423 5.129 2.599 — 2.346 3.651 38.246 11. 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. . Source: Fair Trade Commission.967 7.766 3. 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.501 13.364 5.309 14.774 7.398 — 2.486 6.574 3.929 12.433 3.Table 2.158 1.458 6.457 14.956 3.995 2.370 6.287 10.395 31.177 — 6.990 2.853 1997 53.158 7.455 22.690 3.996 1.924 2.951 3.677 3.743 40.935 2.090 6.117 4.640 4.303 3.

6 (0.8 Assets 12.0 31.1) (0.1 (3.1 2.4 26.0) 3.6 25.3 1.7 0.8 18.1 10.5) (0.4) (0.2 0.9 1.0) ROA 1.4 0.2 1.2) (0.1) 0.5 5.8 27.2 0.3 1.3 0.2 (16.8 0.1 27.4 (2.9 17.Table 2.4 12.3 9.5 20.5 19.7 10.2) 1.3 15.1) (1.3 14.3 19.0 0.2 11.6 18.3 3.3 27.5 2.1) (0.2 20.9 3.3 11.3) 0.2 3.0 2.0 2.6 19.2 (2.12 Growth and Financial Performance of the 30 Largest Chaebols.0 1.4) 1.0 17.7 10.9 20.1) 0.3 16.9 24.2 (5.2 (2. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.6 4.1 (2.0 6.5) (0.4) (14.9 18.5 (0.7 15.7 1.7 13.0 2.9 20.5 32.1 19.4 30.0) 12.7) ROE 5.2 0.3 0.7 15.2) (2.5 27.6 Financial Performance Net Profit Margin 1.0 0.7 4.0 19.9 3.6 1.4 38.7) Source: Bank of Korea. .5) (0.1 (1.

However. and the companies that are under the control of the largest shareholder.” This “identical person.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. chaebols had a higher average DER than the corporate sector as a whole.13). the net profit margin of the aggregate sector exceeded that of the top 30 chaebols.765 percent (Table 2. In general.7 percent growth in total assets. it refers to the degree of concentration and shareholdings in the hands of an “identical person.95 percent.” in Korea’s legal and regulatory framework. resulted in the chaebols’ excessive leverage. Their worst year was 1997 when ROE hit -15. a pyramidal structure of corporate ownership is prevalent. his/her relatives. II 2 percent in their sales and a very low 4. loopholes and inconsistent policies spawned strategic behavior and agency problems. 5 While “ownership concentration” can be defined and measured differently in different contexts. Vol. 2. technology. 2. except for 1995. There has been a wide range in DER among chaebols. and government intervention interacted through a set of laws and regulations to bring about the existing structure. includes the largest shareholder. and vulnerable balance sheets. Ownership patterns. the average DER of the 30 largest chaebols reached 519 percent. internal and external control mechanisms. coupled with weak corporate governance. 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.5 Founding families are mostly still the largest shareholders and. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. Only the top five chaebols registered a positive net profit margin in 1997. more important.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. and access to credit. in this instance. weak corporate control. and led to a high concentration of ownership. The Commercial Code stipulates the basic governance framework and applies to all corporations.3. . from 190 to 3. By the end of 1997. The absence of a well-developed equity market and the provision of subsidized credit. The better showing of the top five chaebols was a direct result of their dominance in human resources.74 Corporate Governance and Finance in East Asia. However.

4 205. Hansol 17. Newcore 30.2 924. Halla 17.5 2. Samsung 3. Hyundai 2.6 2. Daewoo 5. Haitai 26. Kohap 25.2 2.5 464.5 383. Dongkuk Steel 19.065.2 471. Doosan 13. Kukdong Construction 29.2 292. Hansol 23. Jinro Debt-to-Equity Ratio 376.441.7 688.4 622.3 297.1 674. Ssangyong 7. Dongbu 24.0 486. Hyundai 2. Dongah 14.1 385. Lotte 11.13 The Top 30 Chaebols’ Debt-to-Equity Ratio. Daewoo 5. Kia 9.4 175.7 621. Hanbo 15. Halla 13.7 354. Kia 9. Doosan 15.9 751.6 516.8 336.1 3. Hanjin 8.244. Byucksan 1996 1.2 423. Tongyang 22.Table 2.8 312. Hyosung 18. Jinro 20.7 267.6 . Ssangyong 7. LG 4. Daelim 14.3 315. Dongkuk Steel 19.0 218. Dongah Construction 16.7 620. Hanwha 10.3 328. LG 4. Sunkyung 6.0 506. Hanjin 8. Kumho 12. Kolon 21.6 409. Daelim 16.1 190.1 477.3 572.855.2 346. Sunkyung 6.5 337.6 936. Hanwha 10. 1995-1997 (percent) Chaebols 1995 1.764.5 3.9 321. Sammi 27.1 278.5 343. Samsung 3. Kumho 12. Hanil 28.0 436.0 370. Lotte 11. Hyosung 18.7 416.4 556.2 328.4 192.8 313.

1 433.0 907. Newcore 26.5 1.6 478.3 399.8 647. Kamgwon Industrial 30. Kohab 18. Ssangyong 8.9 490.3 676.8 399.501. Financial Statement Analysis Yearbook. Halla 13.4 1. LG 5. .5) 404.1 472.7 1.600. Dongbu 21. Dongah 11.5 323.9 578.8 347. Shinho 1997 1.8 468.6 424.9 216.8 307. Hyundai 2. Miwon 30.9 1.8 338. Tongyang 24. Daewoo 4.5 576.6 335.Table 2. Lotte 12.0 305.7 370. Daesang 27. Kolon 19. Anam 22. Newcore 28.6 Sources: aFair Trade Commission. Hanjin 7. Hanwha 9. Dongkuk Steel 20.8 590. Hansol 16. Dongbu 23. Keopyong 29. bBank of Korea.1 359. Kumho 10.498.4) 513. Samsung 3. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Kolon 21.13 (Cont’d) Chaebols 20.6 590.8 658. Haitai 25.3 347. Tongyang 24.5 386.5 (893.1 375. Haitai 25. Jinro 23.784.5 519.9 465.5 261.9 472. Anam 27. Daelim 14.0 505. Shinho 26.1 438. Hyosung 17.7 944. SK 6.6 416. Doosan 15. Keopyong 29. Kohab 22.214.5 (1.3 1. Hanil 28.0 419.225.

Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. the year the stock market was in a frenzy due to buying sprees. that is. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range.14). i.7 percent by 1997. The holdings of financial institutions.e. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2.1 percent. However. but their shares declined to 21. Among listed nonfinancial companies. and then steadily declined after 1993. managerial entrenchment becomes more likely. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992. and insurance companies increased during the period.Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares.6 percent by 1997.” foreigners. large ownership can also bring about the entrenchment effect. the ownership structure can bring about an incentive effect. The controlling shareholders of chaebols hold comparatively smaller percentages of shares. including investment trust companies. However. the incentive effect once again dominates. the percentage of holdings by individuals slipped to 60. The pattern of distribution changed little through 1992-1997. individuals were also the largest shareholder group. 10 to 30 percent). Theoretically. The next important group was “other corporations. the Government. including banks and other financial firms. The reduction can be . Composition of Ownership Among listed companies. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. Thus. Beyond that range.” followed by banks. the extent of ownership by these individuals declined gradually after 1988. and state-owned companies and securities companies declined. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced. The percentage of shares owned by “other corporations. the entrenchment effect outweighs the incentive effect.. fluctuated widely during the period. with a given range of managerial shareholdings (for instance. resorting to extensive use of pyramiding to maintain control. while those owned by banks. From 69.

1 8.7 59.4 14.0 60.1 10.1 60.5 16.5 1.14 Ownership Composition of Listed Companies.2 2.8 1995 548 2. .” includes commercial banks. d Constructed from data files of the Korea Listed Companies Association.3 1.6 36.0 28.9 2.6 16.9 17.6 1991 505 0.3 17.5 7.2 4.0 5.3 1.6 9.8 5.1 8.1 11.8 2.5 Note: Ownership is based on number of shares.8 59.4 Insurance Firms Other Corporations Foreigners Individuals 39.5 6.7 9.2 3.5 60.0 5.7 1990 531 0.5 18.b A.6 16.6 16.3 17.1 2.6 2.4 13.3 5.7 9.0 27. b “Banks.2 9.9 2.6 8.0 4.8 17. mutual savings.4 1997 551 1.8 4.8 69.3 26.1 18.9 5.1 17.4 6.9 36. of Firms The Statea Banks.9 15.3 5.7 8.6 22.9 37.4 18.0 59.1 3.5 6.7 6.3 39.2 5.6 12. and finance companies. etc.3 1994 521 1.2 18.2 8.0 9.3 18.8 5. Listed Nonfinancial Companiesd 1988 406 0.1 18.9 4.2 1. merchant banks.2 7.2 17.3 18.1 68.7 14.2 5.5 1992 508 2. etc.2 9.6 20. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.5 1989 498 0.1 4.2 1993 511 2.8 2.5 1.2 B.6 Year No.4 34.8 17.2 8. a The State covers the Government and state-owned companies.0 7.6 13.7 18.0 8.5 7.9 1.3 8.1 1.4 5.1 21.Table 2. c Data from Korea Stock Exchange.8 59.9 1.1 21.4 5.5 12.6 19.4 13. investment trust companies.9 19.7 4.9 26.7 7. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.3 1996 570 2.5 4.3 2.6 9.5 62.7 3.

Individuals held the majority of the shares in all industries except in telecommunications. However. Compared with its holdings in all listed companies. categorized into large. When independent companies are distinguished from firms affiliated with the 30 largest chaebols.17). with the Government continuing to hold a sizable share in the Korea Electric Power Corporation.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. In most instances. held 26. UK. electricity. whether partial or absolute. This is low compared with those in Japan. Before such liberalization. This trend can be explained by government ownership. and US (Table 2. of some banks. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . Corporate holdings averaged 16 percent throughout 1988-1997.15). medium. indicating their heavier reliance on inter-firm financing investments. indicating their increased investments particularly in the service industries with high growth rates. foreign holdings were derived from purchases through country funds and direct capital investments.8 percent of listed shares in 1997. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. as distinguished from individual and foreign investors. Institutional investors. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms.16). a more detailed breakdown of the data on majority shareholdings in the next section shows significant differences in the two groups’ composition and level of majority shareholdings. However. Over the years. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. the Government was the sole owner. The ownership distribution in listed nonfinancial firms. and service of motor vehicles (Table 2. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. financial institutions had more shares in the manufacturing sector than in primary industries. In general.18). did not vary significantly (Table 2. government ownership in nonfinancial companies was remarkably smaller and more concentrated. and small companies. The holdings of other corporations are mainly equity investments in affiliate companies. other corporations’ holdings shifted toward service industries. In 1998.

5 19.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.4 8.3 62.7 63.9 23.7 20.2 2.6 11.4 8.8 1.6 24.3 1.9 1.5 0.7 17.9 52.9 19.3 0.8 3.3 57.4 1.7 22.0 — 0. Rubber.4 2.9 0.2 — 0. and Printing Chemicals.5 0.2 0.8 Individuals 83.2 17.1 0.0 1.6 1.5 85.0 9.8 8.2 7. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.0 8.7 59.5 — 1.1 1.1 19.4 — 0.4 Banks.4 0.9 1.3 38.7 20.0 9. Paper.8 7.8 73.9 66.2 1.1 27.0 20.1 0.4 5.2 0.2 9.6 8.7 2.7 64.4 8.9 60.2 1.7 1. Etc.5 7.7 2.5 17.3 4.3 2. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.1 10.1 0.8 5.3 1.3 13.7 22.15 Ownership Composition of Listed Nonfinancial Firms by Industry.8 7.2 — — 0.4 14.4 1.0 0.0 10.9 42.9 55.3 0.9 8.3 0.3 2.3 6.5 0.8 7.2 9.7 2.2 54. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average .4 62.5 12.6 — — 2.1 4. and App.2 9.9 4.0 9.1 7. Elecl Mach.5 6.2 0. Gas.6 18.4 56.8 3.1 65.3 7.5 3.0 7.4 56.3 10.6 5.9 10.Table 2.2 0. Motor Vehicles Electricity.7 14.4 7.1 8.6 3.9 15.0 — 39. Paper.8 6.5 0.0 2.9 16.1 0.9 59.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.1 8.8 7. and Printing Pulp.5 — — 0.2 64.7 14.3 9.2 22.5 — 0.7 29.8 7.5 4.1 88..3 11.0 9.7 6.

5 4.2 5.4 6. Paper.1 6.9 2.78 81.6 18.7 23.8 2.0 43.3 8. Motor Vehicles Electricity.9 7.6 0.6 2.4 4.6 2.3 15.3 31.5 6. merchant banks.1 1.0 60.9 7.4 — 1.6 14.4 16.3 6. Paper.9 18.9 69.5 3.4 1.7 2.2 23.7 2.8 5.7 19.1 — 0.2 8.9 1.8 0.6 6.9 5.1 1.3 1. and Printing Chemicals.5 12.2 1.2 4.5 0.7 2.” includes commercial banks.5 3.3 2. and App. Gas.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.9 2.6 — = not available.2 3.6 3.0 11.9 6.4 9.1 25. Rubber.2 5.1 — 1.5 1.8 4.9 6.8 3.2 0.2 0.6 59.2 4.6 75. and Printing Pulp.2 7.0 1.5 5.6 60.6 6.9 1.3 60.9 2.5 3. investment trust companies. b “Banks.6 1.7 1.6 5.4 45.8 12.4 43.9 20.0 6. . a The State covers the government and state-owned companies.8 11.8 0.2 1.0 4. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.8 2.3 65. Note: Ownership is based on number of shares.1 9.4 68.5 3.9 5.9 2.3 6.7 17.9 20.7 2.0 7.1 4.9 0. etc.6 7. Elecl Mach. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.1 54.2 49.8 5.8 6.1 18.8 57.4 2.9 57.0 6.5 7.0 8.6 0.1 2.1 3.4 2.4 1.4 20.1 3.8 27.1 2.5 63.5 — 2.4 76.4 58.1 9.3 0.8 2.7 6. mutual savings.9 78.4 1.2 4.7 5.8 54.3 7.6 20.5 59.2 13.9 1.3 57.5 4. and finance companies. Source: Constructed from data files of the Korea Listed Companies Association.3 1.6 2.4 0.0 5.4 3.4 4.2 6.4 2.0 3.4 58.7 4.2 4.

4 1. . etc.5 6.7 Foreigners 4.4 2.9 5.8 2. 1997 (percent) The State 1.8 6.16 Ownership Composition of Listed Nonfinancial Firms by Size.6 16.8 4.Table 2.7 4.4 2.2 1. The State covers the government and state-owned companies. and finance companies. Source: Constructed from data files of the Korea Listed Companies Association.1 8. mutual savings. Securities Firms Insurance Firms 2.4 4.4 Firm Sizea No.8 60.8 1.7 Control Type No. 1997 (percent) The Stateb Foreigners 4.7 1. 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.3 6.5 62.4 61.5 19.1 Banks.4 61.8 3.c Securities Firms Insurance Firms Other Corporations Individuals 58.0 1.1 2. c “Banks.7 0.0 Other Corporations 16.5 8.5 2.9 2.” includes commercial banks.0 6. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.5 16.9 4.6 60.7 6.8 4.3 Banks. merchant banks.4 21.4 5. etc. Others are medium firms.7 8.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.5 Individuals 60.4 17.5 18.5 4. b Table 2. investment trust companies. etc.1 6.4 5.

the majority shareholder group in all listed companies consists of the corporate. only closed-end investment companies and traditional investment trust companies are allowed. At the moment.18 Ownership Composition of Listed Firms in Selected Countries.3 54.8 9.20). his/her family members.4 26. Institutional Investors 42. minority shareholders.3 6.19). and other shareholders who do not belong to either the minority shareholders or the majority shareholder group.6 39. 1997 (percent) Country Japan Korea Taipei.6 Individuals 23.8 10.6 Foreigners 9.3 47.5 45. including those of the largest shareholder. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. defined as those holding less than 1 percent of shares.8 56. But these may .7 16. 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.Chapter 2: Korea 83 Table 2. In 1997.1 financial institutions’ establishment of corporate pension fund accounts. corporations held 70 percent of the controlling blocks of shares. Generally.China United Kingdom United States Source: Stock Exchange of Korea. Among nonfinancial listed firms. Foreign holdings of Korean shares were 9.5 20. investors (Table 2. rather than the individual. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. This has had profound implications for corporate governance and the market for corporate control in Korea. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2. and the companies under the control of the largest shareholder.1 8. for example. while family members accounted for only 30 percent.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.

1992-1997 (percent) Majority Shareholders Corporation 15.9 3.Table 2.19 Ownership Concentration of All Listed Firms.1 32.4 3. Minority shareholders are those holding less than 1 percent of shares.1 28.8 73.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.9 6.0 22.7 44.9 32. .6 5.3 30.3 Subtotal 5.8 Individual Subtotal Other Shareholders Corporation 3.6 46.9 Individual 2.1 21.2 2.0 2.0 69.0 66. his/her family members.3 18.1 5.6 22.4 7.1 15.0 1.9 2.5 43.7 Note: The majority shareholder includes the largest shareholder.7 18.4 5.1 5.0 4.1 4.9 33.7 6.2 2. Source: Stock Exchange of Korea.7 16.0 29.1 37.8 72.6 73.2 Minority Shareholders Subtotal 71. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.6 2.2 26.8 8.1 14.0 25.9 7. and the companies under the control of the largest shareholder.7 7.3 2.1 23.6 26.

5 23.4 Source: Constructed from data files of the Korea Listed Companies Association. thereafter.7 18. In such cases.8 54. rubber and plastics. .9 12.4 28.2 15.5 60.8 Majority Shareholders 27. the majority owner held more than 20 percent of an average firm.9 29. the Government has retained a large number of shares. ownership was relatively diffused due to government regulation.9 27.3 25. minority shareholders. In telecommunications. Meanwhile. hiding shares offers no additional tax or other benefits.3 62.9 25. It was highest in medium-sized firms before 1993 and. Ownership concentration tended to be lower in large compared to medium and small listed firms. Majority ownership is also high in the chemicals.8 57.9 Other Shareholders 18. Across industry.0 20.1 50. collectively owned less than 50 percent of an average firm. 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.5 13.8 25. which held less than 1 percent of a company’s outstanding shares as of 1997. The practice of hidden shares seems to have been less prevalent in recent years. utility companies have a relatively higher degree of ownership concentration with the majority shareholder owning nearly 45 percent of an average company (partly because these companies were owned solely by the Government before their privatization [Table 2.6 57. in the small firms.Chapter 2: Korea 85 Table 2.5 12.4 23.21]).0 58. Besides. In most industries.8 28.8 12.0 22.22). The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.9 48. and mining categories.6 11.20 Ownership Concentration of Listed Nonfinancial Firms. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53. 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 2.6 58.

7 21.5 19. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.6 38.9 44. Motor Vehicles Electricity. Paper.3 26..5 44. 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. and App. Paper.8 21.3 19.5 21.0 51.5 23.9 26.9 10.4 11.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.8 31.0 54.8 24.0 30.7 29.3 39.6 19.1 17.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood. Rubber.7 26.2 46.8 25.7 36.2 20.8 29.1 19.6 50.8 51.7 17.0 39.1 43. and Printing Pulp.6 34.2 22.5 16.4 53.5 20.8 55.6 53.2 23.8 44. Elecl Mach.8 41. Gas.6 25.2 37.1 49.5 41. and Steam Supply Other Manufacturing Construction Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Total Source: Constructed from data files of Korea Listed Companies Association. .5 47.2 26.7 27. and Printing Chemicals.2 48.2 19.2 34.Table 2.5 52.0 21.4 16.9 Minority Shareholders Majority Shareholders Other Shareholders 12.7 24.

2 21.2 52.9 56.5 10.9 60.9 16.6 65.6 59.9 17.Table 2.6 24.1 16.5 21.2 26.7 57.2 18.9 21.2 55.2 Majority Shareholders 26.1 58.0 24.4 30.5 19.5 26.1 27. .3 19.2 11.1 48.7 17.3 27.5 51.9 55. 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.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.2 50.7 16.8 52.6 15.7 15.8 28.8 17.6 31.6 55.7 22.9 53.8 62.0 66.5 12.2 56.5 28.5 49.2 Source: Korea Listed Companies Association.8 52.5 27.5 19.0 26.2 21.4 30.0 55.8 56.3 55.6 62. 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 53.7 14.5 12.4 21.4 51.4 29.9 28.8 11.4 30.3 26.5 33.7 31.2 21.3 25.7 28.8 50.1 20.6 11.5 Other Shareholders 19.2 12.7 57.4 47.9 26.0 59.9 22.1 15.6 27.3 21.9 23.9 12.2 32.8 27.

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

Partial results are shown in Table 2. 59 were parent firms with one or more subsidiaries. 53 percent were domestic nonfinancial firms. not individuals.5 corporations and two individuals. the top 30 chaebols’ shareholding by subsidiaries was 34. although they are likely to be insignificant. Until recently. for example. In Table 2. 34 percent were foreign companies.Chapter 2: Korea 89 guarantees from other members of the group at no cost.5 percent. the average shareholding of the controlling owners and their families was 8. These shares should be added to the control block although the financial institutions belonging to the 30 largest chaebols are prohibited from exercising their voting rights in the member firms of the chaebol. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. 62 percent (16 out of 26) had a corporation as the largest shareholder. If we define the internal shareholdings of a . Of the 81 respondents.9 percent of shares.5 percent as of 1997. Among the subsidiaries or firms receiving investments. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. For the whole sample. For the same year. and about 11 percent were domestic financial institutions. together having a total of 292 domestic subsidiaries. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms.23.5 percent of shares. Among chaebol affiliated firms. or about five subsidiaries each.14. Thus. Thus. there are instances of direct cross-shareholding in Korean firms. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. Twenty-two of the 81 respondents were independent. In many instances. or an average of 13 firms per company. standalone setups.4 corporations. together owning an average of 37. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. 59 parent companies collectively had investments in 759 firms. the top five shareholders consisted of 2. The extent of pyramiding can be seen in some of the previous tables. together owning an average of 38. Among the 81 listed firms in the ADB survey. The fact that corporations. In the case of the 30 largest chaebols. and 319 foreign subsidiaries. or about four firms each.

5 2.1 3.4 1. 1999 Five Largest Shareholders No.7 37.5 2.3 26.5 4. A few companies reported less than five largest shareholders.7 5.7 19.9 5.7 39.4 21.8 31.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.0 3.6 3.Table 2.5 31.5 24. a Number of shareholders.0 3.5 4. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.4 42.4 2.3 12.5 1.5 2.6 34. .4 11.4 38.1 1.7 0.4 18.5 2.9 34.8 37.5 18.2 25.0 1.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.6 3.6 3.9 29.8 8.1 22.9 21. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.2 37.6 16.0 21.0 13.4 25.0 17.8 38.8 18.0 1.5 38.0 2.

Ungki Lim. 79-95. H. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family.7 9. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. 1997. Table 2.1 1997 43. 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.2 15. Lee.7 31. Based on these studies.4 13. it appears that the chaebol families have had a strong desire to expand their business bases. Table 2.” In Korean Managerial Dynamics.7 1992 46. edited by K. The family and member companies’ shareholdings have been declining over time.5 34.0 8.4 10.2 33. pp. Chicago.24 Internal Shareholdings of the 30 Largest Chaebols. 1987 56.4 1990 45.5 percent and member companies. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. 6 7 Hattori. Jae Woo. 34. “Japanese Zaibatsu and Korean Chaebols.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. C. New York: Praeger. the controlling families owned 8. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. . “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. the ownership patterns can be described as follows.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. As of 1997. Hattori (1989) identified three patterns based on data in the early 1980s. Tamio.2 12.2 1994 42.5 percent.5 Judging from the historical record.8 40.6 33.4 1993 43. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held.8 33. Chung and H. 1998.” Paper presented at the Annual Conference of Financial Management Association. 15 October 1998.24 shows the average internal shareholdings in the 30 largest chaebols. Lee. 1989.

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

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

there have been no significant changes. who is universally called the “group chairman. and transferred funds generated by one firm to another. Despite chaebols’ decision to dismantle the chairman’s offices. Their operating costs were borne by the member companies rather than by the controlling shareholder.2 Internal Management and Control Monitoring of corporate management by shareholders.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. Some chaebols have disintegrated or shrunk in size. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. boards of directors. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents. and the capital market was almost nonexistent until the recent reform . unlike the regular consolidated statements that only cover those firms that are related through direct equity participation. which put together the accounts of all members of a chaebol. These offices were legally informal and functioned as the headquarters of chaebols. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. Vol. The Fair Trade Commission has been deeply involved in promoting managerial transparency by exercising its power to investigate and levy penalties on “unfair internal transactions” among member firms of chaebols. The office established strategies for the group as a whole. Since the economic crisis. The staff of these organizations were employees of member firms. usually in the rank of a company president. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. The chairman’s office had its own chief executive officer.) 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. planned for capital raising and allocation on a groupwide basis. 2. until urgent restructuring is complete.3.94 Corporate Governance and Finance in East Asia. The 30 largest chaebols are now required to publish “combined” financial statements. II etc. Chaebols maintain that the restructuring headquarters will exist only for a limited period. In 1998.

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

cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. A few large companies had more than 50 directors. Further. Moreover. . and their positions (accept or reject) on matters voted on in board meetings. The rules further require that the number of outside directors be not less than a quarter of the size of the board by the annual shareholders meeting in 1999. the stock exchange recently amended the listing rules to require that companies disclose a detailed profile of the candidate and the person who made the nomination. the listing rules restrict the eligibility of independent outside directors to those who have no family ties with the managers and no significant business transactions with the company. members of the board. almost all companies succeeded in adopting cumulative voting. The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. Recent Reform Efforts on the Board System In 1997. With the boards consisting only of insiders.96 Corporate Governance and Finance in East Asia. However. 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. II When the Commercial Code first introduced the corporate board system in the 1960s. were supposed to be outside directors. other than the representative director(s). it has been common practice that candidates for directorship are handpicked by the controlling shareholder/CEO from among the senior managers and are automatically approved at the general shareholders meeting. the attendance rate of outside directors. In the 1999 annual shareholders meetings. Vol. Despite the qualification requirements. Most of the outside directors in those days were the controlling shareholders of chaebols or executives of affiliated companies. In order to address this concern. all of whom were managers. companies have to disclose in their annual reports the frequency of board meetings. 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. However. 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.

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

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

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

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

41 percent of the companies believed that they have followed some international accounting standards. 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. 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. Only 10 percent of the respondents have followed all international accounting standards. but 49 percent confessed that they have not followed international standards at all. The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC. they cannot be expected to discharge this responsibility because the representative director selects the internal auditor and can force him or her to resign. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. Consolidated reporting was introduced before the outbreak of the crisis. however. In the ADB survey. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. In practice. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. The new accounting standards for financial institutions adopt the mark-to-market basis to account for securities. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. the internal auditor is considered to be a subordinate of the . Those that never adopted international standards show their willingness to do so once the Government introduces international standards. they also have the power and duty to monitor the activities of executive directors. Thus. Under the Commercial Code.

does not have the power to hire and fire the managers. Vol.102 Corporate Governance and Finance in East Asia. then the Securities and Futures Commission can appoint a new one. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. Big Korean accounting firms are affiliated with US accounting firms. underdeveloped market discipline for accounting firms. 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. If the status of internal auditors is elevated to that of independent board members. This is because the auditor. 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. In order to increase independence. Accepting these arguments. Listed and registered corporations must publish financial statements audited by external accounting firms. this problem will largely disappear. In the ADB survey. If the company changes its external auditor for reasons that are not listed in the relevant regulation. In the past. however. and lack of strong professional ethics in the accounting profession. and creditors selects it. outside directors. almost all firms affirmed that the external auditor is independent from the company. . Previously.6 years. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. II controlling shareholder/CEO. External auditors are selected for a term of three years. as a monitor of management in the Korean (and also the Japanese) system. but since 1998 a committee consisting of internal auditors. About 100 listed firms will be subject to this requirement. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. The Securities and Exchange Act will also be revised to require an audit committee for large listed companies with total assets equal to or exceeding W2 trillion. 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. the board of directors had the power to appoint an external auditing firm. 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. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. But this problem can be mitigated if auditors function under the umbrella of the board.

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

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

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

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

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

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

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

Many of the takeover targets in the past did not have a controlling shareholder (group). 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. Some had two or more large shareholders who had joint control of the firm but could not cooperate. 2. . in which the Government still holds the largest ownership. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. Vol. Charter amendments have also been employed by some firms to limit the maximum number of directors. Currently the limit is 3 percent.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. an electric power company. Hostile takeovers in Korea will be rare in the future.7 percent on average as of the end of 1997 for nonfinancial listed firms). 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. It is harder now to find such firms.3. The Government-owned listed companies. was newly listed. For the others. 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. As of the end of 1997.110 Corporate Governance and Finance in East Asia. 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. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. and a bank had government ownership. a steel company. 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. the limit will be eliminated when it is fully privatized in two years. In 1998. Another reason is that many listed firms belong to chaebols. In their charters. For the steel company. In 1999. Korea Telecom. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. are designated as public companies. II The Securities and Exchange Act was revised in 1998 to abolish the 10 percent limit on share repurchases and the Government simultaneously eliminated the limit on foreign ownership of shares of listed firms. except for the banks. As of February 1999.

Even where employees hold . nominated by the minister in charge of the company in question.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. Control Over Private Companies One of the pronounced purposes of government intervention in the corporate sector has been to prevent concentration of economic power in the hands of a few large chaebols (see 2. Further. Meanwhile. which limits the total amount of bonds issued by the five largest chaebols. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. especially those belonging to chaebols. The Government has frequently imposed restrictions on the use of capital markets by large companies. In addition. 2. Beginning in 1999. The Government’s right to send public officials to the boards was eliminated. which was introduced in 1996.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. The nonexecutive directors are now recommended by a committee. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. more state-owned corporations became subject to this new board structure. It was abolished before the economic crisis but another regulation. There is no active debate or discussion going on about this potentially difficult issue. the main bank system. and approved by the Chairperson of the Planning and Budget Commission. There were also limits on the amount raised and the number of issues per year. Labor is not represented in corporate boards. the Government. administering through a self-regulatory committee of the securities industry. But this rule. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. as applied to four large corporations.1). 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.3. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management.3. For example. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. only qualified firms could issue new shares. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees.

Under another law enacted in 1972 to induce private companies to go public. of which 2 percent were senior managers. Collective bargaining is. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. 32 percent technicians and professional staff. The relevant regulation was amended recently in order to facilitate voting by individual employees. Under the Labor Management Council Law. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. and 66 percent manual workers.112 Corporate Governance and Finance in East Asia. The typical collective bargaining agreement has a one-year duration. Two thirds of the respondents had an organized union. the council meetings have been superficial. Under the Capital Market Development Act of 1968. In 1987. and 2. but 27 percent of them felt that it was strong. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. 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. there are two federations of labor unions. in principle. In 70 percent of the firms with organized unions. In actuality. employers are required to meet with representatives of labor unions at least once every three months. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. 2. carried out at the enterprise level. which were generally much lower than estimated values. union members account for 54 percent of the employees. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. and development of the company. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. they delegate their voting rights to plans’ representatives. About half of these firms considered the influence of the union on the management of the company to be weak. II shares of their companies through employee stock ownership plans. the management usually consults the union on major issues relating to the management. The union had no influence on the management in 17 percent of the firms.9 in 1980.5 in 1990. The percentage of shares held by the employee stock ownership plans in listed companies was 1. In these firms.1 in 1997. Local unions in the same industry have established industrial labor federations. Trade unions are organized on an enterprise basis. . At the national level. Vol. The respondents of the ADB survey had 2.654 employees per firm on average. operation.

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 Government adopted a cautious approach. It included such important issues as interest rate deregulation. Moreover. With the privatization of nationwide commercial banks. In addition. mutual savings.4. Some policy loans were also abolished. was liberalized drastically in 1998 after the financial crisis.2 Patterns of Corporate Financing Corporate Financing Practices In this section.1). revision of the credit control system.2. Vol. Meanwhile. Also. the Government simplified various directives and instructions regulating personnel management. In June 1993. implementing the first stage in November 1991. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. especially the domestic bond market. Since 1985. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. II Interest Rate Deregulation Plan. On the basis of flows of funds. 2. and the 30 largest chaebols. which resulted in the establishment of a number of new banks. and liberalization of foreign and capital transactions. and organization of commercial banks. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. the Korean Government announced its Financial Liberalization and Market Opening Plan. listed companies. The capital market. as a first step toward liberalization of capital account transactions. Internal funds include retained earnings.118 Corporate Governance and Finance in East Asia.5 percent in November 1981. depreciation. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. . Korean firms have been allowed to issue CBs in international financial markets. budget. etc. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. the business scope of financial institutions was greatly widened from the early 1980s. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. development of the money market. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. short-term finance companies. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. finance companies.

depreciation. Table 2. It measures the degree of financing growth in total assets by additional debts. on average. The corporate sector used . and allowances) and new equity capital. Equity capital represents the shareholders’ commitment to the business. Securities finance became a more important source from 1988 onwards.26 shows the four measures of corporate financing calculated from Table 2. particularly in the short term. This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs.25. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. 1994. capital surplus. The share of external financing. and government transfers.Chapter 2: Korea 119 and net capital transfers from the Government. including all sources other than retained earnings. The SFR averaged 28. Before 1988. Meanwhile. In 1988 when the stock market boomed.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). This means that internal funds after dividend payment were insufficient to finance growth in total assets. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. 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. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. It measures the degree of financing growth in total assets by additional equity. In securities finance. the corporate sector’s most important source of external finance was bank borrowings. except for the stock market boom of 19871988.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. Financing Patterns of the Aggregate Corporate Sector Table 2. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. financing by corporate bonds and CPs was more significant than by new equity. was 71 percent during the period. but it remained less than 10 percent of total financing. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. except in 1991. particularly in the 1990s in response to the liberalization of the capital market. and 1997. the proportion of foreign borrowings in total finance rose steadily. depreciation. comprising internally generated capital (retained earnings.

6 11.4 2.9 73.7 2.1 — — — — 12.6 4.4 71.1 0.6 4.4 27.0 11.9 34.1 36.6 10.8 1.1 2.8 1.3 5. a Includes retained earnings.6 25.9 0.7) 11.4 11.7 14.6 14.4 0.3 30.7 1.5 2.4 27.3 2.2 26. Source: Understanding Flow of Fund Accounts.3 6. 1994.1) 4.7 8.7 4.1) 4.6) 5.2 — 28.3 27.4) 13. b Includes capital surplus.0 3.5 29.5 16.6 0.5 0.6 (0.2 — — — — 9.1 (1.9 28.8 56.2 5.8 15.0 1997 26.6 2.3 — — — — 8.6 8.4 (2.1 10.0 9.1 1.3 3.1 2.7 15.0 16.2 (0.0 0.0 (0.6 3.4 1.4 1.7 2.0 2. which is the excess of current value over issue value of stock.6 5. Bank of Korea.3 1.1 8.2 6.6 9.4 15.7 13.5 16.0 17.7 4.4 10.7 1.1 3.8 1.9 9.1 72.8 1.3 6.1 1.7 6.1 27.8 17.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.6 4.2 6. . 1988-1997 (percent) 1988 43.1 12.6 11.4 8.3 25.7 12.7 14.0 9.7 8.3) 11.1 3.8 — 26.0 — — — — 8.8 30.6 0.7 (0.4 — 28.2 2.8 4.8 0.3 1.2 14.7 32.5 0.7 2.3 3.7 1989 1990 1991 1992 1993 1994 1995 1996 22.7 73.0 10.0 3.5 9.4 2.2 13.3 10.4 27.9 10.25 Flow of Funds of the Nonfinancial Corporate Sector.Table 2.4 21. and Flow of Funds.6 0.5 2.2 15.1 3.4 9.7 71.0) 12.4 (0.1) 6.1 1. and net capital transfers from the Government.0 0.4 2.0 70.6 0.2 10.1 23.6 1. Bank of Korea.2 0.8 27.3 — 30.8 (0.9 2.3) 15.1 (0.4 2.4 3. 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.9 6.6 77.4 0.1 — 27.5 2.5 13.0 5.7 7.7 11.3 6.9 72.2 13.9 10.9 38.0 1.0 22.6 9.7 10.1 17.5 2.3 72.8 -2.7 10.3 1.7 — — — — 9.6 9.7 10.5 0.0 3.6 3.2 34.8 8.1 0. depreciation.3 16.8 1.2 1.

in the manufacturing sector.4 percent.1 26. On average. and IEFRs were declining.4 percent.6 26.7 28.5 12.3 11. declining to 26.9 28. the corporate sector relied heavily on external financing for its expansion.7 40.26 Financing Patterns of the Nonfinancial Corporate Sector.0 5. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years. Bank of Korea.4 NEFRa 20.2 IDFR 36.5 68. and Flow of Funds.1 53.5 31. an average of 59. was financed by additional debts. 45.1 17.7 26.9 60.27).5 and 76.5 percent in 1997. respectively.8 percent of its total asset growth through debts. Lower income diminished the industry’s equity position toward crisis year 1997.9 percent by 1997 when net profit margins were negative.8 28.7 40.6 percent over the 10-year period.3 59.7 40.0 42.0 27.9 46.7 9. Bank of Korea. but also continuously fell. NEFR registered 20.1 12. While SFRs.4 27.7 30. and the total debt ratio was much higher in 1996 and 1997 at 62. IDFR reached 73.3 59. NEFRs.4 IEFR 63. additional equity to finance 12. respectively.0 57.6 percent.5 percent.8 62. higher than the aggregate 28.6 62.3 60. higher than the aggregate 40.4 percent (Table 2. but plunged to 5.0 11.1 percent in 1988 during the stock market boom.6 percent and 1. Source: Calculations from Understanding Flow of Fund Accounts.9 22. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.2 37. 1994. Manufacturing financed 54.4 12.1 39.2 percent of incremental asset growth was financed by equity.3 12.4 37.3 27.8 10. Its IEFR and NEFR dropped to 23. In periods of high economic growth such as in 1988.3 73. dropping to 26. .2 percent of the growth in total assets.6 Excludes capital surplus.6 percent. Incremental financing from equity was 40. indicating a high financial risk position. Across industry.3 percent in 1997. It dropped to 28 percent the following year. SFR peaked at 44 percent. average SFR was 37.Chapter 2: Korea 121 Table 2. There were significant time trends. The balance.7 percent in 1997.

3 52.2 62. which decreased to 8.5 76.7 47.2 21. gas. large firms showed more cyclical patterns in these financing ratios than small.7 37. It had the highest average SFR in 1988 at 31. In 1997. II The construction industry showed the most cyclical pattern in annual asset growth. Vol.6 36.0 57.2 5. Equity financed an average 25.6 37. explaining partly the collapses of several construction companies in 1995.8 percent in 1990.4 3. and steam) and the transportation. Since 1992. and communication sector had relatively high incremental equity ratios.4 47. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.4 63.4 54. and low total debt and short-term borrowing ratios. then increased to 20.4 37. from 17.0 42.6 37. the two sectors also had low equity financing ratios and high debt financing ratios.8 4.7 percent in 1996.1 29.27 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 54.8 percent in crisis year 1997. Financing patterns of the wholesale.5 1.2 percent in 1993.9 percent of asset growth. the proportion of short-term borrowings in total financing has been high. Categorized according to company size.3 28.6 45.9 IDFR 34.9 percent.7 37.5 NEFRa 9.6 53. Since large firms were more profitable.0 42. their average SFR was higher.7 47. storage.8 50.9 6. and fell to about 10 percent in 1997.2 3.6 53. this dropped further to 15.6 4.1 percent of total asset growth for the period.2 . Total debt financed an average 74.4 45.6 62.and medium-sized firms. and hotels sector and realty/renting/business activities sector were similar. On the other hand. the utilities (electricity. one year ahead of the other industries.8 IEFR 65.122 Corporate Governance and Finance in East Asia.5 7.6 3.0 30.4 46. Table 2. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. retail.0 3.5 23.

7 1994 53.8 76.9 30.9 9.6 14.2 46.5 21.0 1990 12.1 84.7 Wholesale/Retail Trade.4 28.7 1997 8.8 9.4 26.5 20.3 57.5 76.9 47.7 15.0 68.7 1989 26.9 80.0 10.9 1993 63.0 31.5 12.2 70.6 1997 29.0 3.0 82.5 1.0 1990 50.8 25.1 Trasport.0 65.4) 2. and Communication 1988 64.9 1.6 37.Table 2.2 4.8 81.8 2. Household Goods.5 1993 22.8 70.6 9.5 87.2 Average 53.3 1996 16.9 1.2 74.0 1992 24.7 41. Hotels 1988 33.5 1996 42.9 29.1 4.6 73.1 25.6 9.2 20.7 78.3 10.2 1995 16.7 15.1 70.0 60.2 5.3 8.9 1989 63.1 59.6 7.1 69.9 1.8 74.8 1994 15.5 23.9 20.6 37.0 34.2 3.4 1995 53.7 53.3 21.3 47.3 84.2 25.3 4.5 70.27 (Cont’d) Year SFRa NEFRa IDFR 53.2 10.9 33.3 (9.1 66.5 29.9 15.1 1991 14.8 29.0 1.9 2.9 52.0 17.2 8.8 54.3 19.7 42.8 4.7 78.2 23.6 2.5 62. Storage.4 62.6 4.0 .7 7.1 19.4 IEFR 46.9 16.7 80.6 8.0 4.0 0.2 29.0 74.7 6.0 40.8 1991 51.9 1992 56.3 4.2 18.6 8.3 7.9 Average 19.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.4 2.6 71.

4 0.7 69.7 70. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.9 45.4 IEFR 69. Long.8 Average 22. and Business 1988 51.3 7.1 70. however.9 28.1 0.1 42. Vol.6 1990 82.and short-term borrowings of these firms shot up in that period.1 34.2 1992 18.3 85.8 17.0 79.6 1995 17.0 1997 24.7 1996 18.4) 3. Gas.1 54.8 36. Their average IEFR was also higher and IDFR smaller.0 56.4 1994 72.1 71.8 1990 19.4 (107.0 33.4 47. Source: Calculated using data from Bank of Korea.0 (0. Financial Statement Analysis Yearbooks.3 207.9 65.3 31.7 14.1 1991 56.6 1989 118. II Table 2.7 1994 8.3 92. SFR = self-financing ratio.6 52.1 1993 55.6 Real Estate.3 81.4 1995 62.6 7. NEFR = new equity financing ratio.3 29.7 18.8) (35.7 37.9 57.8 135. . and Steam Supply 1988 118.9 Average 75.4 5.and mediumscale firms.124 Corporate Governance and Finance in East Asia.0 53.9 64.0 0.6 1997 23.8 1993 11.4 7.8) 7.6 1991 18.0 67.9 IDFR 31. when large firms had much lower equity financing ratios and higher debt financing ratios than small.6 IDFR = incremental debt financing ratio.3 3.0 46. The trend was reversed in 1996-1997.27 (Cont’d) Year SFRa NEFRa 6.3 62.0 0.2 63.0 1.5 22.4 1.5 77.0 21.1 1989 34. a Excludes capital surplus.0 43.6 1.5 8.3 Electricity. Renting.4 0 0 0 0 1.9 29. The large firms had a higher proportion of external financing in 1996-1997.4 1996 45.1 35.0 1992 51. IEFR = incremental equity financing ratio.

The largest borrowers were the top 11-30 chaebols.7 percent for all listed companies. respectively. the IDFR of listed companies increased to 93. about the same as that of the corporate sector as a whole.2 percent. The proportion of their short-term financing averaged 72. The average IEFR and IDFR were 10. In 1996-1997. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.3 and 89.5 percent is lower than that of the corporate sector in general.9 percent.7 percent. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. and were large borrowers. External financing reached 94. The debt financing ratio of listed companies was high since they relied more on external financing.1 percent of their equity capital.29).8 percent of their total finance in 1997. 153. and the top five chaebols.8 percent. the top 6-10 chaebols.6 percent. the average SFR was 28.30). and using cross-payment guarantees among affiliated companies. and higher than that of listed companies (Table 2. compared with 89. . compared with the entire corporate sector’s 35 percent and 65. at an average 70. In 1997. The average IEFR of the top 30 chaebols of 29.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2.7 percent.4 percent.5 percent and their total external financing.6 percent of total asset growth. for listed companies.9 percent. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. but higher than that of listed companies. All of the top 30 chaebols relied heavily on short-term borrowings. the lowest ratio of 58. In 1997. 91.3 percent of their equity capital in 1997 (Table 2. the top 11-30 chaebols had the highest guarantees commitments at 207. Their shortterm borrowings accounted for 86. Cross-payment guarantees have been declining since 1993 and reached 91.28). They were able to borrow easily from banks by issuing corporate bonds and CP. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. The chaebols’ drive to expand their empires resulted in heavy borrowings. Financing Patterns of Chaebols For chaebols. Group-member firms borrowed less.

3 5. 1994-1997 (percent) SFRa 41.1 8.8 89.7 12.3 IDFR 57.5 2.5 2.6 70.9 7.3 28.2 23. Korea Federation of Industries. .5 8. Table 2.7 1.29 Financing Patterns of the Top 30 Chaebols.6 11.9 NEFRa IEFR 14. Source: Calculated using data of Seung No Choi.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus. Largest Business Groups in Korea.1 1.4 1.2 NEFRa 1.4 88.Table 2.9 6.28 Financing Patterns of Listed Companies.1 93.3 1.2 10.7 13.2 36.8 76. 1994-1998 (percent) SFRa IDFR 85.2 1.4 38.6 0.5 91.3 86.6 61. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.5 8.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.8 22.4 29.6 1.6 IEFR 42.4 12.

. According to the ADB survey. Interest payments on debts were considered a loss when calculating taxes. the Government applied high tax rates on net profits of corporations. Source: Fair Trade Commission and the Federation of Korean Industries.9 — — — 1994 258.9 — — — 1996 105. First. Firms now prefer internal funds and new equity capital. the Government provided implicit guarantees on bank lending and large businesses.1 — = not available.1 — — — 1995 161.Chapter 2: Korea 127 Table 2.0 1997 91. so that the firms engaged in lobbying to gain access to them.3 64. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. in order of ranking.30 Cross-Payment Guarantees of the Top 30 Chaebols. bond issues. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control.0 207. bond issues. Further. more than half of bank loans were priority loans with low interest rates. Second. and extended loans based on cross-payment guarantees.9 153. Fourth. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. and loans from NBFIs. Financial institutions did not strictly screen their loan projects and monitor their debtors.3 58. These are followed by loans from banks.7 150. loans from banks. Factors Influencing Corporate Financing Choices Until recently.3 200. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. the Korean economy was plagued with high inflation. company preferences in financing investment projects before the crisis were. This change implies that firms now give more attention to financial risks. And fifth. Third. Korean firms preferred debt financing (bank and nonbank borrowings). especially in the 1970s when real interest rates of bank loans were negative. poor financial and corporate governance resulted in overlending by banks. Few firms ranked loans from NBFIs as their first preference. There were several reasons for this. and underdevelopment of the stock market. and reserves and retained earnings. inefficient investment and excessive diversification of corporations. rights issues.

more than half (53 percent) hedged against exchange rate fluctuations. and Corporate Performance Corporate Performance and Financial Structure Many chaebols were vulnerable to unfavorable cyclical shocks such as the business downturn at the end of 1995 and the terms of trade shock in 1996. The 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. Nonetheless. and others (29 percent) expected the local currency to appreciate in value.128 Corporate Governance and Finance in East Asia.3 Financial Structure. Among those that never hedged against exchange rate risks. many firms (or 42 percent) never considered hedging. A futures exchange launched in 1999 trades foreign exchange options. and futures and other financial derivatives. II In seeking external financing. in selecting financing sources. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. the percentage of foreign currency denominated debt in the portfolio was 14. This preference has changed little after the crisis. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. Other factors include.36 percent on average for these companies. For these firms. Vol. Korea now provides a better environment for financial risk management. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. firms give their first consideration to minimization of transaction and interest costs. even with a heavy debt burden. 2. maintenance of the existing ownership structure. and reduction in tax burden. in order of importance.4. Among the responding companies that had foreign currency denominated loans. some (36 percent) thought that a hedging facility was not available or not working properly.5 percent at the end of 1997. According to the survey. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. they survived for two to three . Only a few firms sought foreign loans because domestic loans were not available. Diversification. ensuring the liquidity of the company.

Nam et al. Table 2. In order to determine the relationship between financing patterns and corporate performance.2. But since 1992.. the top five chaebols’ ratios were much higher. except in 1991. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. Among the main findings were the following. They were also higher than those of the top five chaebols until 1991. as well as lax financial supervision (Nam et al. (ii) In terms of net income to total assets.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. except in 19931995 when semiconductor prices were extraordinarily high. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. (i) In terms of total borrowings to total assets. 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. . the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. They were also higher than those of the top five chaebols until 1992. These findings indicate that independent firms have had a lower leverage and performed better financially. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. but the ratios of independent firms were much lower. (iv) In terms of EBITDA to total assets. The ratios of the top five chaebols were similar to those of the top 6-70 chaebols until 1991 when the top five chaebols’ ratios shot up. However. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998.3. the top five chaebols and the top 6-70 chaebols had similar ratios.13). 1999).

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

8) 0.2) (13.1 1.1 1.4 (0.3) 0.9 0.3) (1.4) (1.8 0.2 (0.7 (0.4) (4. 1998.8) (1.6 0.4 1.5) (0.5 (4.4 (1.8 (0.6 0.4 (0.6 0.3 1.7 0.6) 0.6 0.5 (0.0 (7.2) (0.6) (12.1 1. Source: Whan Whang.8 1.1) — = not available.3 0.4) (1.4 (1.8) 1997 0.2) (4.3) 12.6 0.5 1.5 (0.3) 0.2) (0.7) (1.5 0.2 (0.31 Net Profit Margins of Chaebols.2) 0.3 1.3 1.3 (0.9 1.Table 2.6) (0.3) 1.6 5.6 1989 1.2 1.8 0.6 3.9) (8.9 (0.6) (12.4 (1.7 1.0 0.0) 0.0 (0.5 2.4) (6.1 (4.1) 1.1 1.3 0.8) 0.5) (2.7 0.5) (1. Background and Task of Structural Adjustment.6 7.1 0.8) 2.0) (4.2 (17.5 1.5 (6.3) 0.6 0.8 (0.8 0.9 0.6 1.7 0.2 4.3 1.9 0.6 1.9 1.9) 2.6) (20.3 1.5 (0.2 (0.3) 0.0 0.4 (0.1 (9.0 6.8 0.2 1.2) 2.9) (9.7 2.1 0.3) 0.2) 1.8) (11.9 0.7 — (0.2 1995 3.2 (1.1) (6.7) 0. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.1 0.7 0.1) 0.5 1.4 1.6 1.6 (0.1 0.2) 1.3 1. .9 1.6) 0.6) (0.8) 1.4) (2.3) (12.9) 2.3) 0.8) (4.1) 0.4) (0.1 0.6) 0. Beyond the Limit.5 4.9) (1.0) (3.4) (1.9) 2.6 (10.2) (13.1 (4.7 1.1) 2.2 (0.1) 1.7 3.4 0.9 1.4 1.4 0.8 (0.1 1.7 (1.7) (0.3 1.8 1.8 0.3 0.1 (1.1) (5.8) 0.7 0.8 3.6 1.2) (3.2 1.8 3.3 1.1 2.4 0.3 0.9) 0.0 (2.6 0.7 (0.5 1.1) 2.1) (2.1 0.3 0.4 1.2) 1.3 1.2 1.3 1.8) (0.2 1. Management Research Institute.3 (0.1 4.1 0.1 (3.7 (4.3) 1.1 1.3) (0.3 (3.6) 0.0 1.2 1.4 1996 0.4 (2.1) (1.0 4.4 2.3) (0.7 1.0) 0.1 0.6 (0.8) 0.0) (0. Court Receivership.2) 2.8) (20. p.2) (4.7) 0.1 1. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.8) 0.0) (0. Chung Ang University.3 (0.5) (2.3 3.8) (37.3 1.11.5 (0.6 0.5 1.0 1992 1994 1.4 0.7 0.2) (4.0 1.7) (0.1) (1.0 1987 1.0) 0.6 1.3 (0.5) (7.5) 0.1 (0.1 0.7 1.9 8.8 1990 0.8) (3.3) 0.8) (1.2 0.

Moreover. a firm’s board of directors had the power to appoint an external auditor. Ownership concentration also had ramifications on corporate transparency. Along with government policies to protect the status quo. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. But in 1998. the boards of all listed companies were composed of insiders only. and creditors should select (recommend) the external auditor. Internal and External Control Concentration of ownership has been and will be the major obstacle to the independence of the board of directors from management. The Code of Best Practice recommends board audit committees for large listed firms and the Commercial Code is being amended to introduce the audit committee system as an alternative to the internal auditor system. the independence and objectivity of the external auditor were often questioned. after the crisis. Thus. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. a committee composed of internal auditors. this has led to entrenched management. 2. Thus. outside directors. They were then almost automatically elected at the general shareholders meeting. Until 1997. Now. 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. Meanwhile. 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.5. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. A remote trigger in the Thai crisis was all that took to push the economy over the edge. Until 1997.1 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. and to the development of the market for corporate control. . Vol.132 Corporate Governance and Finance in East Asia. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. internal auditors cannot be expected to perform their function independently of management.

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

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

obviously contributed to overlending and aggravated the situation. In November 1997. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. and bond issues. After the financial crisis erupted in Indonesia and Thailand. As of the end of 1997. At the end of 1996.5 billion. The poor state of corporate governance in the banking and financial sectors was responsible for overlending by banks and NBFIs through perfunctory screening of loan applications. However. In the international financial market. 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. won/dollar nondeliverable forward rates increased rapidly. signaling a bearish speculative move on the won. as evidenced by occasional. which were the most important financing source until 1987. reducing foreign exchange reserves to a dangerous level. Other factors also contributed to this preference. . large-scale bailouts of financially distressed firms. which generally required guarantees or collateral. 63 percent of which was short-term. Implicit guarantees by the Government on bank loans to large businesses. The preference for debt finance also led to a relatively large foreign debt. the Government and the Bank of Korea defended the currency. Bank loans. 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. Nonpolicy loans were also considered to be cheap because of interest rate regulations. the top 30 chaebols showed a DER of 519 percent. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. total foreign debt amounted to $157. The lending practices of banks. The ratio of external debts to GDP reached 48 percent at the end of 1998. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. consisted of high proportions of policy loans. bank loans. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. 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. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. share issues. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms.Chapter 2: Korea 135 follows: internal funds. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing.

the ratios of net profits to sales. The inevitable result of inefficient investment was a fall in corporate profits.1 percent in 1996. and estimated losses. The monthly number reached more than 3. The Government could hardly help them because of the number and magnitude of business failures. the NPL ratio of commercial banks increased rapidly from 4. Further. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11.000 in September 1998 (Table 2.000 during January-September of 1998. and returned to about 1. They utilized mutual payment guarantees among their affiliates and believed that they would never fail. they are defined as loans for which interest payments are overdue by three months or more. However. especially chaebols. and shareholders’ equity of all industries. Following the “three months” definition.136 Corporate Governance and Finance in East Asia. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. the NPL ratio8 of banks and other financial institutions began to increase. According to the “six months” definition. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. The banks and merchant banks lent to large businesses. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. then 20. the NPL ratio reached 7. excluding the financial sector.32). total assets. reaching highs of 6 percent in 1997 and 8. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. Fixed loans are those for which interest is not received for six months or longer.000 from December 1997 to February 1998. were low in 1996 and 1997. starting 1 July 1998. Moreover. Meanwhile. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. Before the crisis. Financial Sector Vulnerability Because of financial losses in the corporate sector.6 percent in June 1998. . Vol.7 percent in 1997. and the pursuit of growth through excessive diversification and inefficient investment. without strictly evaluating the creditworthiness of businesses and the profitability of projects. has given rise to various types of self-dealings by the controlling shareholder. decelerated from March 1998.200 in 1997. These were the definitions until 30 June 1998. Doubtful loans are those for which interest is not received for six months or longer. In 1997 they became negative. and there is collateral. It jumped to 17. and there is no collateral.000 per year starting 1992. nine out of the 30 top chaebols failed. legal and other barriers prevented the exit of financially nonviable firms.

and Taipei.69 20. 2.Chapter 2: Korea 137 Table 2. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.856 7.265 6.China.890 4.573 3. This was mainly due to the high ratios of NPLs. The current account deficits in terms .135 1. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.33).589 171. Compared to ROAs and ROEs of domestic branches of foreign banks.673 Construction 380 354 242 195 294 585 1. In 1990-1993. Source: Bank of Korea.855 6.553 3.502 11.850 3.985 Services 3.259 2.386 5. 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.210 1.647 8. low efficiency.637 6.457 2. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.754 3.979 8. European countries. Meanwhile.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September. the ratio reached 7-8 percent.769 9.133 3.238 4.751 1.5. As a result they had largely overvalued currencies.657 3.992 11. those of domestic banks were lower in the 1990s.255 13.114 811 706 696 866 1.517 2.859 3. and large government-directed loans. This speculation was said to be one of the causes of the financial crisis in Korea.244 3.250 2.159 10.472 2. and continuous and large current account deficits. and declined to 4-6 percent in 1994-1996 (Table 2. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.053 5.759 6.544 2.027 Manufacturing 1.32 Number of Firms with Dishonored Checks.107 6.131 1.

652 29.537 10.0 7.484 11. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.874 22.739 241. even in times of economic slowdown. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.584 Fixed (A)a 5.8 5.639 1.138 Corporate Governance and Finance in East Asia.562 18.192 Doubtful (B)b 952 1.4 5.077 NPL Ratio (%) 8.221 8. Korea -4.649 375.China. although per capita income in Korea was much lower.160 11. Thailand -8.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.929 11. the ratio of short-term debt to foreign reserves was very high. Meanwhile large businesses could not legally lay off workers.475 143.954 9.266 10. Mass layoffs became legally possible only after the economic crisis.1 percent (1995). Source: Bank of Korea. Related to this.33 Nonperforming Loans of General Banks. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.997 9. Land prices and real estate rents were also high compared to trading partners.8 percent (1996). In 1997.2 4. of percentage of GDP were as follows: Malaysia -8.176 7.705 160. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.116 1. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.1 7.556 118.832 337.827 289.390 12. .520 194.430 12.China. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.0 7. In addition to the overvaluation of the won.600 10. Businesses served as a social safety net.1 6.310 6.6 percent (1995). Vol.6 percent (1995). and Indonesia -3.0 8.170 1. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei. which led to large corporate losses.190 9.910 1.584 2. because of the rigid labor market. and 30 percent in 1996. II Table 2. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.736 8.

the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. and subsidizing money-losing units. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. They have also been urged to divest themselves of strategically ill-fitting businesses and sell equity holdings of attractive business units to foreign firms to reduce debts. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. including banks. had been forced into bankruptcy proceedings or merged into healthier entities. Downsizing by curtailing employment has been prevalent.1 Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness. They have been pressured to stop such practices as providing loan guarantees. However.Chapter 2: Korea 139 2. Corporations. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. To achieve this. which were laden with huge amounts of debt and were on the verge of bankruptcy.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. 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. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412.6 2. .6. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. Nonviable firms and financial institutions. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions.

281 in April to 2. In their first review. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure.138 by the end of October. On the other hand. banks and other creditors were reluctant to absorb losses realized by debt compositions. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets.140 Corporate Governance and Finance in East Asia. 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. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. Locally. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. More important. Banks did not have the incentive to force financially nonviable firms to liquidate. More than 59 percent of potential buyers were foreign firms. Data collected by the Korean Chamber of Commerce and Industry show that the number of potential domestic and foreign buyers in the M&A market increased by about 50 percent over the six-month period from April to October 1998. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. Noticing this disincentive. 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. sellers could not find buyers as almost all domestic firms struggled to raise cash for debt reduction and for working capital needs while there was a severe credit crunch following the outbreak of the crisis. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. potential foreign buyers waited for the price of acquisition targets to come down further. Internationally. the number of potential sellers decreased somewhat from 2. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. In many cases. This number was at 779 firms in April and grew to 1. Vol. the creditor . Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. The reasons are manifold.045 in October.

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

Vol. In the early days after the outbreak of the crisis. inducement of foreign direct investments was considered to be the most effective means of achieving that end. In another. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. Big deals have been elevated to the status of the most important means of effective corporate restructuring. purchase of divested assets. power plant facilities. some of the acquisition agreements have been discarded for various reasons. the foreign buyer demanded specific protections against adverse developments in the business environment. labor union demands of the seller were not acceptable to the transacting parties. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. These deals could eliminate excess capacity in such industries as semiconductors. automobiles. In the case of automobiles. However. it is hoped.5 billion on agreement basis during the 10-month period after December 1997.142 Corporate Governance and Finance in East Asia. Foreign investment—in the form of acquisition of controlling interests. As of April 1999. enable chaebols to streamline their overly diversified operations and focus on several core business areas. and petrochemicals. Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Restrictions on foreign ownership of land were also abolished. vessel engines. Big deals would. Big Deals Ever since the outbreak of the economic crisis. Korea adopted and implemented policies to open its capital market completely. On 3 September 1998. most of the big deals have entered their final stages of negotiation. oil refineries. Thus. and equity participation—reached about $8. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. This figure contrasts sharply with the total of $700 million for all of 1997. aircraft. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. In one case. railroad cars. uncertainty over the future . Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. First.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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 1.000 corporations. With economic reforms introduced in the 1980s and 1990s.7 8.0 8.1 5.2 During 1988-1997.1).9 6.4 4. which was taken as a representation of the Philippine corporate sector.3 8.7) 10.5 (7.8 5.5 8.1 8.3 9. Table 3. of 9.2) 4.7 (13.2) 0.7 5.3 9.2.2 Source: ADB.9 7.5 8.2 (0.0 (0.0 8.5) 5. Vol. net sales of the top 1.2 Korea.6) 0.8 5.4 Philippines 3. This rate of growth was sustained by a comparable 18. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.0 7.3 2. Rep.0 (6.1 4.2 Thailand 11. however.7) (10. only nonfinancial companies were used. 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.2). In this section. 3. only to be unsettled by the crisis of 1997.5 9.000 Philippine companies grew 17.5 percent per year (Table 3. II market.8 8.8 8.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.1 GDP Growth of Southeast Asian Countries.000 Corporations covers financial and nonfinancial companies.9 5.7 Malaysia 9.2 8. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.8 4.2 7.8 10.2 7.2 9.158 Corporate Governance and Finance in East Asia. Key Indicators of Developing Asian and Pacific Countries 2000.9 (1. .6 7. Its growth rate began to catch up with others in 1996.5) 3.1 5.3 7.

1 1.4 1.4 260.6 35.4 602.3 382.5 887 0.131.2 707.7 218.341.1 197 14.9 952.332.6 954.6 75 6.1 881.1 1.1 615.6 426.8 902 1.7 20.2 136.7 238.6 5.8 5.3 107 13.5 Leverage = total liabilities/stockholders’ equity.6 149 12.2 2.3 941.8 618.2 4.4 898 1. Source: SEC-BusinessWorld Annual Survey of Top 1.1 4. return on equity (ROE) = net income/ stockholders’ equity.0 148.9 629.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.3 68 7.5 4.6 900 1.8 4.9 1.1 714.3 60 10.7 73 6.9 149 6.2 378.5 119 12.978. turnover = net sales/total assets.123.8 741.Table 3. of Companies Sales per Company (P billion) 899 0.1 5.4 63.9 617.4 776.1 73 5.6 1.0 900 1.2 Compound Growth (%) 17.647.4 861.697.1 54 11.209.561. net profit margin = net income/net sales.8 22.3 46.1 468.9 96.2 900.6 102 16.317.4 555.6 109 12.4 8.5 72 7.5 64.1 181 11.7 443.5 192.5 1.7 28.6 1990 1991 1992 1993 1994 1995 1996 1997 1.5 446.1 33.9 78 6.8 411.2 1.1 72.9 3.1 Other Indicators No.6 144.5 1.3 862.225.7 1.3 898 1. return on assets (ROA) = net income/total assets.0 1.177.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.160.1 66 12.1 6.6 896 0.0 1. .5 508.2 Average 146 12.000 Companies.000 Corporations in the Philippines.1 95.8 6.5 14.8 77 7.9 2.191.9 898 1.2 Growth and Financial Performance of the Top 1.394.9 480.2 338.3 306.8 26.9 896 2.7 903 0.5 1.5 570. 1988-1997 1989 519.4 3.3 121 12.5 51 4.5 193.6 290.1 51.7 1.6 18.893.2 2.781.4 188.2 27.512.4 411.

352 1. Assuming Table 3. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. . various years.697 1.3 percent.172 2.1 19. and the SEC-BusinessWorld Annual Survey of Top 1.9 23. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. 1988-1997 Top 1.4 24.6 percent and 5.248 1. Vol.3).178 1.8 19.427 13.906 2.5 Ratio of Estimated Value Addeda to GDP (%) 17.160 Corporate Governance and Finance in East Asia.474 1. Further.1 Net Sales (P billion) 465 519 630 741 862 954 1. Sources: ADB.077 1.9 percent for the period. for the 10-year period.5 16.000 Corporations in the Philippines. but the extent of the increase was not as dramatic as in other Asian countries.394 1.8 percent per year.979 17. Net profit margins for the top 1.8 17.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.5 Value-added is assumed to be 30 percent of net sales.000 companies averaged 7. Total assets grew at an average annual rate of 22.693 1. Asset growth was funded by debt that grew at an average of 20.2 percent. respectively.5 17. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. This is high compared with developed countries but compares favorably with other Asian countries. Key Indicators of Developing Asian and Pacific Countries 1999.7 percent.9 21.4 20. and by equity that grew at a higher average annual rate of 26. II assets. Return on equity (ROE) and return on assets (ROA) averaged 12. These rates of return are high compared with other Asian countries.3 The Corporate Sector and Gross Domestic Product. leverage increased from 109 percent in 1996 to 149 percent in 1997. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.

000 Corporations in the Philippines.6 Total Assets 29.5 27.4 28.8 percent of the corporate sector’s total sales between 1988 and 1997.1 22 10. of Companies 73 Sales per Company (P billion) 2.1 ROA 8.5 23 4. Averaging 42.5 Retained Earnings 30. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.0 31.3 22.5 Other Indicators Share of Sales (%) 17.5 GovernmentOwned 4.4 Fixed Assets 19. these figures suggest a significant and increasing contribution of the corporate sector to GDP.9 158 13.8 606 0.8 14.3 9.9 22.8 ForeignOwned 21.3 11. 1988-1997 Indicators Publicly Listed Privately Owned Rate.4).8 22.0 5.9 26.Chapter 3: Philippines 161 a constant ratio of value added to sales.0 4.8 Growth Indicators (Compound Annual Growth Net Sales 20.2 103 5. (iii) Government-owned.0 Net Income 19.0 Turnover 53 Net Profit Margin 15. size.8 2.1 12.3 42. The foreign-owned companies were the Table 3.3 27.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.2 9.4 Total Liabilities 26.4 190 5.0 5.1 Financial Ratios (%) Leverage 89 ROE 15.3 22. (ii) foreign-owned.8 No. and (iv) privately owned. . corporate control structure.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.8 3.7 22.4 Stockholders’ Equity 32.0 28.7 2. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.3 146 6.9 17. A study of company performance by ownership type. %) 17. The premise is that these variables have a direct bearing on corporate performance and growth. privately owned companies constituted the largest group (Table 3.0 142 22.9 196 1. various years.

The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. But by being most efficient in employing assets. although small in number.5 percent. 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. they generated the highest return on investments.000 list. Privately-owned and Government-owned companies grew at slower rates. the highest net profit margin of 15. With an average leverage ratio of 142 percent. and the second lowest asset turnover. exceeding the 17.1 billion per company in 1997. selling an average of P4. the asset base is large. followed by publicly listed ones. meaning that the remaining 62 percent were relatively small in sales and assets. and low return on investment is the norm. Bases Conversion Development Authority. However. The privately-owned companies had a high average leverage ratio of 158 percent. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration.162 Corporate Governance and Finance in East Asia. Publicly listed companies had the lowest leverage at 89 percent. . Publicly listed companies had a minor though steadily increasing share in total sales. were among the top 1. or 38 percent. but lower than those of foreignowned and publicly listed companies. the second best ROE and ROA. Governmentowned companies in the top 1. with an average ROE of 22. Vol. compared with P2.3 percent.9 percent. foreign-owned companies borrowed more than publicly listed ones.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. It should also be added that the profit margin of Government-owned companies is distorted by the presence of holding companies such as the Philippine National Oil Company.75 billion per company for foreign-owned companies. The compound annual sales growth rate was 21. registered the largest per company sales at about P9 billion in 1997. a level high by Western standards but at par with those of other Asian countries. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). Their ROA and ROE were both more than twice as high as those of government-owned companies.5 percent average growth rate of the entire corporate sector. These were mostly large public utilities.2 percent and ROA of 9. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income.000 companies in 1997. these companies were comparatively large. II second largest at about 27. while there were few of them.

2 23.7 Stockholders’ Equity 34.1 Source: SEC-BusinessWorld Annual Survey of Top 1.3 No.0 55. various years.6 26. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.1 Retained Earnings 32. a company can be a member of a conglomerate or independent. had a lower leverage ratio. Sales and resources of the .3 Financial Ratios (%) Leverage 98 ROE 15.000 Corporations in the Philippines. and small companies.4 24.1 124 5.0 22. and achieved higher returns on invested assets than independent companies (Table 3. grew faster.2 Net Income 21.6 715 0.0 166 15. medium.0 Turnover 67 Net Profit Margin 12. depending on assets and sales.7 2.5 Growth and Financial Performance of the Corporate Sector by Control Structure. the corporate sector is divided into large. %) Net Sales 20. Performance by Firm Size By firm size. of Company 159 Sales per Company (P billion) 2.8 6.8 ROA 8. But the conglomerates were larger measured in sales per company.7 Total Assets 32.8 Growth Indicators (Compound Annual Growth Rate.2 Fixed Assets 25. 1988-1997 Indicators Group Member Independent 18.Chapter 3: Philippines 163 Performance by Control Structure By control structure.3 Total Liabilities 30. compared with 32.0 25.5).3 percent for the conglomerates.3 Other Indicators Share in Sales (%) 32. Table 3.

4 Total Liabilities 18. .1 No.2 Stockholders’ Equity 18.0 156 16.7 44. Medium-sized companies also performed better in terms of ROE.5 Total Assets 18.6 Growth and Financial Performance of the Corporate Sector by Firm Size.6 36.6).4 28.9 26. referring to the remaining companies in the list.0 7.9 Retained Earnings 13. while small companies. although they comprised only 8.000 Corporations in the Philippines. Medium-sized companies.5 25.9 Financial Ratios (%) Leverage 158 ROE 13.2 29.4 billion in 1997. %) Net Sales 15. averaging 16 percent.6 47.164 Corporate Governance and Finance in East Asia.1 4.0 730 0.6 Small 19. averaged a far less P3 billion in per company sales.1 percent of the total sales of the corporate sector. defined in this study as the next 200 largest companies in the top 1.5 12. various years.9 32. which.3 Turnover 65 Net Profit Margin 8.8 percent of the total number of companies in the list (Table 3. II Philippine corporate sector are highly concentrated among the large companies. Sales per company in this group averaged P13. of Companies 79 Sales per Company (P billion) 7. averaged only P920 million in per company sales during the same year.000 list. Large companies accounted for 56.1 81 9.2 Other Indicators Share in Sales (%) 56.5 73 6.6 31. Vol.3 Source: SEC-BusinessWorld Annual Survey of Top 1. sales of mediumsized companies grew faster than large companies. However.0 32.1 25. are defined as the largest 100 companies in the top 1.000 list.5 Growth Indicators (Compound Annual Growth Rate.7 Net Income 1. indicating that they deployed resources more efficiently than large and small companies.1 ROA 5. 1988-1997 Indicators Large Medium 19. Table 3. for this study.3 Fixed Assets 15.2 25.5 128 10.6 49.9 89 1.

Large. and the construction sectors than for the manufacturing.4 percent in 1997 from 11. especially during the period 1994-1996. and equity up to 1996. as indicated by the negative annual growth.8 billion in . but suffered its largest decline in net profits in 1997. The real estate and property sector also suffered significantly in sales. at 158 percent on average during 1988-1997. net income.5 percent for medium-sized companies and 8. but lower than that of construction. although the largest in number. utilities. Mediumsized companies’ leverage level was slightly lower. compared with 9. of net income. showed the lowest ROE. unlike their counterparts in other Asian countries.6 percent.7 percent in 1997 for medium-sized companies. i. The sector showed consistent growth in sales. assets.e. and utilities and services sectors. net income. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales. and profitability in 1997 when the crisis started. Net income declined from P54.8 percent.7 percent in 1996 to 8. with their ROE dropping to 3. are shown in Table 3. from 14. The Asian financial crisis affected large companies most severely.1 percent. manufacturing.7 billion and P35. Leverage was the highest for large companies. But small companies’ leverage was significantly lower. reflecting to some extent a “bubble” phenomena in the former two sectors. For small companies. at 128 percent for the period. Poor returns appear to have been caused by the low profit margin at 6. ROE dropped to 7. averaging 10.7 percent a year earlier.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. and assets was much higher for the real estate and property. ROE dropped from 10. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector.8 the previous year.8 percent in 1997.1 billion in 1996 to P4.2 percent for large ones. profits.7. Sales revenue and net income declined from P76. and construction. and utilities and services sectors. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. Performance by Industry This study also looked at corporate performance by industry. at -12. The growth and financial performance of selected industries. real estate.Chapter 3: Philippines 165 Small companies. Growth of sales. at 156 percent. specifically those industries least and most affected by the financial crisis..2 billion in 1997 for this sector.

3 5.3 Fixed Assets 20.166 Corporate Governance and Finance in East Asia.9 5.3 20.4 Source: SEC-BusinessWorld Annual Survey of Top 1. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997. it does not appear to have been excessively exposed to foreign currency-denominated loans. respectively.7 Indicators Manufacturing Construction 27.5 Other Indicators Share in Sales (%) 82.7 ROA 5.2 8.2 12.8) 17.9 2. 1988-1997 Utilities Real Estate and and Services Property 39.0 21.7 19.7 percent to 10.5 12.4 3.4 Total Assets 19. the sector’s ROE dropped from 15.9 billion and P24.7 billion in 1997.8 41.7 52.0 25.6 Growth Indicators (Compound Annual Growth Rate. 1996 to P56.2 28 0.4 16. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.0 31 0. and was also much more limited compared with the property sectors in other Asian countries.0 Turnover 112 24 Net Profit Margin 5.0 23.3 Retained Earnings 17.9 17.6 No.000 Corporations in the Philippines. of Company 454 17 Sales per Company (P billion) 1.7 83 2.9 2. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.2 45.7 10. various years.7 Net Income (12. Vol.000 companies’ total sales on average during 19881997.7 192 9.6 Financial Ratios (%) Leverage 142 181 ROE 13. II Table 3. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.2 37.4 percent.8 Stockholders’ Equity 21.6 Total Liabilities 18.1 24 42.1 2.7 Growth and Financial Performance of the Corporate Sector by Industry.7 28.3 55.8 48.1 10.9 23.4 19. %) Net Sales 16. . As a result.6 69 16.

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

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

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

a single shareholder held operating control of a company. Individuals did not constitute a significant shareholder group among the top five shareholders.174 Corporate Governance and Finance in East Asia. In four of 11 nonfinancial sectors. or 78 percent of the total. or 20 shareholders owned more than 50 percent (signifying operating control). minority shareholders are unlikely to be able to influence the strategic and operating decisions of a company without the support of one or more large shareholders. Vol. which are mostly privately owned and controlled by family-based shareholder blocs. the top five shareholders owned more than 50 percent of the voting shares. 66 percent (signifying strategic control). including pure holding companies. In four companies. and 20 shareholders? In Table 3. a single shareholder held two-thirds majority control.2 percent of outstanding shares of publicly listed companies.1 percent of publicly listed companies in the Philippines in 1997. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. Table 3. With such high levels of ownership concentration. II analysis of the number of companies in which the top one. In 76 companies. In 111 companies. and share prices are sensitive to movements of foreign funds. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. The shares of publicly listed companies are thinly traded and illiquid. In 116 companies. the top five controlling shareholders were classified into eight groups. or 3 percent of the total. holding only an average of 2. the top five shareholders held more than two-thirds majority control of a company. Through these. or almost 75 percent of the total. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. or 51 percent of the total. The largest group is nonfinancial corporations. nonfinancial corporations held majority control. Who are the top one. five. or 80 percent (only nominally publicly listed) of outstanding shares. controlling an average of 52. five. or 14 percent of the total. the top 20 shareholders collectively owned a majority of a company’s shares. a single owner owned more than 80 percent of outstanding shares. or about 30 percent of the total. large and family-based shareholders pool the family’s ownership over many . In 21 companies.10. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders.9 shows that in 44 companies. There are advantages to establishing pure holding companies.

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

0 1. Recreation.2 59.1 9.2 3.2 0.1 7.3 0.0 1.0 1.0 0.5 53.0 0.0 0.0 0. Distribution.7 0.3 2.0 0.6 0.6 12.0 45.3 5.6 0.4 29.2 3.8 0.0 2.0 1.2 0.6 5.2 3.0 1.7 0.0 0.0 2.6 18. and Trading Hotel.5 13.9 0.7 3.1 0.6 0.2 0.5 4.0 5.3 1.0 0.3 0.8 0.4 19.8 66.7 0.3 1.8 0.6 0.6 0.6 9.7 67.0 1.4 1.0 5.2 10.3 0.9 0.6 1.1 0.4 0.2 0.5 0.6 0.0 0.0 1.0 1.0 5.0 5.7 0.0 0.3 5.7 0.9 6.3 12. and Other Services Property Mining Oil Average Shareholdinga 33.2 3. . Beverage.5 2.0 0.8 11.3 0.7 0.6 33.5 12.5 4.7 3.3 0.0 4.3 37.2 5.4 2.3 26. Source: PSE Databank.4 8. 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.1 1.9 36.5 0.0 0.2 1.0 10.6 0.0 7.1 6.0 0.7 1.4 5.6 2.8 21. and Tobacco Holding Companies Manufacturing.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.6 2.0 0.9 52.1 a Weighted by market capitalization.1 8.5 26.0 0.1 5.0 0.2 0.Table 3.

5 to 12. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. securities brokers (1.7 percent of market capitalization of the nonfinancial publicly listed companies. The 7. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). Holding companies were themselves 66 percent owned by other nonfinancial corporations.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. They can also better manage their income taxes because income from affiliated companies passes through a holding company. commercial banks (1.1 percent). Holding companies as a sector had the largest market capitalization in PSE in 1997. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries.2 percent shareholding by the financial institutions was even inflated to some extent because securities brokers held trading portfolios for their clients rather than long-term investments. financial institutions did not have a significant ownership in nonfinancial corporations. Investment trust funds were the most important institutional investors.2 percent in 1997. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. Privately-owned pure holding companies own a majority of shares and exercise control of publicly listed holding and operating companies through a multilayered pyramid structure. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. respectively. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. The investment funds’ presence in these sectors ranged from 8. while still allowing the public to own minority shares.7 percent of shareholdings). there was no real market for investment information.3 percent). Because of limited ownership by institutional investors.6 percent of market capitalization in 1997. Such advantages have contributed to the popularity of holding companies among publicly listed companies. accounting for P258. and insurance companies (0. 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.1 percent). . As a group. Petron and MERALCO in power and energy.6 billion or 26. with an average of only 7. and San Miguel Corporation (SMC) in food and beverages.

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.8 percent of total companies in number. Corporate financing depends on intermediation by banks. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). However. including SBL and DOSRI rules. identified the companies belonging to each of these groups.178 Corporate Governance and Finance in East Asia.000 Corporations in the Philippines. suggesting that most publicly listed companies are parts of business groups. This is significant considering that there were only 31 local commercial banks in the country in 1997.4 percent of the top 1.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. Vol. The Central Bank deregulated interest rates and foreign exchange. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. using data on the Philippines’ top 1. suggesting that business groups are common in all major markets. Still. 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. the study put together a list of prominent business groups. remain in force to control excessive lending of banks to insiders. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. . many companies in family-owned groups are not publicly listed. To understand the ownership and governance characteristics of family-owned business groups.000 companies. A common feature of corporate ownership of a business group is the centrality of a commercial bank. but they comprised only 23. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Large shareholders and their families own these banks directly or through their controlled companies.11).7 6 7 The study used publicly available shareholder information and published reports. including 16 commercial banks. Some 20 financial institutions were affiliated with these groups. Prudential regulations. For this reason.000 corporations’ sales. about three fourths. and increased the capital requirements for all types of banks. All major industries were represented. of the financial resources in the country. and tracked the financial performance of each company from 1992 to 1997. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. Family-based groups have larger companies since their total sales were about 33. so far limiting their involvement to selected products. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. Commercial banks hold the largest share.

as discussed in previous sections. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. Commercial banks are often affiliated to a particular business group. which was majority-owned by the Henry Sy group.000. namely. the top 10 family-based business groups had only 119 companies in the top 1. the study used the four largest business groups—Ayala. it was manufacturing (36. ranged according to their sales (Table 3. and for the Henry Sy group. retail merchandising (69. including business groups and independent companies. The main constraint may be the availability of family members that could be drawn for top management positions. Lopez. Gokongwei. with the exception of Banco de Oro. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. the two were closely related through their affiliations to business groups. the biggest private company in the Philippines. or an average of about 12 per group. for each of these groups. the largest family-based business group was the Ayala Corporation Group. for the Gokongwei Group. Family-based business groups are most dominant in sectors such as manufacturing.6 percent of the total sales of the top 1. 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.4 percent of the group’s 1997 profits). the largest was the Eduardo Cojuangco group. and more than 20 percent for the Lopez group and Henry Sy group.000 corporations in 1997. In the meantime. the three largest entities were family-based groups. In terms of sales. the principal owner of SMC. These corporate entities accounted for 53. Foreign-owned companies mainly serve the export markets. It is also noteworthy that. for the Lopez group. an average group in the Philippines has fewer member companies. To show this. with 27 affiliated companies in the top 1.000 companies. real estate.2 percent). the nonfinancial sector was real estate (60.Chapter 3: Philippines 179 Compared with other Asian countries. in most . and Henry Sy—as examples. Together. For the Ayala group. In 1997.8 percent). Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. construction.1 percent). Significantly.12). broadcasting (49. and Ayala. 25 out of the 50 top corporate entities were familybased groups. Also. In terms of number of companies. Lopez. and banking. Cojuangco. a substantial proportion of group profits came from its financial subsidiaries.

11.5 49. 3.4 .1 4.5 6.5 26. and Affiliated Bank of Selected Business Groups. 5. real estate. Beverages. beverages. agriculture.11 Total and Per Company Sales. 16. telecom.1 2.0 Average Sales Per Company (P billion) 6. and food Food. and dairy products Investments. 8. Real estate. beverages. and tourism Credit card 18. Flagship Company. and packaging Power distribution and mass communications Real estate. of Affiliated Companies Total Sales (P billion) 123. 4. construction.4 48.9 2. and personal care prods Shipping.5 47.Table 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. 15. food. 13. 6.5 17.4 10.5 44.8 84. coconut oil.5 2. 17.3 11.3 2. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12.6 3.3 15.2 1.4 6. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. 9. food. 10. Eduardo Cojuangco Lopez Family Group Ayala Corp.3 3.2 1.1 4. power.7 98. 14. 2. 7.0 13.0 17.5 13.5 46.6 2.6 3. Consunji 4 3 Food and dairy products Construction and mining 10.6 7.0 5.2 16.0 26. and mining Management. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No.9 3. Sector Orientation.

mining.9 0.7 3. and various company annual reports.5 8.5 2. 28. 38.6 0.1 1.8 1. .0 5.6 2.4 5.9 1.7 1. 35. P. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.8 1.9 6.1 1.3 7.3 2.7 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.2 4.8 6. 37.7 0.7 4.0 0. 22. Ramos Gaisano Family Group Felipe Yap Felipe F. 23.3 2. 27.8 1. 33.19.9 7. 29.4 3.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.6 5. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank. 36. 26. 31.7 0. 24.9 0.000 Corporations (1997). 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 8.1 0.1 805. 25.1 2.0 2.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication. 20.0 1. 4 238 1. 39. 21.4 1. 30.6 3.4 3.2 1.9 1. 34. 32.9 1.2 6. SEC-BusinessWorld Annual Survey of Top 1. distribution.

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

Refers to commercial banks. 35. 37. P. 36.65 billion to P4. F.65 billion. Ramos Gaisano Family Group Felipe Yap Felipe F. Fil-Estate Development Inc.48 billion. 24. Cruz & Co.000 Corporations (1997).East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. 38. 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. 25.48 billion.. Sources: PSE Databank. 27. 33. 29. 39. PT&T Corp. . 32. unless otherwise indicated. small = less than P1. a b Size class is measured in terms of sales: Large = greater than P4. 30. 26. and various company annual reports. 31. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. SEC-BusinessWorld Annual Survey of Top 1. 28. Inc. 34. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 23. medium = P1. 22. Kepphil Shipyard Inc.

Texas Instruments (Phils.). Fujitsu Computer Products Corp. 15. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 5.8 53.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. 18. 13. 19. food.8 22. 14.). and mining Gold and other precious metal refining . 9. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc. 2. banking. and personal care products Shipping. 6. and bank Real estate. Inc. beverages.6 26. and food Food.12 Control Structure of the Top 50 Corporate Entities.5 17. and telecommunications Department store and banking Airlines.4 19. 4.0 37.0 38.5 47.5 26. 22. agriculture. 10. 7.3 15. food. 24. power.Table 3. mass communications.2 49.8 84. Inc.1 17. and dairy products Investments. bank. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 8.5 44. car manufacturing. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.5 77. food. and packaging Power distribution.0 24.2 16.7 98. 12.2 Business Group Business Group Business Group Government.5 15. coconut oil. Beverages. First Pacific/Metro Pacific Group 21. 3.1 60. Philippine National Bank Mercury Drug Corp. 16. and real estate Banking. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. 23. 11. 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. 17. construction.5 46. of the Phils. beverages. 20.4 48. telecommunication.6 18.

Corp.4 10. 41. Jollibee Foods Citibank N.6 1. 36. Inc. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. corn (unmilled). PSE Databank. Philips Semiconductors Phils. real estate.7 13. 39. Inc. National Steel Corporation National Food Authority Phil.9 6.3 8.8 9.9 14. 44.25. 34. 48.8 6.6 12. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. Philip Morris Philippines. 45. Amusement and Gaming Corporation Mitsubishi Motors Phils.0 12. 27.3 13.5 10.1 9.9 7.290 53. 50. 40. 43.4 8. W. 35. 9.0 5. . including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. and various company annual reports.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.000 Corporations (1997). 30. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.9 7. 46. 37.7 10. 31. Consunji Uniden Philippines Laguna. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 29. 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 1.5 8.0 13. 49.A. 14.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. 47.6 9. 28. Inc.2 7.. 33.0 11. Uytengsu/General Milling Group David M.7 10. EAC Distributors Inc. 26. 42.8 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. 32.5 8.

A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). sale or disposition of a substantial portion of corporate assets. business groups had only minority ownership. 8 The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank. shareholder voting in general meetings and legal protection of their rights. and financial disclosure. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. The Corporation Code holds members of the board of directors liable. However.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. removal of directors. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation.8 The Board of Directors As the representative of shareholders in a company. and declaration of cash dividends. 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. the board of directors plays a crucial role in corporate governance. investments of corporate funds in other companies or purposes. issuance of stocks. determination of compensation to board members. . voluntary dissolution. II publicly listed commercial banks affiliated to these groups.3.186 Corporate Governance and Finance in East Asia. Vol. jointly and individually. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. 3. Actual control of the banks was still held by the groups. They are likewise liable if they pursue financial interests that conflict with their duty as directors. amendments in the bylaws. approval of management contracts. accounting and auditing. appointment and compensation of senior executives. such as amendments of the articles of incorporation. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. issuance of corporate bonds. these were dispersed shareholdings. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. although public investors held a majority of shares. Of course. corporate mergers or consolidations.

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

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

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

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

About 93 percent of the respondents contracted .2 69.0 51. 1999.900 shareholders per company did not vote during the last annual general meeting.8 92.2 7.Chapter 3: Philippines 191 in a few controlling shareholders and families.2 43. protection. An average of about 4. About 333 shareholders per company voted by proxy. The responding companies had on average 43. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.0 48. The ADB survey provides further evidence on shareholder rights.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.8 30.8 56. The brokers or securities companies were the most important proxy voters.522 shareholders each. followed by management and banks.13 summarizes rights that the shareholders of the responding companies enjoyed.7 43.0 36. representing 3. Table 3. a company that is widely held but has a large shareholder. the successful hostile takeover by First Pacific Group of PLDT.4 percent of shareholders but 58 percent of outstanding shares.4 No 0. Nominees held about 45 percent of the outstanding shares.3 56. Nevertheless. Table 3.0 63. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.4 70. appointed either by the board or shareholders during the annual general meetings.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.6 30. and their activism in the corporate sector. representing about 24 percent of outstanding shares. Yes 100.

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

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

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

2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. Inc.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. (47. Inc..06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. Inc.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils.Figure 3.96%) Privately-Held Pure Holding Company Public Investors (41. (58. . (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.04%) <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.

2).14%] / [6.7 times Ibid. The situation offers large shareholders tremendous incentive to move resources 10 For details.5% x 14. and Larry H. 1999b.10 The Ayala family’s control rights over BPI was 1. Fan. and 1999c. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. Simeon Djankov.7 times 12 . First Philippine Holdings Corporation. Being in the public utilities sector. is illustrated in the Lopez Group (Figure 3. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. P.44%] / [25%] = 1.11 The Lopez family’s control rights over MERALCO was 5. Vol.3% x 1. P. Expropriation of Minority Shareholders: Evidence from East Asia. Benpres Holdings. Simeon Djankov. The control of companies through indirect corporate shareholdings. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1.44%] / [58. Rockwell Land. See also Stijn Claessens. Diversification and Efficiency of Investment by East Asian Corporations. Lang.5%] [39. and Larry H. defined as control by large shareholders of an operating company through minority ownership by several companies.12 These examples show that even when large shareholder groups are minority shareholders. Who Owns and Controls East Asian Corporations? 11 Ibid.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. MERALCO.14%] / [1.98% x 42. 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. H.44%] = [42.8%] 5. companies in the Lopez Group are large and minority-controlled. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. Joseph P. and a minority-controlled holding company.5%] / [(88. The Separation of Ownership and Control in East Asian Corporations. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. see the World Bank research papers by Stijn Claessens. 1998. however.64% +37. a privately owned company. Lang: 1999a.76%)] [39.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group.64%) + (37.3% x 5.196 Corporate Governance and Finance in East Asia. Generally.

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 1.3% 11. Inc.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.64% MinorityControlled 14.76% Operating Company MinorityControlled 24.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.7% 62.Figure 3. . Privately-Held Pure Holding Company 88.

while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years. 3. the data suggest. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral. whether for working capital or capital expenditure. Suspension of Payments of Debts Under PD 902-A. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. and (ii) how the legal framework protects creditor interests and rights. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions.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. Control by Creditors According to the ADB survey. 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. However. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . The survey results also revealed that creditors did not intervene in the management of borrowing companies and wanted to maintain business relationships with corporate borrowers even when they were in trouble. Vol. The average company.3. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems.198 Corporate Governance and Finance in East Asia.

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

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

4 Ratio of Market Capitalization to GDP 0.7 391.1 524.2 59.0 161.1 0. Source: PSE databank.3 Market Capitalization (year end.251.8 1.121.5 1. .545.445.14 Philippine Stock Market Performance.692.4 728.515.3 4.1 0.3 0.2 61.9 114.0 0. P billion) Gross Domestic Product (current prices.7 0.3 59.1 5.Table 3.5 26.9 682.1 0.8 0.2 0.2 0. 1983-1997 Daily Trading Volume (P million) — — — — 129.1 0.421.386.5 Year 369.5 72.6 261.4 1.6 1.8 102. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.6 1.7 1.474.2 1.9 608.5 16.3 2.0 0.5 1.4 9.351.2 925.0 0.7 2.3 158.906.2 297.9 799.8 1.2 57.3 0.8 1.2 3.5 571.9 2.9 1.0 2.248.2 1.686.3 — = not available.7 41.2 ($ million) — — — — 6.171.5 12.3 314.7 207.373.0 1.9 2. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.1 88.

are in a position to provide such discipline. by volatile interest rates and the absence of a secondary market. corporate bond issuing was even more limited. However.202 Corporate Governance and Finance in East Asia. include bank credits. asset-backed credits. The measures used in the analysis are: . the rights issue was a popular way of raising equity capital. Capital markets cannot provide the market discipline that corporate investors need. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. tight regulations. new equity. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. which in most cases is an affiliate of the issuing company. Because existing shareholders wanted to retain their proportionate control over their companies. leases. sells these commercial papers through brokers. which were the principal source of corporate financing in the Philippines. which buy commercial papers either for their own account or for their clients. The corporate bond market was stunted. Only a few large companies floated commercial papers because of the limited market. The underwriter.6 billion.. The largest buyers have been commercial banks. 3.2 Patterns of Corporate Financing The study looked at retained earnings. Corporate bonds are another type of debt securities. Debt instruments include negotiated credits and debt securities. about 127 companies went public with a total value of offerings of about P134. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. Debt securities include commercial papers and corporate bonds. and the dominance of large commercial banks. which ultimately influences the pricing of commercial paper issues. and high transaction costs.4. Vol. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. of which 85 percent was raised from 1993 to the first half of 1997. Only the commercial banks. discounting of receivables. The picture of the financial system that emerges is thus one of limited capital markets. because business groups often own large commercial banks. From 1988 to 1997. and inventory financing. and debt as sources of corporate financing by using flow of funds analysis. moreover. Under SEC regulations. However. by virtue of their large stakes in the financial system. a strong regulatory system for bank supervision is imperative. lack of competition among financial institutions. Negotiated credits.

New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.1 0.5 0.1 0. It measures a company’s capacity to finance asset growth by equity capital.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.3 0.4 0. By definition.9 0.3 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector. it is one minus IDFR.5 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.2 0.9 0.4 0.0 0. It measures a company’s capacity to finance asset growth by internally generated funds. .7 0. during this period.15.3 0.000 Corporations in the Philippines from 1988 to 1997.0 0. the SFRT was low at Table 3. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.6 0.5 0. 1988-1997. the average SFRF was high at 109 percent.1 0.4 0.2 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.3 0.15 Financing Patterns of the Corporate Sector.2 0.5 2.5 0.4 0.4 0.8 0.5 0. As shown in Table 3.2 0.9 0.3 0.5 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.5 0.4 1. It measures a company’s reliance on borrowings in financing asset growth.8 0.1 Average 1.9 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.4 0.1 0.5 0.8 0.3 0.1 0.3 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.4 0.6 0.000 Corporations in the Philippines.5 0.6 0.2 0. On the other hand.

privately. .8 0.5 Foreign-Owned 1. In all the years.0) 0.16. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 Privately-Owned 0. retained earnings declined and few new equity investments flowed into the corporate sector. In 1997. Retained earnings were the least important. Source: SEC-BusinessWorld Annual Survey of Top 1.2 (0.7 0.000 Corporations in the Philippines.3 0. It can also be observed that the relative importance of stockholders’ equity (including retained earnings and new equity investment) was declining and that of debts increasing in financing the growth of the corporate sector from 1991 to 1997.5 0. Total assets grew by 23 percent that year.9 0. the level of corporate leverage increased. There were significant year-to-year variations. 1988-1997. except in 1991.16 Corporate Financing Patterns by Ownership Type.2 0. 1991. Vol. and 1997. reflecting the capital flight caused by political instability in the early 1990s. As a result. This was mainly caused by the declining contribution from retained earnings. internal funds were not a significant source of financing growth in total assets. In periods of an economic crunch such as in 1989.and foreign-owned.1 a Excludes negative balances. II only 19 percent. Companies financed fixed assets from internal sources in hard times. except for foreignowned companies that had a negative new equity financing ratio.3 0. when it financed 45 percent of it. with debt providing 93 percent of the financing requirements. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. debts were the most important source of financing. On Table 3. implying that internal funds were far from sufficient to finance growth in total assets. Corporate Financing by Ownership Type As shown in Table 3. for all three types of companies—publicly listed. the SFRF was higher.204 Corporate Governance and Finance in East Asia.3 0.6 0.3 0.

7 4.7 100.4 12.9 3.5 41.17.4 43.7 23.8 16.9 16.9 100.2 51.8 51.0 1995 1996 13.3 10.6 48.0 9.8 0.9 16.1 13.7 13.5 9.8 4.8 26.8 38.0 9. especially bank loans.1 49.4 100.0 38. Foreign-owned companies relied more heavily on debt financing.4 2.0 12.0 1994 19.0 1993 14.0 13.9 16.5 16.6 37. publicly listed companies relied more on new equity financing than privately.5 27.9 38.6 26.3 12.2 3.0 9.0 53.4 100. The sector built up its short-term debts.4 10.2 100. 1988-1997.4 100.3 48.2 3. significantly Table 3.2 100. .2 12.000 Corporations in the Philippines.8 39.17 Composition of Assets and Financing of the Publicly Listed Sector.3 12.4 100.7 7. contributing 90 percent of growth in total assets.5 12.6 48.0 6.3 11.1 10.3 12.0 9. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.and foreign-owned companies. It presents a composition analysis of assets and financing sources for the period 1992-1996.9 24.6 43. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.0 8.1 50. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.8 100.0 10.7 2.9 12.9 0.3 10.3 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 14.4 41.0 100.1 9.2 42.8 0.8 17.4 3.Chapter 3: Philippines 205 average.6 0.8 3.3 4.1 7.1 15.0 Source: SEC-BusinessWorld Annual Survey of Top 1.8 3.5 0.9 4.7 2.4 2.8 46.0 10.7 13.3 51.

On average.2 0. their inherent ability to pool risks. The normal standard liquid position is a current ratio of 2 or higher. group companies usually financed their investment in member companies by equity rather than debt. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. As shown in Table 3. Further.3 0. Vol.45 in 1996.13 was at 1.3 0. For these two reasons. the average SFRF of business groups was higher compared with that of independent companies.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. as opposed to 94 and 30 percent.18. 1988-1997. compared with an average of 54 percent for independent companies. and economies of scale in fund raising.6 Independent Company 0. for independent companies.1 0.18 Financing Patterns by Control Structure.206 Corporate Governance and Finance in East Asia.9 0.5 0. respectively. Group companies financed an average of 45 percent of growth in total assets by debt. indicating that many publicly listed companies were likely to be in a tight liquidity position. Group companies were generally more profitable than independent companies. the current ratio. 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 1997.000 Corporations in the Philippines. 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. the easier access to external credit. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.5 0.3 0. . Table 3. The traditional measure of liquidity. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.

1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. The corresponding ratio was 0.19 Financing Patterns by Firm Size. and 1997 with 131 percent.9 0.1 0.88 for large companies (Table 3. With assets growing at a fast pace during this period.50 (Table 3.8 0.6 0.000 Corporations in the Philippines. Large companies’ IDFR of 0.2 0. Table 3.08 and SFRT of 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.3 0. 1988-1997.5 0. Excluding . equity financed 42 percent of incremental asset growth.76 for small companies and 0. 1993 with 96 percent.47.3 0. These years were 1991 with 110 percent.55 was substantially higher than the small companies’ 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth.Chapter 3: Philippines 207 independent companies. Large firms consistently increased their reliance on debts from 1994 to 1997. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997. Source: SEC-BusinessWorld Annual Survey of Top 1. with an average of 3. medium-sized companies used more debts.5 Excludes negative balances. compared with 55 percent for large companies and 47 percent for small ones.5 Medium 3.2 0. On average.06. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.2 0. Corporate Financing by Firm Size SFRF was highest for medium-sized companies.6 0.19).20).3 0.4 Small 0. averaging 61 percent of growth in total assets. There was also increased reliance on debt financing.

1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. Since the real estate boom coincided with that of the stock market.7 0. achieving an average SFRF of 3.4 0.000 Corporations in the Philippines.4 3. SFRF for the sector averaged 0.208 Corporate Governance and Finance in East Asia.5 0. 1988-1997.5 0.04. While this level is considered prudent. with an SFRF as low as 0. During the crisis year.6 0.1 0.58 and SFRT of 0. In the eight years preceding the crisis. The utilities sector showed weaknesses in internal fund generation in 1989-1994.3 0.20 Financing Patterns by Industry.79 and in 1997 at 0. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.6 a Excludes negative balances. the incremental equity ratios of the industry were high.2) 0. The sector had the highest leverage among all industries that year. II 1991. when debts declined.3 0. The effects of the crisis of 1997 were adverse. Vol. . the industry generated internal funds. Up to 1997.27.47 two years later. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.29. The situation improved beginning 1994. Equity financed an average of 62 percent of total asset growth. the manufacturing industry financed 57 percent of its total asset growth by debt. while SFRT averaged only 0.3 0. The real estate industry financed its growth by substantial equity funds.5 Utilities and Real Estate Services and Property 0.5 (0. Excluding 1997 when fixed assets declined.4 0.3 0.32. Incremental equity financing amounted to an average of 44 percent of total asset growth. The construction sector was a heavy user of debt financing. debt financed about 78 percent of asset growth in real estate.91.6 0. increasing to 0.6 0. Source: SEC-BusinessWorld Annual Survey of Top 1. Table 3. ranging from 41 to 118 percent. the total debt ratio was much higher in 1996 at 0. many of the leading real estate companies successfully went public during that time.4 Construction 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.4 0.

00036 2.287 0. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. ROE. 14 See for example Michael Jensen (1993). and leverage. Exit.421 0. ownership concentration = the total shareholdings of the top five shareholders. Using the PSE database.00125 2. as the dependent variable. ROA = return on assets. more profitable. knowing that if an investment turns out to be successful they could capture most of the gain.008 5. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Journal of Finance 48: 831-880. and financial leverage are all positively and significantly related to the degree of ownership concentration. The Modern Industrial Revolution. ROE. the degree of ownership concentration. .004 3.860 Leverage = the ratio of total assets to total equity. and the Failure of Internal Control Systems.21 Ownership Concentration. measured by the percentage of shareholdings of the largest five shareholders. Table 3. ROA. while if it fails. ROE = return on equity. 1992-1996.21. was regressed against measures of profitability and of financial leverage. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant.4. creditors bear the consequences. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.009 5. alternatively. As shown in Table 3.769 0. Financial Leverage. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. at the same time. Source: Author’s estimates based on the PSE databank.14 Large shareholders may borrow excessively to undertake risky projects. Profitability.130 ROA 0.Chapter 3: Philippines 209 3. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.3 Ownership Concentration.230 Leverage 0.00056 1.

but its share had been declining by 4 percent per year since 1995.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. Manufactures accounted for about 85 percent of exports. with commodities accounting for the balance. Because of limited local capital. notably remittances of overseas workers. and agriculture at 21 percent. Vol. Exports were growing at about 20 percent per year in the three years preceding the crisis.5 3. the country’s GDP growth pace indicated that it did not have a “bubble economy.8 percent of GDP from 1995 to 1997. In sum. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. Historically.5 percent per year from 1992 to 1997. II 3. Net investment inflows were $3. which averaged 4. Although much lower than those of other Asian countries. an overexpansion of capacities. foreign investments in the country have been low.” that is. Garments was the second largest export sector at about 9 percent. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). industry at 34 percent. the country was less dependent on foreign private capital. Net trades in goods and services averaged a deficit of 4. The export sector had a very narrow breadth. more than half (52 percent) of exports were semiconductors. The largest contributors to GDP were services at 43 percent.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. and intermediate goods. In 1997. Commercial and industrial activities in the country were largely oriented to domestic markets. raw materials. Compared to other East Asian crisis-affected countries.210 Corporate Governance and Finance in East Asia. their growth gathering momentum only beginning in 1992. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. 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. the economy still showed vestiges of its import-dependent and substituting character.1 The Corporate Sector in the Financial Crisis The Financial Crisis: Causes and Manifestations A devaluation of the local currency signaled the arrival of the financial crisis in 1997. The country experienced balance of payments surpluses but these were due to transfers. After a . The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. with a narrow exporting industry base.5.

depended on the quality of the corporate sector’s investments. From 1988 to 1996. From 1993 to 1997.3 percent. Total debts were only 52 percent of assets or 108 percent of equity. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. . assets grew at a compound annual rate of about 31 percent.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. however. Profitable operations since 1992 had allowed it to build equity. the Government sought stability and achieved this in 19921997. The lessons from debt restructuring became the basis for the Government’s economic policies. 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. an average inflation rate of 7. an average Treasury bill rate of 13. Financial institutions called on their shortterm loans and shortened the maturity of existing loans.6 billion as of March 1997. After hovering in the range of 100 to 127 percent. The corporate sector was in a relatively stable financial condition around the time of the crisis. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. resulting in stability in the short-term debt to reserves ratio. 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. and a relatively healthy banking system. the Government restructured its debts into longer tenors with a maximum of 25 years.8 percent. unlike their counterparts in the region. fueled also by successful IPOs during the stock market boom of 1993-1996.5 percent. During this time. a positive balance of payments from 1992 to 1996. a government fiscal surplus from 1994 to 1997. the country and the corporate sector had no access to foreign currency debts from the international financial market. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. Closer analysis. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. while sales grew by only 20 percent per year. In the Philippines. adjustments were focused on the quantity and quality of the banking system’s corporate loans. Eventually. average ROE was 13.1 percent. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. which. in turn.

but to a lesser degree.718 30. Net foreign portfolio investment amounted to $1.300 1.609 1.101 billion or 196 percent of net FDI in 1996. 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.073 (406) 121.517 1. mitigated the effects of the pullout and liquidation of investments in the aftermath.47.212 Corporate Governance and Finance in East Asia. 1998 = 41.5 billion in 1995. growing by about 34 percent per year from 1994 to 1997. In sum. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. Vol. But portfolio investment amounting to $406 million flew out of the Philippines. 1997 = 29.650 32. .7 Note: Peso-dollar exchange rates used are: 1995 = 25.22 Foreign Investment Flows. In 1997.4 1997 762 1.” 3.101 92. It rose to $2. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. These patterns in investment and financing are similar to those of other countries in the region.303 23.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. 1996 = 26.22. Table 3.749 26. precisely. It financed 26 percent of corporate capital growth. or 114 percent of net foreign direct investment (FDI). net FDI remained stable at more than $1 billion. Most of this leverage happened during the boom years in the region. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region.074 2.485 145. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.22). Debts financed a large part of this expansion. Data for 1998 cover only January-August.71.0 1998 739 555 328 69.0 1996 3.5. Sources: Bangko Sentral ng Pilipinas and SEC. 1995-1998 Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1.06. the other immediate impact of the crisis was that on foreign investment flows. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion.

Loan calls. with commercial banks holding P2. Loans outstanding of commercial banks declined by the first quarter of 1998. the commercial banking sector’s capital remained strong at 17. Lending rates were well above the 20 percent level from July 1997 to March 1998.7 percent in January 1998. The real problem of the corporate sector during the crisis was the rise in interest rates. The interest rates on Treasury bills. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. in varying degrees for each sector. With the increase in borrowings and reduced liquidity.2 percent in November 1997. ranged from 11 to 13 percent from 1993 to July 1997. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans.2 to 28. Although corporate borrowers were not highly leveraged. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. the corporate sector became vulnerable to loan calls and high interest rates. The resources of the financial system that year totaled P3. lending rates also came down. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond.2 percent was barely above inflation rate. sparking a rise in interest rates on corporate loans.369 billion. ROE at 6. then rose to a high of 22. and the wholesale and . Average bank lending rates climbed to their peak of 25.3 percent of assets. When the Treasury bill rates eased in March 1998. Net profit margins were at a 10-year low at 4. depended on the liquidity and capital position of commercial banks. in turn. By March 1988.9 percent. new borrowings financed asset growth. Companies deferred investments in new fixed assets. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. Because of weak internal fund generation. the sectors with the highest outstanding loans had reduced their credit exposures. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. Because commercial banks were strongly capitalized. which held about 75 percent of the assets of the financial system in 1997. albeit at current market interest rates. they were willing to restructure and renegotiate existing loans by corporate borrowers. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. meanwhile. and leverage increased to 149 percent compared with 109 percent in 1996. By October 1998.513 billion. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation.

and the financial system. However. This allowed the Central Bank to convince the banks. the ratio increased to a high of 11. the fiscal position. and set up a hedging facility for borrowers with foreign currency-denominated loans. 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. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts.3 percent in December 1997. As for nonperforming loans (NPLs). The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. In March 1997. and its experience of low. These peaked at 14. single-digit NPL ratios began only since 1989. set limits on overbought/oversold foreign exchange positions of banks.9 percent of bank loan portfolios. But the Philippine banking system had gone through worse crises in the past. as with its counterparts in other Asian countries. II retail trade sector. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. Vol. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. and subsequently went down to 13. Still. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1.6 percent in June 1998. thereby reducing overall intermediation costs.5. The Central Bank adopted other measures to strengthen the financial system.5 percent by September 1998. by 12 percent. real estate loans averaged 11. The move retained the liquidity position of banks but lowered their cost of reserves. including (i) a regulatory limit of 20 percent on banks’ loans to the .5-6 percent. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. was a problem sector.214 Corporate Governance and Finance in East Asia. These figures show that adjustment problems were industry-specific and that the real estate industry. through the Bankers’ Association of the Philippines.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. 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.

the largest telecommunications setup in the Philippines. the corporate sector dealt with the crisis as any company facing a recession and drying up of credit would—companies cut costs by reducing staff. The economy avoided a recession in 1998 and achieved 3.6 percent growth in 1999. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. (v) improving disclosure requirements on the financial position of banks. The policy directions and actions taken by the Government appear to have ushered in recovery. took more action. subcontracting and outsourcing. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. consolidating business units. and giving up noncore businesses. Financially strong companies were able to survive the crisis by effecting such internal restructuring. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. and the legal framework for reorganization and liquidation conditioned its response to the crisis. the country’s flag carrier. With its weakened financial position.Chapter 3: Philippines 215 real estate sector. bank loan rates have also come down. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. was known to have a policy . the Asian crisis opened a unique opportunity for foreign investors. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. changing technologies. In response to calls for lower bank intermediation costs. PAL. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. Large companies with heavy loan exposures such as Philippine Airlines Inc. Average Treasury bill rates have cooled since mid-1998. the Government kept inflation below 10 percent. Responses of the Corporate Sector The corporate sector’s financial position. With prudent monetary management. (PAL). its accessibility to foreign capital. In the case of PLDT. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. First Pacific Corporation. The acquiring company. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Budget deficits also increased throughout the Fourth Plan. External factors. canned foods. including luxury goods. however. The decline in imports was steady. Unemployment. including a weakening of the dollar. Inflation levels were low. In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. processed steel. especially foreign aid from the United States. Industrial sector growth was also rapid and many industries (tires. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. Budget deficits remained a major problem during the Fifth Plan. The Third. Average growth for the period was 4 percent per year. and reduced current account deficits. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. To close the fiscal gap. averaging 1. At the same time. Thus. remaining high until 1981. an improved trade balance.4 billion from overseas and increased taxes on numerous items. But the sustained importation of heavy machinery and equipment resulted in large trade deficits.Chapter 4: Thailand 231 During this period. Inflation reached 15. leaving the Government no choice but to resort to overseas borrowings. became a major problem as domestic investment declined.4 percent of GDP. capital inflows. with the devaluation of the baht in 1984 a major step in this direction. textiles. Fourth. Consequently.5 percent in 1973 and 24. resulted in increases in the current account deficit. chemicals. The Government had to shift emphasis to restoration of economic stability.3 percent in 1974. however. it proceeded with its development plan for the industrial sector. The results were increased exports.15 billion per year or 4. with the agricultural sector the major contributor. lower than anticipated due to a worldwide economic recession. and increases in world food and oil prices. and automobile assembly) emerged. The average budget deficit reached an all-time high of $2. the current account registered a surplus in 1986. However. helped offset these deficits. the Government borrowed $6. the value of the baht remained stable. As a result.6 percent per year. . the industrial sector grew at a faster rate than the agricultural sector. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. The focus shifted to export promotion. the government’s debt burden escalated. gross national product grew by about 7 percent per year.

Thailand became a debtor’s market. From 1989. the bulk of domestic investments went to speculative ventures such as real estate. while exports expanded considerably. compounded by a slump in property sales. compared with the 14. The exchange rate was steady at around B25 to the dollar. better than the 5. On top of its predominantly “borrowed” nature. from only $31 billion in 1992.2 percent per year. invited a deluge of capital seeking profitable investments. reaching an annual inflow of $2 billion in 1991. . Private sector investment grew at an average annual rate of 7 percent.5 percent. averaging 10. By 1995. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. and the stock market.2 and 13. Inflation was 4. with private foreign debt reaching $92 billion by the end of 1996.6 percent target of the Seventh Plan. Average annual growth in real GDP was 8 percent. Growth of exports and imports averaged 14. China—went to export-oriented manufacturing industries. lower than the target of 8. combined with its liberal financial policies.4 percent targets. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. Singapore. an oversupply of housing emerged. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. The country’s high ratings in the international capital market.8 percent. Most of the FDIs—originating mainly from Japan.232 Corporate Governance and Finance in East Asia. The manufacturing sector became a dominant force in the economy. Vol. Europe.8 percent. property development.6 percent.5 to 13. and Hong Kong. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. United States. the property sector began to collapse in 1996.2 percent target. rather than to productive activities. increasing its share in total export value from 42 to 76 percent.7 and 11. The country also attracted a large amount of foreign direct investments (FDIs). respectively. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. compared with the 8. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. Growth rates during 1987-1991 ranged from 9.

Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. In May 1974. a policy that held throughout the first six economic development plans.” which later became the master plan for the development of the Thai capital market. the corporate sector’s main source of funding was the banks. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. Before the capital market emerged. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. 4. many companies considered the Act too restrictive and a hindrance to growth. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. the Government amended the “Announcement of the Executive Council No. which was amended in 1979 and 1985. However. In 1972. In his report. Exports went into a tailspin. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996.” extending its control and regulatory powers to the finance and securities companies operating freely at the time.Chapter 4: Thailand 233 Toward the end of the Plan period. its policy had always been to protect domestic banks. which raised the debt service ratio. Foreign banks were barred from competing directly with domestic banks. a former Chief Economist from the US Securities and Exchange Commission.2. placing all publicly listed companies under regulation. the Bank of Thailand and . on account of an overvalued baht that weakened export competitiveness. Sidney M.8 percent in 1995 to 1. SET officially became “the Stock Exchange of Thailand” in 1991. The deficits caused the Government to rely on even more external borrowing. In 1978. prepared a comprehensive report entitled “A Capital Market in Thailand. 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. the capital markets didn’t play a significant role until 1975. And because the Government considered the banking system vital to the development of the economy. Robbins. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. the signs of an economy about to falter were there. Under the 1962 Commercial Banking Act. with growth shrinking from 23. In 1969.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development.3 percent in 1996. the Government passed the Public Limited Company Act.

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

Gas.6 23. and Communication Financing. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. 4.6 1.9 1. Financial deregulation and liberalization were key to realizing that vision.5 791. Ministry of Commerce. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. Hunting.6 2. In terms of capital. Worldwide. finance. 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. the financial sector is the largest.5 50.Chapter 4: Thailand 235 fast-growing neighbors.2 Type of Business Agriculture. and Restaurants and Hotel Transport. The result was a corresponding growth and development in Thailand’s capital markets.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. Insurance.1 78.9 34. in that order. however.0 Paid-up Capital (B billion) 1. Thailand.1 trillion and paid-up capital of B1.3 83. and Fishing Mining and Quarrying Manufacturing Electricity.1 30. and Water Construction Wholesale and Retail Trade. and wholesale/ retail trade and restaurant/hotel sectors. and Business Service Community.394. with B1.1).6 350.0 19. Social and Personal Service Total Note: The data for 2000 is as of October 2000. The majority of the companies are in manufacturing. . 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.0 110.0 21. the country became recognized as an economic development model for other emerging economies. Source: Department of Commercial Registration.9 16.5 111.2. Storage. Forestry.2 11.9 261.291.1 Public Companies Registered.4 trillion in registered capital and B791 billion in paid-up capital.3 trillion have been registered with the authority (Table 4. about 661 companies with total registered capital of B2. Real Estate.101.

3 1996 1997 65.2). The preeminence of the financial sector is a direct result of financial deregulation and liberalization. While a rebound was apparent beginning in 1998.1 286.5 — — 56.4 51.3 6.2 40.9 1998 1999 15.6 — = not available. 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 1.3 194. allowed Thai financial institutions and corporations to obtain funds overseas. respectively.8 1995 64.2 Public Offerings of Securities.0 0. from only B20.5 1.6 7. Table 4.5 39.4 277.5 1.7 27.7 136.7 billion and B27. reaching a precrisis peak in 1996 (Table 4. reached .0 1994 82. After the passage of the SEA of 1992.6 8. Domestic and offshore debt issues reached B54.7 5. Market capitalization.7 7.3 31.4 34.1 — — — 6. Vol. the capital market became instrumental in the rapid growth and development of the corporate sector.2 25.1 2. The number of listed companies and securities steadily increased until 1996 (Table 4. These peaked at B89. meanwhile. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994. reducing the value of offerings to a little more than a quarter of the previous year’s level. The stock market also became an invaluable source of funds for corporations.8 201.2 5.3).6 39.6 174. II B261 billion. the year before the crisis struck.0 20.9 37.7 billion in 1996.8 — 26. Securities and Exchange Commission of Thailand.3 22. moreover.1 599.236 Corporate Governance and Finance in East Asia. The signing of Article VIII with the IMF.1 54.5 billion and B1 billion the previous year. The development of the corporate sector closely followed the development of capital markets.4 96. The 1997 crisis battered the primary market for securities.9 31.8 billion. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together. Source: Key Capital Market Statistics. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. the value of public offerings rose steadily.8 151.7 9.2 12.

By the early 1990s. The trend reversed in 1995.560 1. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. their share rising from 17 percent in 1993 to 43 percent in 1997.4).4 percent in 1996. Throughout the 1990s. Corporate profitability. From 10. then stalled in 1990. not all public companies are listed on the SET. Source: Securities and Exchange Commission of Thailand. resulting in their inability to fulfill debt obligations. gross profit margin rose until 1991 before falling in 1992.3 Statistical Highlights of the Stock Exchange of Thailand. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . was the ominous deterioration in the key financial ratios of publicly listed companies.535 1. had been on the rise throughout the 1980s.5 at its peak in 1987.281 832 373 356 482 Due to listing requirements and other reasons. however.1 by 1996.325 3. pulled down by active public offering activities. return on equity (ROE).114 1.4 percent to 5.610 1.360 1. The key financial ratios of all companies listed on SET bear this out (Table 4.193 2. But instead of shifting to a low gear. ROE similarly fell from 21. its high point in 1995 at B3.303 930 855 1.6 trillion.Chapter 4: Thailand 237 Table 4.8 percent.565 2.3 percent in 1989 to 3. in the end. ROA dipped from 10.201 2. The financial leverage of all companies declined until 1994.133 1. as measured by return on assets (ROA). corporate profitability had been declining. and gross profit margin. Foreigners accounted for an increasing proportion of SET’s turnover value. Meanwhile. the average times interest earned (TIE) was down to 5. Side by side with this surge of financing for corporate growth.683 1. While the decline in gross profit margin was not as sharp. the companies could not generate enough net returns from their assets and equity. The upward trends for ROE and ROA continued through 1989. 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 3.301 3. the averages for all three profitability ratios took a downswing all the way until 1996.268 2. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. however.

7 20.238 Corporate Governance and Finance in East Asia.7 12.7 5.2 10.1 16.5 30.5 38.4 7.5 9.1 16. and footwear had the lowest at 11 percent. Severely affected by global competition throughout the decade. these companies opted for debt.3 91. was also distinct in the region.6 138.4 47. clothing.6 12.7 35.1 60. Vol.2 215.7 5.8 51.9 51.6 41.9 66. Thailand’s ROE.9 77.4 4.8 11.8 5.0 139.8 8. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. Hotels and travel showed the highest ROE of 15 percent while textiles.3 10.4 12. Overall. The downtrend in corporate profitability.6 168.9 140. II Table 4.9 7.7 5.5 15. Among the crisis-hit countries. They were generally more efficient in managing their assets and . large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4. 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 (%) (%) (%) 3.2 35.7 12.4 5. resulting in higher collateral values for borrowers. practice of heavy borrowing.4 3. US.6 7.8 5.8 25.0 125.6 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 28.7 54.4 12.9 14.7 27. clothing.7 15.2 161.7 12.4 24.5 51.9 144.7 34.8 54.7 12.1 242.1 44.8 151. was felt across industries.3 12.2 10.6 27.7 4.4 26.9 27.4 7. and footwear industries also experienced losses.6 125.3 8. Despite the availability of the equity market.6 36.4 51.8 14.1 52.8 88.0 145.2 6.7 59.7 21.9 8.1 114.3 4.4 139.2 10.0 29.2 64.4 44.2 27. which fell from 16 percent in 1991 to just under 6 percent in 1996.7 27. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.5 50. A major reason for this was the rapid rise in asset prices.5 52.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.9 7.1 120. which was particularly significant in the two years preceding the crisis.0 117.5 63. the textiles.7 80.4 34.4 18.2 49.0 3.0 7.9 39.2 27.4 Key Financial Ratios of Publicly Listed Companies.1 9. Korea and Thailand had the highest debt-to-equity ratios.4 9.4 119.0 63.5).

also deteriorated. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness. They also tended to use more financial leverage than small companies as their total DERs show.8 10.0 48.3 88.1 5.Chapter 4: Thailand 239 Table 4.2 18.2 121.3 135.8 6. For instance. the overall activities of listed companies. total asset turnover declined after 1989.3 49. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.8 26. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.2 10. .3 164. During the 1990s.6 12.5 6.6 30.4 116.8 62. it was thought. In sum.6 61.6 5.3 52.8 47.5 7.1 13.8 6.1 6. weaknesses became evident. capital despite the higher gross margins of small companies.1 Small Medium Large 5.6 31.2.3 23.5 87.1 25.9 13. However. by the 1990s. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.2 134. although the performance of listed companies in the late 1980s was strong.7 6. which would be disruptive to company management.7 10.3 43.3 25. US. 4. measured by total asset turnover.9 20. the law disallowed cumulative voting.5 Average Key Financial Ratios by Company Size. Cumulative voting.6 6.6 7. could lead to a high turnover in the board.4 8.0 20.5 94.0 83.3 15.7 14.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 30.4 Legal and Regulatory Framework Before 1992. 1985-1996 Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6.1 29.4 52.2 12.8 142.3 176. Although stable in the 1980s.3 49.6 10.

Fortysix companies responded. as a group. played an important role in bringing about the financial crisis. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600.5. The protection of minority shareholders was inadequate under the Public Company Act of 1992.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. concentrated ownership. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. The law prohibited the largest shareholders. However.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. An Asian Development Bank (ADB) survey conducted for this study shows. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. As it turned out. The Public Company Act of 1992. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. that creditors had generally little influence on the management of corporations.240 Corporate Governance and Finance in East Asia. relaxed the contentious provisions of the 1978 Public Limited Company Act. This will be discussed in Section 4. coupled with weak corporate governance. The provision discouraged original family owners from registering their companies. but not all questions were answered. for instance. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. As the succeeding sections point out. Vol. II Another issue was the proportion of shareholding by top shareholders. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. adopted to promote the development of publicly listed companies. 4. Cumulative voting was made optional. and external monitoring and control of corporations were also weak. . and the punishment for management misconduct was also lightened considerably. the exit of these provisions appears to have contributed to the 1997 financial crisis.

9 54. But with their increased reliance on new varieties of equity and debt instruments.4 6.1 11.9 55.4 4.4 10.6 57.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.6 28.9 6.China have the least concentrated ownership. with the largest shareholder on average controlling 10.4 26. the top five shareholders of each of publicly listed Thai companies held. and Hong Kong. this was not the case.1 3. Most large Thai corporations listed on SET started out as family businesses.9 52.4 26.5 9. In contrast.6 27.2 11. Unfortunately.9 3.Chapter 4: Thailand 241 4.3 percent. In the past. Source: Comprehensive Listed Company Information Database. 33.9 26.0 7.9 52.9 3.1 12. and minority shareholders to stake their claim in the control and regulation of these companies. Stock Exchange of Thailand.7 11.7 12.6). Indonesian.1 percent of control rights. there were only slight variations in the pattern.2 4.1 5.3.9 11.5 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. with the top three shareholders accounting for almost 50 percent (Table 4.0 7.1 5.3 7.0 56.4 percent of outstanding shares. and 28. .2 4.3 5.1 7.1 4. 56.3 percent and 18.7 7.0 3. Thai.8 32.4 6.1 5.3 16.9 52.6 68.0 3. on average. China firms have the highest single shareholder ownership concentration at 35.0 5.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.7 percent.4 26.0 53. respectively. Table 4.9 percent of shares of a company.3 11.2 56. one would expect the public.7 6. 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. Ownership Concentration Between 1990 and 1998.2 4.8 11.6 4.4 5. these companies obtained funding solely from banks or from their own retained earnings. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. Ownership was most concentrated in the packaging.9 4. creditors.3 28.8 5.3 7.5 Average for 1990-1998 period. Across industries.

003 0. * Denotes significance at the 10 percent level. as measured by debt-to-equity and debt-to-asset ratios.647 Note: The regression included dummy variables for industry.7).115 9. Through these holding companies. Leverage. results show a significant positive relationship between ownership concentration and financial leverage. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.022*** 0. II agribusiness.090 0.072) (0. Table 4.116) Debt-to-Equity (1. 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 4.7 Statistical Relationships between Corporate Profitability.800 0. founding families maintain effective control of entire groups.005** 0. Based on a regression analysis. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.058* ROE (0.8). It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries. Company size is significantly related to ROE and leverage. Vol. 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. Ownership Concentration. year. US. and building and furnishing industries.001 0. including those that are publicly listed . and ownership types. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.031 3. owning 26.7 percent of outstanding shares on average (Table 4.242 Corporate Governance and Finance in East Asia. ** at the 5 percent level.001*** 0.533)*** Debt-to-Assets (0. with a top-five ownership concentration of at least 60 percent.029 3. *** at the 1 percent level.034*** 0.169*** 0.080 6.001) 0.037 0. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. On the other hand.

a NBFIs denotes nonbank financial institutions.5 percent.7 1.4 1.5 Government Other 0.3 27.6 1.6 25.7 Bank 2.5 1.3 1. one of the founding members.9 18. operates five of the most successful shopping malls in Thailand.6 1.5 0. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.6 percent of outstanding shares. Individual family members also hold a significant amount of outstanding shares.5 5.9 6.9 7. the company increased its registered capital and became a public company listed in SET. In 1994. Stock Exchange of Thailand.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.3 0.8 0.0 17.Chapter 4: Thailand 243 Table 4.4 22.0 18. in SET.6 1. the company.3 27. Established in 1980 with a registered capital of B300 million.3 — = not available.5 1.1 1. the affiliate firms rarely hold shares of their parent companies.5 0. Typically.3 27.5 NBFIsa 6. including finance and investment companies.8 28.8 23.1 4.3 20.0 19.7 — 1. . The largest shareholder is Central Holdings Company. Although holding companies set up affiliate firms. averaging about 18. individual members of the Chirathivat family aggregately hold 25. a joint venture among three families.5 26. The ADB survey indicated that listed companies held shares in an average of 11 companies.2 18.6 28.5 2.7 5.5 0.6 5.9 15.1 0.2 7.3 1.3 1.9 0.2 1. a company listed in the real estate sector of SET.0 3. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.8 1. These individuals usually hold important management positions in concerned companies.1 1. Source: Comprehensive Listed Company Information Database.4 1.4 1. This practice is illustrated by Central Pattana. unlike in Japan where crossshareholding is common.3 percent of outstanding shares. The top 10 shareholders include a holding company owned by the Tejapaibul family.9 19.2 1.4 20.2 5.7 0. In addition. owned by the Chirathivat family.5 Individuals 13. with 29.

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

directors are required to act with care and honesty for the company’s best interest. while 30 percent of respondent companies held board meetings monthly. directors shall be elected at the annual general shareholders’ meetings (AGSMs). In five other companies. while 15 percent of respondents went beyond the requirement. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. Three companies indicated that the CEO and the chair were close relatives. Unless stipulated in public companies’ articles of association. Meanwhile. If found in violation of these provisions. an executive board consists of senior management and some main board members. In their business conduct. Generally. the majority (71 percent) had board chairs who were also members of top management teams. and to comply with the laws and articles of association. Although 28 percent of the chairpersons came from the ranks of independent outside directors. Chair of the Board and Chief Executive Officer The SET survey showed that about 73 percent of listed companies had a separate executive (management) board. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. The ADB survey indicated. selection was based on relationships with controlling shareholders. Nineteen companies stated that selection was based on professional qualifications. directors could be compelled to compensate the company for damages arising from their misconduct. but not in 22 others. Most companies (83 percent) satisfied SET’s requirement of having two independent board members.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. . In addition. Some companies (36 percent) had five to six main board members holding seats in their executive boards. Many companies have a formal policy on corporate governance and business ethics. meanwhile. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. directors may be imprisoned or fined. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings.

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

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

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

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

a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. The first category is the acquisition of shares in the open market. Although merger and acquisi- . In 1996. there were only six tender offers. In this case. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. Recently. only a limited number of successful mergers of public companies have taken place. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. of shareholders: (i) all shareholders must receive tender offers. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. There are detailed requirements regarding such notification. with a total tender offer value of B42.3 billion (Table 4. there are two categories of merger and acquisition activities with associated regulatory measures. if the purchase of shares implies a change in the directors or business activities.3 billion. The dearth of tender offers before the crisis suggests that the Thai capital market did not offer a venue for imposing market discipline on corporate management. In 1994 and 1995. Such efforts would serve to strengthen external discipline on controlling owners. before the extent to which the bankruptcy framework has been strengthened becomes clear. It will take years. SEC was later made responsible for regulating corporate takeovers. The market for corporate control has not been active in Thailand. however. The second category is the tender offer. SEC has no authority to either approve or reject tender offers. and failed to provide managers with strong incentives to perform efficiently. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. 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 1978.250 Corporate Governance and Finance in East Asia. Vol. its main role is to ensure transparency and fairness. whether directly or indirectly. with a significantly lower total tender offer value of B8. According to the SEA of 1992.9). (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days.

While the Thai mutual fund industry compares well to those in other developing countries in the region.1 58. they have mostly been concerned with short-term gains. Eleven of the 46 responding companies in the ADB survey offer ESOPs.9 3.1 75. Source: Securities and Exchange Commission of Thailand. But instead of opting for an active role in the market for corporate control.3 60.5 6. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.7 11. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. it remains small. but employees have never been represented in the board of directors since their shareholdings are minimal.2 6.4 23. employee participation in corporate governance in Thailand. not with a view to becoming involved in actual management. Employee Participation in Corporate Governance There has been little. employees are even less willing to accept common shares as a form of compensation or benefit. Twenty-nine firms indicated that employees held shares of their companies. employees regard the plans as monetary incentives. Since 1994.8 81.3 11. most of these were forced mergers or related to rescue packages.1 84.3 6. .2 7.Chapter 4: Thailand 251 Table 4. trading by mutual funds in SET represented less than 10 percent of total trading.0 55.2 8. but the average shareholding is smaller than 1 percent of total outstanding shares. Because of the current crisis. Even when companies offer ESOPs.0 B billion 4.7 Purchase Value Number of % of Tender Offer Value Companies 84.1 19. if any. tion activities increased after 1997. Provident funds for government workers and workers in public enterprises have been established only recently.6 17. Pension funds are perhaps even weaker in Thailand.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.2 6.9 Merger and Acquisition Activities. Few companies offer employee stock option plans (ESOPs).

0 8. II 4.5 trillion.4 3.5 Outstanding Loans from Commercial Banks 2. The share of domestic banks in the banking system’s total assets was 80 percent.133.161.6 1.1 3.1 3.430. .906.5 5. the next four largest banks accounted for 63 percent.8 941.559.5 6.0 SET Market Capitalization 1.477.4 4..825. Thai Bond Dealing Centre.252 Corporate Governance and Finance in East Asia. there were 29 commercial banks.979.0 3. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.4 4.0 339.037.564.663.268.2 262. although its role increased in the wake of the crisis.912.4 1.119. The country’s largest bank. accounted for 28 percent of the banking sector’s total assets.4. In 1996.669.1 5. 15 of which were domestic banks.372.5 4.325.3 5.9 2.3 546.10) shows that Thailand is a highly bank-dependent economy.360.10 Size and Composition of the Thai Financial Sector. Vol.6 6.1 6.5 4. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.230.485.300. The bond market played only a marginal role in corporate financing. the banking sector was highly concentrated.1 7.0 424.4 519. Table 4.8 3. Bangkok Bank Ltd.193. and Bank of Thailand. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.390.1 Domestic Debt Securities Outstanding 215.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.3 1. The Banking System Until recently.2 2.775.6 2.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.171. total assets of commercial banks amounted to B5.

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

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

A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. the market for these bonds has been slow owing to the change in the Government’s original policy of requiring the use of state-guaranteed bonds as legal reserves. The proportion of domestic convertible debt instruments increased until 1995. which encouraged limited companies and public companies to issue debt instruments. 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. however. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. Upon its founding in 1942.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. A turning point of the corporate debt market was the enactment of the SEA of 1992. it represented only 9 percent of GDP. in 1994. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. The recent financial crisis. However. compared to 110 percent in the US and 74 percent in Japan in the same year.11). Four years after the passage of the SEA. the Bank of Thailand assumed responsibility for regulating the bond market. while secured debt instruments accounted for just above 10 percent. it accounted for a small share of the entire financial sector. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. the size of the corporate debt market rose to B132. Beginning 1961. and the Government did not issue new bonds during 1990-1997. To gain some perspective of the size of the bond market in Thailand. The bond market in Thailand started in 1933. In 1996.9 billion. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. the Government issued more bonds to finance industrial development projects and perennial deficits. the first bond rating agency in Thailand. was also instrumental to the growth of the corporate debt market. The budget surpluses of the 1990s eliminated the need for new bond issuance. The Thai Rating Information Services. Investors had limited knowledge of debt instruments. .

7 5.3 — — 3.0 86.5 — — 32.5 37.2 39.0 — 5.3 — 14.7 — — — — — — — 77. By 1995.9 30.1 41.1 — — 6. this had climbed to B200.2 89.1 107.7 — — 40.1 315.8 47.5 — 39. total offshore debt offerings had plunged by 68 percent to a mere B28.256 Corporate Governance and Finance in East Asia.3 46. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.5 — — — 3.0 0.9 40.2 43.5 — — — — 1.0 7.2 57.5 138.9 5.5 — 0.9 37.5 43.8 167.6 — — 0.0 5.3 8.3 13. then declined substantially in 1996 and 1997.1 141.4 billion. The following year.0 17. the year the crisis unraveled and the baht was floated.8 191.3 46.2 45.3 140.0 281.8 31. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.1 61.0 — 5.0 — 26.3 6.2 — — 50.8 55. Vol.3 22.1 59.3 3. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.5 10.1 21. II Table 4.1 12.9 329.9 0.5 billion.3 29.7 0.5 55.6 19.7 90.7 538.0 26.7 0.4 57.1 121. 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 — — — — — — 400.0 60.6 billion.4 — 26. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.7 821.7 — — — — — 4.4 7.1 289. .6 — 0.5 5.8 2.7 95. a surge attributed to capital inflows encouraged by high returns on Thai bonds. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.2 28. by the end of 1997.9 37.1 8.7 132.7 28.1 6.9 20.4 110.0 333.4 49.11 Offerings of Debt Securities.0 27.4 — 9.1 10.0 33.4 — — — 1. turnover value had reached B51.1 55. Total offshore debt offerings peaked in the run-up to the financial crisis.7 5.7 7.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.1 — — — 29.3 50.2 2. However.

Chapter 4: Thailand 257 compared with investment in equities. 4. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. with equity levels remaining high despite an increase in debt. Retained earnings accounted for about 30 percent of total equity financing. The average for all industries was only 22 percent. turnover value plummeted to B106. and marketable securities holdings. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. these comprised 31 percent. they also had a relatively small proportion of equity and . In 1997.12). cash balances. Longterm loans accounted for about 20 percent of total liabilities. Across industries.2 billion as a result of the default of debentures due to the Asian crisis.4. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. Construction and property development industries tended to have high proportions of long-term loans and debentures. In addition. judging by their relatively low levels of retained earnings. Companies in construction and property development seemed unable to generate internal funds. Equity financing remains an important part of listed companies’ long-term financing. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. In any case. significant variations can be noted. From 1990 to 1996. Turnover fell further to B72. while for the property development industry. In the same year. There was also little change in the trend in retained earnings within the seven-year period.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. steadily easing up between 1990 and 1996. these accounted for 33 percent of total liabilities. a trend most apparent in the leap between 1991 and 1992. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. short-term loans accounted for more than 40 percent of total liabilities.1 billion in 1998. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. For the construction industry. The proportion of accounts receivable also declined steadily. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. At lower than 5 percent of total liabilities.

2 17.9 50.3 18.4 14.2 1. were highly leveraged.9 40.8 3.2 2.5 1.8 6.1 36.1 17.9 18.4 48.0 48.0 100.9 2.6 10.6 50.8 1.9 17.0 100.8 9.4 43.2 17.9 0.13). medium.7 0.8 19. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.5 37.6 0.4 6.6 0.7 1.2 12. compared with the 44 percent general average.4 17.4 2.0 15.9 6.0 100.8 37.1 5. US.9 14.2 2. II Table 4.2 45.2 1.3 14.2 17.1 2.0 100.1 50.8 9.6 2.7 18.8 20.6 0.2 42.0 51.2 16.6 0.5 1.3 6.7 36.0 6.7 16.2 2.3 38.2 3.2 2.3 34.6 15.9 3.0 12.3 34.5 11.6 51.8 7.8 14.12 Common-Size Statements for Companies Listed in SET.0 100.8 37.7 9.9 14.2 1.6 38.4 17.9 14.5 43.3 1.0 7.0 2.4 49.3 21.1 49.9 6.6 11.9 14.6 36.0 100.0 100.6 13.8 10.6 6.1 7.6 22.258 Corporate Governance and Finance in East Asia.2 34.2 16.2 17.3 1.0 14.0 100.0 13.5 9.7 16.8 21.9 10.3 12. The level of total liabilities for the group characterized by high ownership concentration .3 18.5 9.1 18.0 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.2 22. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.0 1.6 100. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.0 100.8 17.0 100.2 43.2 35.6 12.8 25.7 50.4 8.0 10.3 49.6 14.8 34.7 7.2 43.6 100.9 16.0 100.5 1.0 100. Vol.4 21.0 10.0 100.9 49.3 14.3 2.5 14.1 13.3 17.7 17.6 21.9 20.9 17.3 48. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.4 7.3 25.5 0.4 49.8 35.7 14.7 52.9 14.3 50.9 12.6 8.7 15. Printing and publishing companies had lower financial leverage than companies in other industries.9 15.0 100.9 43.2 15.8 8.6 18.9 38.8 46.

For the high ownership concentration group.1 49.0 Low 1.2 14.9 2.9 7.1 36.3 100.7 percent for medium ownership concentration companies and 49.9 100.2 0. was 53 percent of total assets compared with 49.3 8. .0 100.2 45.6 100.7 12. 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 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.13 Common-Size Statements of Public Companies by Ownership Concentration.4 35.9 0. US.6 0.5 percent for low ownership concentration companies.1 18.0 19.4 1.9 36.2 11.0 16.4 50.3 1.1 44.6 47.7 19.2 8.4 13.6 14. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.0 14.4 7.3 1.5 100.Chapter 4: Thailand 259 Table 4.9 21.8 12.9 50.3 35. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.4 18.8 37.0 6.4 49.0 Medium 2.6 15.0 41.8 13.0 100.0 6.6 2.8 13.6 9.7 17.9 16.4 3.5 21.2 22.3 16.1 53.5 13.4 37.0 7.6 22.5 18.5 11.

4 7. Public companies relied more on short-term debt financing in the period before the financial crisis. thus rendering them more vulnerable. Short-term debt accounted for most of the increase.7 28. the choice of financing is determined by the company’s liquidity considerations.14). Generally.1 44.260 Corporate Governance and Finance in East Asia.6 41.1 16.5 38.8 51.4 51. More important. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.8 5.1 31.1 64. followed by bank loans. Table 4.0 50. . Such deterioration of financial positions during the period was a common feature of listed companies. 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. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.8 percent in 1990 to 52. US.5 52. While further detailed investigations are necessary.7 34.15. was the headlong deterioration of firms’ ability to meet their interest payment obligations.7 34.0 25. The TIE ratio declined from its peak of 7. especially from 1994 to 1996.6 7.1 23. bond issues. however.14 Financial Ratios of All Listed Firms. and rights issues. 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 4.8 151.7 66.2 35.1 52.3 61.7 11. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.0 145. Vol.1 in 1996.1 144.9 140.0 28.3 31.7 5.7 percent in 1996.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 5.9 14. and maintenance of the existing ownership structure.4 44. bond issues overtook loans from commercial banks as the second preference.4 12. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing.4 139. these firms more easily increased their leverage.9 63. As a result.1 16.8 65.8 65.1 31.7 in 1994 to 5.9 51. The ratio of total debt to total assets increased from 50.6 125. however.6 138. minimization of transaction and interest costs.7 12.2 68.7 12.2 49. After the crisis.9 7.

5 4.8 29. Their average annual growth rate declined from 28. US. Additionally. The proportion of external debt as a percentage of GDP consequently increased from 42.1 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. unhedged foreign exchange liabilities.9 percent in 1997.5 34.7 percent from 1991 to 1996.Chapter 4: Thailand 261 Table 4. From only 34 percent in 1986.5 percent of external debt in 1996 (Table 4. and a preponderance of short-term debt liabilities. continued to slide from 1985 to 1997.4 27.3 42. on the other hand.8 28. This decline was accompanied.1 High 6.8 14.4 13. 4.5 percent between 1985 and 1990 to 8. The composition and term-structure of this debt.8 Medium 7.5.2 percent in 1986 to 251. From 45 percent of total net capital movements in 1985.6 30. by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF.16). The proportion of nondebt-creating capital flows.5 126.0 64. peaking in 1994 at 84 percent. debt-creating capital inflows rose to 65 percent in 1990.15 Financial Ratios of Listed Companies by Ownership Concentration.8 49.4 63.2 49. .4 percent to 46 percent during the same period. however. is even more telling. the proportion of short-term debt increased from 15. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.6 11. 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 6.5 148. Nonbank private debt increased from 27.2 124. such as direct equity and portfolio investment.4 52.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. private debt accounted for 84.8 percent in 1986 to 52 percent in 1995.8 66.

8 31.16 External Debt.9 3.0 11.4 — — — — — — — 1.2 2.1 30.9 29.0 3.5 12.7 20.5 14.9 13.1 2.7 10.2 32.9 0.6 — 0.3 0.9 6.4 2.4 18.6 7.0 6.8 3.7 2.Table 4.1 23.6 52.4 15.7 1.3 3.9 43.2 0.3 37.3 0.1 34.3 3.1 0.1 0.0 8.1 95.5 19.6 18.8 10.3 20.9 7.4 3.7 109. .1 22.3 12.9 1.3 0.8 13.5 1.0 21.3 16.8 3.3 0.0 11.9 10.4 10.3 105.1 64.2 14.7 0.9 4.9 35.7 24.0 4.8 0.6 Total 18.9 10.5 16.2 10.9 6.5 12.1 0.0 13.5 4.3 10.1 12.0 0. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.2 2.3 0.3 0.2 2.9 3.1 5.2 15.9 5.3 2.9 1.3 7.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.5 4.8 108.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.1 Source: Bank of Thailand.1 0.3 0.2 0.9 100.6 1.8 12.2 0.9 31.4 5.3 — — — — — — — 6.7 13.9 11.7 23.3 0.

The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. the index declined to 1. according to the Bank of Thailand. 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. At the end of 1994. .17). and (iii) bankruptcies. Similarly. Due in part to liquidity problems on the one hand. Even before the crisis. Aside from the problem of NPLs. from its peak in 1995. and drastic decline in the number and capital of newly registered companies. Meanwhile.6 billion from the 1996 level of B201 billion. The effects of the crisis were felt across all industry sectors. the SET Index stood at 1. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. leaving domestic investors with large capital losses. trading activity at SET had been on the downturn. On average. closures. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. the liquidity problems faced by the corporate sector are likely to continue for some time. outstanding credit also declined throughout the second half of 1998. Most of these foreign debts were not properly hedged. the number of newly registered companies dropped to a 10-year low in 1998. based on the three-month past due definition. exposing the companies to disaster when the baht started tumbling on 2 July 1997. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. With easy access to foreign funds. and poor business confidence on the other.281 in December 1995 and to 831. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. large Thai companies had actively borrowed at low interest rates from foreign financial institutions.360.6 in December 1996. banks would be recording more of such NPLs. After that. If lending rates remained high. Foreign investors retreated from the market. reaching 45 percent of total outstanding credit in December.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. The value of public offerings sank in 1997 to B56. It hit a 10-year low in the second quarter of 1998. Trading volume has since been thin. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. suggesting that serious investors have not returned to the market. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market.

052 36.201 24. The IMF financial package was a credit facility of $17.2 billion for balance of payments support and buildup of the country’s reserves.224 4.134 31. II Table 4. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.288 35. . 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.105 4.695 3. But when assistance from other sources did not materialize. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures. 4.112 9.777 11.915 37.17 Number of Newly Registered and Bankrupted/Closed Companies.264 Corporate Governance and Finance in East Asia. A steady price decline over the past few years has dragged down the ratio of market price to book value.218 3. As part of the assistance package.797 4.977 Source: Department of Commercial Registration. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.925 12.096 22.5.933 25.095 14.792 7.334 4.902 3. Vol.677 Bankrupted/Closed 2.6 in 1997.407 28.410 5.307 4. Ministry of Commerce.2 Responses to the Crisis Initially.066 19.080 9. the Government was left with no choice.410 37. Thailand. The price-to-earnings (P/E) ratio deteriorated from 19.5 at the end of 1994 to 12 in 1996 and further to 6.312 25.409 6.904 20. It also explains the higher dividend yield ratio.

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

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

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

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

and procedures for debt restructuring. the court had more than 80 cases for disposition. only 7. although since then.6 trillion) have agreed to cooperate with CDRAC’s restructuring process.6 trillion. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. and manufacturing sectors. In addition.147 cases (B1.1 trillion of outstanding credit. In particular. CDRAC’s target debtors comprised 10.068 cases involving B475 billion are undergoing restructuring.767 cases involving outstanding credit of B2. This point is crucial because compared with . In response. Another 77. accounting for B1. Within three months. personal consumption. as well as those that did not cooperate with CDRAC’s restructuring process. By October 2000. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. where bankruptcy procedures are swift and effective. accounting for B1. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution.8 trillion had been completed. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. with the majority of the debtors coming from the commerce. Some 82 percent of these cases have been successfully restructured. 322. However. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. Commercial banks initiated 74 percent of these cases. Cases for which negotiations were unsuccessful. the number of cases has abated. Considerable progress has been achieved on this front. The first bankruptcy court in Thailand opened on 18 June 1999. the Government introduced debt restructuring-related measures to help resolve bad debts. contributing to the unprecedented rise in the corporate sector’s bad debt. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. 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. methods. As of November 2000.764 debt restructuring cases involving B1. will be settled by the courts.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. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations.1 trillion in outstanding credit.

Conclusions. Examination of corporate ownership. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. The study covers the period 1985 to 1996. The economic development of Thailand took off with the implementation of a series of National Economic and Social Development Plans beginning with the first medium-term plan for 1961 to 1966. II Malaysia.6 4. the Government protected certain corporate sectors through tariffs and regulation.270 Corporate Governance and Finance in East Asia. The . For this reason. 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. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. 4.1 Summary. In the next three decades. Vol. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. and performance during this period helps understand the causes of the crisis. behavior. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. It required listed companies to establish their own audit committees by the end of 1999. and even Indonesia. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. despite the weakness of their disciplinary powers. Such improvements in disclosure standards are part of the efforts of SET and SEC.6. and promoted key industries through incentives. 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. to push companies to harmonize their accounting with international standards. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Philippines. Financial information from listed companies will also soon be required to conform to International Accounting Standards. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand.

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

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

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

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

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

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

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

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