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

2 KeyMacroeconomicIndicators Table 2. 1988-1996 Table 1.20 ROE of the Banking Sector.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1997 Table 1. 1992-1998 Table 2.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1996-1999 Table 1. Republic of Korea Table 2.13 Presence of Board Committees in Listed Companies Table 1. 1992-1997 Table 1. 1992-1999 Table 1.1 Listed Firms with Positive Economic V alueAdded.2 Foreign Capital Flows. 1992-1997 Table List of Tables 1.19 DER and ROE of Publicly Listed Companies by Sector.7 Growth Performance of the Top 300 Conglomerates.5 Financial Performance of Publicly Listed Companies by Sector.21 Nonperforming Loans by Type of Bank. 1996-1998 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies.15 V alue of Stocks Issued and Stock Market Capitalization. 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 .4 Development of the Stock Market.17 DER of Listed Companies by Degree of Ownership Concentration Table 1.12 CharacteristicsoftheBoardofDirectors Table 1.3 Subsidiaries of the 30 Largest Chaebols Table 2. 1992-1999 Table 1. 1986-1996 Table 1.18 GDP Growth by Sector. 1992-1997 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies. 1996-1998 2. 1993-1999 Table 1.14 Banking Sector Outstanding Loans. 1990-1997 Table 1.1 Growth of the Banking Sector. Indonesia Table 1. 1993-1997 Table 1.11 CharacteristicsoftheBoardofCommissioners Table 1.4 Growth Performance of Publicly Listed Companies by Sector.10 Anatomy of the Top 300 Indonesian Conglomerates. 1992-1995 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies. 1992-1997 Table 1. 1990-1998 Table 1.

18 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry.20 Table 2. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.9 Table 2.17 Table 2.25 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols.16 Table 2.6 Table 2.10 Table 2.12 Table 2.26 Table 2. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.14 Table 2.21 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 . 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms. 1997 Ownership Concentration ofAll Listed Firms.28 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size.11 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.vii Table 2. 1999 InternalShareholdingsofthe30Largest Chaebols.22 Table 2.8 Table 2. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms.27 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries.7 Table 2.5 Table 2.23 Table 2.24 Table 2. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.29 Table 2.19 Table 2. 1995-1997 Ownership Composition of Listed Companies.13 Table 2. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.30 Private Capital Flows to Korea.15 Table 2.

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 3.19 Financing Patterns by Firm Size.33 Net Profit Margins of Chaebols.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.18 Financing Patterns by Control Structure. andAffiliated Banks of Selected Business Groups.11 TotalandPerCompanySales. 1988-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.000 Companies. 1997 Table 3. 1988-1997 Table 3.Profitability andFinancial .21 OwnershipConcentration. 1988-1997 Table 3. 1997 Table 3. 1988-1997 Table 3. Thailand Table 4. 1997 Table 3.1 GDP Growth of SoutheastAsian Countries.1 Public Companies Registered.16 CorporateFinancing PatternsbyOwnershipType.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.1989-1997 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1983-1997 Table 3. 1985-1997 Number of Firms with Dishonored Checks.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry. Leverage Table 3. 1988-1997 Table 3.14 Philippine Stock Market Performance. 1992-1996 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.20 Financing Patterns by Industry.3 TheCorporateSectorandGrossDomesticProduct.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.22 Foreign Investment Flows.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1997 Table 3. 1995-1998 4. 1990-1999 Table 3. 1986-1998 Nonperforming Loans of General Banks.viii Table 2.17 Composition ofAssets and Financing of the Publicly Listed Sector. 1989-1997 Table 3. Flagship Company. 1978-2000 Table 4.15 Financing Patterns of the Corporate Sector.2 Growth and Financial Performance of the Top 1.SectorOrientation. 1992-1999 .32 Table 2.31 Table 2. 1989-1997 Table 3. 1988-1997 Table 3. 1989-1997 Table 3. The Philippines Table 3.2 Public Offerings of Securities. 1989-1997 Table 3. 1997 Table 3.12 Control Structure of the Top 50 Corporate Entities.

4 Table 4.16 Table 4. 1993-1999 Size and Composition of the Thai Financial Sector.2 Figure 3. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. 1992-1999 Offerings of Debt Securities.15 Table 4.14 Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.17 StatisticalHighlightsoftheStockExchangeofThailand. 1992-1999 Common-Size Statements for Companies Listed in SET.1 Figure 1.11 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1993-1999 Key Financial Ratios of Publicly Listed Companies.8 Table 4.13 Table 4.ix Table 4.1 Figure 3.12 Table 4.7 Table 4. 1990-1996 Financial Ratios of All Listed Firms. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies. 1985-1996 Average Key Financial Ratios by Company Size.9 Table 4.5 Table 4. Ownership Concentration.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. Leverage. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration.3 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.10 Table 4. 1990-1998 Merger and Acquisition Activities. 1990-1996 External Debt.6 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.

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

In the early 1970s. However.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Section 1. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). The industries that emerged were highly import-dependent and reliant on tariff protection. 1. in the course of the fight for nationhood from 1942 to 1950.1 Overview of the Corporate Sector Historical Development The marked permeability between the State and business in Indonesia goes back to the country’s struggle for independence.2 Section 1. and tobacco industries. how it was affected by the crisis. and its response. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. Section 1. substantial volumes of private investment entered the scene. a gradual shift in public investment away from manufacturing took place. Not all items in the questionnaires were answered by the respondents. Despite the oil revenues. medium. It also examines the statistical relationship between corporate performance and corporate governance characteristics. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. Subsequently.5 examines the corporate sector during the financial crisis in terms of its role. Up until the mid-1960s.and large-scale companies were dominated by state-run industrial concerns. while Chinese and indigenous entrepreneurs ran some large businesses in trading.2.4 analyzes corporate financing patterns. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. textiles. . This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies.2 1.

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

began to face competition. Interest rate regulations on state banks and credit ceilings in general were removed. During this period. with a total value of Rp16. state-owned banks were still among the biggest. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market. In 1988. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. Thus.Chapter 1: Indonesia 5 At the end of 1988. which up to then was channeling oil revenues to priority sectors. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. However. the banking sector has undergone many reforms. . six SOCs had issued equities in the market. the controlling shareholder of these SOCs is still the State. The initial banking sector reform was introduced in 1983. Consequently. more significant reforms were introduced. from 24 in 1988 to more than 300 in 1997.2. Table 1. But in terms of assets per bank. 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 number of private domestic banks increased. and increased access of domestic banks to international financial markets. Since 1977. Partly as a result of these reforms. reduced restrictions on foreign exchange transactions. Through the years. These included the opening of the banking industry to new entrants. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). However. private domestic banks dominated the sector in terms of number and total assets.5 trillion. to date. the number of listed companies in the stock exchange increased substantially. Conglomerates carried out 210 out of 257 IPOs. the banking sector has been and still is the major source of credit for the corporate sector. However. companies could no longer enjoy low-interest credit from state banks. The Government also allowed foreign investors to buy up to 49 percent of listed shares. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. the capital market played an increasing role in raising long-term funds needed by the corporate sector. which were previously constrained to 4 percent per day. with a total value of more than Rp8 trillion. The banking sector. The dominance of state banks started to erode.1 shows that from 1994 to 1998.

2 10 14.3 30 7.9 762. .9 39 18. the 10 largest were all affiliated with major business groups.8 391. The other banks among the top 10 were state banks.8 27 147. II Table 1.8 29 6.6 7 7. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector.8 27 200. In terms of assets.9 10 11.7 351.4 789.8 166 248. Bank Danamon (ranked 7th).1 240 1995 122.8 10 19.9 291.5 7 7 7 5 15.6 7 12.5 27 66. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group). and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA). Both BCA and BUN have shareholders linked to the former President Suharto. banks could earn profits even when they did not gather and process information about risk.9 31 9. and Bank International Indonesia (ranked 9th). Of these.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks. 1993-1999 Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks Source: Bank Indonesia. BCA.9 304.6 240 1996 1997 1998 1999 141.5 528. 1993 100.3 10 17.6 164 144 130 92 387.8 31 10.6 34 14.3 201. But the banking system proved incapable of performing its intermediation function. Among private domestic banks.0 234 1994 104.5 7 9. while BUN has been closed down by the Government. Bank Danamon. Because regulation was weak.4 10 35.4 34 12.1 Growth of the Banking Sector.9 27 113. Vol.3 27 51.9 248.6 Corporate Governance and Finance in East Asia.8 10 37.5 165 308.1 10 47.2 161 214.7 27 37.5 27 88.

Until the onset of the crisis. In 1994.2 Foreign Capital Flows. as shown in Table 1. textiles. Increasingly.09 1. Source: IFS CD-ROM. Table 1. Successive policy deregulation facilitated FDIs in various light manufacturing industries. Most FDIs came in through joint ventures with business groups having strong political connections.74 5.59 billion in 1996.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).2.48 1.59 4. there was a phenomenal growth in direct borrowings by Indonesian corporations. IMF. they still amounted to a large sum for the economy to absorb. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). foreign investment also had a strong presence in the services and infrastructure sectors.11 3.87 7.78 2. . foreign creditors were eager to provide financing to Indonesia.01 (2. In the 1990s.63) (1. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. 1.33 (13. and footwear.15) — = not available. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. But FDIs were only one form of foreign capital inflows to Indonesia. From the mid-1980s until July 1997. Between 1990 and 1996.00 2. September 2000. except in certain strategic sectors.88 4. especially through bank loans.10 5. In effect. Net FDI flows increased to $5. FDI flows were strong. such as metal goods. the Government allowed foreign investors to own 100 percent of an Indonesian company.2.01) (0.09) 1. when the financial crisis hit Indonesia.Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way.88) — — — — — — 8. 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.09) (0.40) (0.81 3. initially from Japan and the Republic of Korea. Indonesia received capital inflows averaging about 4 percent of GDP.50 (0. November 2000.

II Up until the late 1980s. plus 4 percent for the depreciation of the rupiah. In September 1997.4 trillion in 1997. From 1987 to 1996. increasing the total trading value from Rp8 trillion in 1992 to Rp120. the limit on foreign portfolio investment was removed and foreign investors were allowed to buy up to 100 percent of shares of a listed Indonesian company. especially the short-term ones. This increased to 30 percent by the end of 1993.2. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. foreign banks became a significant source of financing for the corporate sector. . with the onset of the Asian crisis. the average borrowing rate for dollar loans was 9 percent. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country. but declined to an average of 25 percent during 19951997. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. participation in the Indonesian stock market was exclusive to domestic investors. of which two thirds were rupiah-denominated. Domestic corporate debt was about $50 billion equivalent. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. The following section looks at the growth and financial performance of the corporate sector. By the end of 1997. 1. Due to data constraints. Consequently. The Government relaxed this restriction in 1988. Private borrowers preferred foreign loans since these were relatively cheaper. In the 1990s. Between 1989 and 1992. the average foreign ownership of listed companies was 21 percent.8 Corporate Governance and Finance in East Asia. 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. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 devaluation under the managed floating system. foreign investors began to dominate daily trading.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. total corporate debt reached nearly $118 billion. an interesting question is whether standard measures of corporate profitability and performance also indicated the same. state-owned companies (SOCs). the analysis focuses only on publicly listed companies. Vol. In November 1998. The external corporate debt owed to foreign commercial banks was $67 billion. and conglomerates.

3 Growth and Financial Performance of Publicly Listed Companies. Despite such rapid growth. total sales of listed companies grew at an annual average rate of 31 percent.6 24.7 percent in 1997. Asset turnover was above 30 percent until 1996.0 3.5 34.2 1995 37.3 3. 226 firms. 1993.1 4. although the contribution increased over time.3 shows the growth and financial performance of Indonesian publicly listed companies.4 1996 18.0 12.9 310.1 percent in 1997 when the crisis began to buffet Indonesia.2 30. b Asset turnover is defined as sales over assets.5 3.6 percent in 1997. while total assets grew at 43 percent. Return on assets (ROA) was also relatively stable during 1992-1996.6 3.7 — 250. but dropped to 1. a Value added was assumed to be 30 percent of total sales.5 240. ranging from 220 to 250 percent between 1992 and 1996.0 10.1 0. and 1992. 246 firms. 1996.8 6.7 — = not available. the average DER increased to 310 percent from 230 percent the .4 38.4 percent.4 1993 45.5 34. Average return on equity (ROE) of listed firms was 11. In 1997.0 6.0 64. 250 firms.1 220. 248 firms.3 6.4 1997 7. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.0 11.6 48. publicly listed companies as a group contributed less than 10 percent to GDP. 1995. Table 1.0 1. there were 204 firms. but fell to 24. Note: The number of firms is not identical for each year. but declined to 0.6 1994 50. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. 1992-1997 (percent) Item Growth Indicators Sales Growth Share of Value Added in GDPa Asset Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb 1992 — 3. but turned negative in 1997. 174 firms.0 12.7 3.4 31. During 1992-1997. averaging 3.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.8 percent between 1992 and 1996. 1994. When the crisis battered Indonesia in 1997.0 12.8 230. The growth of listed companies was sustained by continuing investments.2 7.5 37.9 37.0 33.8 220. Source: JSX Monthly (several publications).

7 percent during 1992-1996. ROA of all sectors dropped in 1997. ROE fell drastically because the sector had one of the highest DERs. averaging 21.64 percent in 1997. miscellaneous industry. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. due mainly to the domination of the International Nickel Company of Canada. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. real estate. Before the crisis. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. miscellaneous industry. trade.3 percent between 1992 and 1996. property. Table 1. consumer goods. the dominant sector was the finance sector. The finance sector’s contribution to GDP. When interest rates increased. and building construction. meanwhile. In terms of sales and asset levels in 1997.5 presents the financial performance of listed companies by sector. Four sectors (basic industry and chemicals. mining.4). the banks eagerly provided credit to property development companies. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. investment. and services. helped in part by the relatively strong demand for consumer goods. This sector was less affected by the crisis. the mining sector ranked first. In terms of share of value added to GDP. the mining sector had the highest ROE. Meanwhile. During those years. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. which operated in nickel and copper mining in 1992 and 1993. But the sector’s ROE fluctuated a lot. basic industry and chemicals. followed by agriculture (Table 1. in terms of growth of sales and assets. infrastructure. The finance.10 Corporate Governance and Finance in East Asia. real estate. only two sectors (mining and finance) showed a consistently increasing trend from 1992. and trade. Also. and property. averaging 17. still posting a positive but lower ROE. the property sector was severely affected by the crisis. Vol. when the property sector was booming during 1993-1997. and trade) even posted . The same applied to the trade sector. From 1995. However.73 percent in 1992 to 1. increased from 0. finance. with ROE falling to -11. indicating its reliance on equity to support growth. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. although asset turnover was slow. the companies in the sector did not operate with a high leverage. II previous year. and services. For instance. Overall. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened.2 in 1997. property. investment. the mining sector had the lowest DER. The consumer goods sector ranked second in terms of ROE.

3 31.2 13.3 0.0 1.6 1.0 0.4 44.9 14.6 1994 (75.1 0.5 61.1 1.0 (28.2 41.7 1995 51.5 28.4 (149.3 0.1 0.7 90. Source: JSX Monthly (several publications).5 13. Infrastructure Finance Trade.0 24.9 54. and Services — = not available. Industry Consumer Goods Industry Prop.9 123.0 18.2) 0.7) 17.1 42.7) (27.2 59. Constn.3 0..9 1.4 21.8) (12. and Bldg.8 51.0 (192.0 1996 1997 58.3 51.7 21.6 15. Investment.3 31. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.5) 49.1 16. and Bldg.6 0.5) 6.2 0.1 (41. Investment.7 40.7 28.1 0.6 24.3) 53.0) 46.1 0.0 (20.6 28.9 54.6 135.5 68.7 133.5 (11.7 24. Real Estate. Real Estate.3) 39.1 1.9 59.5 23.1 0. Investment.0 22. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.9 31.9 (7.4 1.8 66.5 95.5 53. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.3 0.0 64. Infrastructure Finance Trade.4 1.7 (82.8 (76.6 22.5 1.4 1993 155.3 340.1 1. Constn.3 17.7 34.2 0.7 43.0 0.4 170.1 — 39.9 8.5 0.4 30. Investment.9 25.0 43.8 29.1 0.7 17.7 62.4 30. and Bldg.8 50.3 1.6 26.0 16.3 0.5 45.6 85.1 1.3 92.8 0.7 0.6) 19.Table 1.8 62.5 1.2 5. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.4 103.4 1.0 0. Real Estate.5 (8.1 71.5 0.1 35.6 (41.. Real Estate.6 133.1 67.9 64.1 0.5 92.4 38.1 0. Infrastructure Finance Trade. Industry Consumer Goods Industry Prop. Industry Consumer Goods Industry Prop.4 31..4) 8.8 27.2 35.4 77.8 24.0 0.7 54.8 32.8) 0.4 0.7 — 36.7 112. Industry Consumer Goods Industry Prop.4 64.6 (0.5) 13.6) 119.7 — — 11. Constn.6 0.2 41.1 1.5 1.7) 26..7 0.0 68.1 32.4) 6.0 0.1 0. Constn.4 Growth Performance of Publicly Listed Companies by Sector.9 0.0 0. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.4 43.9 53.6) 25.6 0.1 (11.5 9.8 1.6 83.8 1.0 31.3 (203.6 51.9 .8 28.7) (113. and Bldg.2 14.9 36.6 0.1 0.9 0.1 28.2 11.1 23. Infrastructure Finance Trade.

7 8.0 39.0 170.5 5.3 1.1 4.2 39.0 380.4 4.1 1996 100. Investment.0 130.0 80.7 10.5 56.8 44.1 11. Infrastructure Finance Trade.0 86.7 10.4) (1.0 80.9 14.4 79.0 90.1 9.9 40.5 13.3 7.1 89. Industry Consumer Goods Industry Prop.2 11.0 140.8 11.0 120.0 70.1 4.1 8.1 (3.0 1997 230.4 46. Constn.2 6.6 23.8 25.7 12.8 8.0 160.8 479.0 110. Industry Consumer Goods Industry Prop.4 1.Table 1.4 71.3 5.4 6.0 3.7 26.7 4.6) 18.5 19.3 17.4 35.8 16.5 7.7 5.4 46.3 64.5 4. Industry Consumer Goods Industry Prop.0 110.0 190.3 18.0 180. Real Estate.0 700. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.0 9.0 100.3 7.6) 36.5 17.8 67. Investment.9 38.8 20.0 100.0 190.8 382.7 8.8 3.3 0. and Bldg.7 (3. Real Estate.0 120.0 160.6 18.0 17.7 71.6 8.3 38.0 110.5 Financial Performance of Publicly Listed Companies by Sector. Constn.5 43.2 23. Real Estate.0 100.0 70.8 81.7 10.0 12.0 190.6 74.9 38. Investment.9 87.1 (5.0 150.0 3.4 20.8 168.1 10.7 4.1 2.0 150.5 1995 80.7 1.6 13.0 140. Real Estate.0 150.0 69.0 110.0 160.0 60. Infrastructure Finance Trade.1 6. and Bldg.0 46.1 7.9 29.0 560.0 100.0 70.2 13.4 13. and Bldg.0 50.0 110.3 73.3) 5.0 110.9 4.4 .0 14.1 3.5 14. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.0 120.0 650.7 12.0 210.7 9.7 13. Infrastructure Finance Trade.0 220.4 6.4 5.2 8.2) 7.8 9.2 7.1 1994 80. and Services Source: JSX Monthly (several publications).2 111.1 63.1 13.1 9. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.4 17.4 35.1 10.1 1. Constn.9 10.6 (2. Infrastructure Finance Trade.2 1993 130. and Bldg.0 (0. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.1 4.0 8.2 7.0 630.0 8.0 680..9 41.0 66.9 17.9 7.2 30.0) 7.0 110. 1992 20.7 1..2) 15.0 180.6 8.3 33.8 5.8) 8.0 180.6 19.0 80.2 15.7 5.3 17. Industry Consumer Goods Industry Prop.0 15.5 11..8 11.2 3.0 19.9 42.5 4.7 4.6 13.2 53.0 120. Constn.6 14.1 65. Investment.7 46..6 1.0 11.1 10.6 (11.0 650.3 13.4 13.7 61.2 (4.2 3.7 12.

Similarly. SOCs diversified into many businesses. Six SOCs were listed in the Jakarta Stock Exchange. and finance company (four companies). but dropped dramatically to 4. However. between 1993 and 1995. increasing from 21. SOCs’ sales growth fluctuated during 1990-1996. The DER was slightly higher than for listed companies. .3 trillion. Trade had the highest ROA of 39.8 percent between 1992 and 1995 (Table 1. This was relatively high compared to the 3. the subsidiaries and affiliates number 459 with total assets of Rp343. much lower than that of companies listed in the stock exchange. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). insurance (11 companies). the ratio decreased from 8.7 percent in 1990 to 6 percent in 1996.6).7 percent. the Department of Finance supervised 30 SOCs. growth of net profits and assets was erratic. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. ROA had been at high levels from 1992 to 1995.1 percent in 1992 to 28. Just like private companies. This was due to large sales by the National Oil Company (Pertamina).4 percent the following year.3 percent in 1995. and basic industry and chemicals sectors had relatively stable ROA before the crisis. By 1995. SOCs’ ROE ranged from 6. Assuming a fixed ratio of value added to sales. The finance and miscellaneous industry. the SOCs’ value added as a percentage of GDP ranged from 6 to 8. banks (seven companies). Asset turnover rates were lower relative to those of publicly listed companies. there were 58 SOCs with subsidiaries and affiliates. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest.7 to 7 percent for publicly listed companies. State-Owned Companies At the end of 1995.6 to 8. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. SOCs actively operated in various sectors4 under the supervision of “technical” departments. These growth rates were low compared to those for listed companies during the same period. averaging 24 and 31 percent. there were 165 state-owned companies (SOCs)3 in Indonesia. Taken together. For instance. respectively.1 percent in 1993. registering an average annual rate of 10 percent.Chapter 1: Indonesia 13 negative ROA. indicating SOCs’ declining contribution to GDP. which collectively had the largest assets.

1 6.1 310. Assuming a constant ratio of value added to sales.8 11.1 19.4 percent in 1992 to 28.1) 5.0 28.4 16. . Source: Indonesian Data Business Center.0 6.766 business units.0 8.5 3.0 12.4 1993 16.0 7. Table 1.4 13.3 30.0 17. SOCs’ asset turnover rates showed a downward trend from 32.14 Corporate Governance and Finance in East Asia. but dropped to 11. but climbed to 30. b Asset turnover is defined as sales over assets.6 percent in 1994. 1992 — 7.8 21.4 13.0 8.8 percent in 1990 to 13.7 (2.6 1995 25.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia. a Value added was assumed to be 30 percent of total sales.4 13. the contribution of conglomerates to GDP increased from 12.7 16.6 Growth and Financial Performance of State-Owned Companies. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.6 28.1 32.3 12.3 250.6) 260.2 — = not available.2 — 370.4 percent in 1994. II companies consistently declined over time.5 percent in 1995. a Value added was assumed to be 30 percent of total sales.2 18. 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. Their total sales increased from Rp90.6 28.7 13.7 Growth Performance of the Top 300 Conglomerates.4 7.1 12. mostly private companies.1 30.7).7 1994 (9. Vol. In 1997.0 24. these conglomerates owned 9.8 12.1 trillion in 1990 to Rp234 trillion in 1997. Table 1.2 percent in 1997 (Table 1.2 23. Source: Indonesian Data Business Center.

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

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

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

Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.2 11.3 1995 47.9 Source: The Indonesian Capital Market Directory.8 1.8 68.4 2.5 1997 48. and 0.9 2.0 0.5 72. 13.8 Ownership Concentration of Publicly Listed Companies.7 1994 48.9.8 68. Meanwhile.4 percent. the five largest shareholders owned 68. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.6 3. Zebra Nusantara (taxi services).6.18 Corporate Governance and Finance in East Asia. the founder usually continues to own the majority of shares through a . Table 1. The percentage owned by each of the five largest shareholders was 48. mining.0 4.5 12.6 percent. issued 93. When a company goes public. The pattern of ownership concentration changed little over this period. When a company makes a rights issue.8.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.0 2.7 1996 48. Rig Tenders Indonesia (shipping services) issued 51.5 16. II Publicly Listed Companies Table 1.2 1.2 67.9 percent of total outstanding shares. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.1 0.9 14.6 3.0 67.7 3. This preserves the pro rata share of existing shareholders. 3.0 1. Table 1.6 4.6 68.0 0.9 2. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.9 0. consumer goods.1 4. the controlling shareholders usually act as standby buyers. Vol. respectively.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture. and basic industry and chemicals sectors than in others.1 1. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.1 13. 2.5 Average 48. On average.5 percent.6 13.6. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). for instance. This is because a few companies in the transportation sector issued high proportions of shares to the public.

1 1.2 This is confirmed in Claessens et al. two thirds (67.6 1.6 9.3 2.2 2. Investment.1 13.7 13.9 50. Constn.1 2. and Bldg.4 11.7 percent of the market.9 44. Real Estate.3 48. in a cross-country study.4 54.1 percent) of Indonesian publicly listed companies were in family hands. Industry Consumer Goods Industry Prop.1 2. and corruption.9 44.3 14.9 Ownership Concentration of Publicly Listed Companies by Sector.7 9. (1999) also found.9 0.9 1. and the efficiency of the judicial system. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54. and Services Average Source: The Indonesian Capital Market Directory.8 14.2 0.0 5. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.2 15.1 0.6 percent of total market capitalization while the top 15 families control 61. the top family controls 16.1 2.4 4.. and only 0.4 44. Claessens et al. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.2 46.4 1.2 10.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas). (1999).7 1. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in . In fact. the rule of law. 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. is strong.4 6.7 6.7 4. that the correlation between the share of the largest 15 families in total market capitalization.1 1. as well as the existence of corruption.6 0.5 1.1 0.6 8.9 3. which shows that in 1996. on the one hand. Util.5 58.. Indonesia has the largest number of companies controlled by a single family. and Transportation Finance Trade.3 0. Table 1.6 percent were widely held.1 1. Infrastructure.5 4. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.1 1.3 36. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families. on the other.6 2.1 11.3 0. In terms of capitalization.

and family origin. The nonindigenous businesspeople are usually Chinese. resulting instead in a decline in the proportion of foreign investor ownership.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. Indian.55 percent in August to 25. Batak. ethnicity. most were established during the New Order Government. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. Indigenous businesspeople include the Javanese. II the small number of families and the tight links between companies and the Government. numbering 162 in 1988 and 170 in 1996.5 Conglomerates Table 1.42 percent in December. conglomerates established before 1969 dominated in terms of sales. their number increased to 5 In 1997. political affiliation. Sundanese. accounting for 64 percent of total conglomerate sales in 1988-1996. However. was able to create a favorable environment for business development. . or other ethnic groups. This may indicate that the New Order Government. In September 1997. the legal system is less likely to evolve in a manner that protects minority shareholders. but later declined and steadied at around 25 percent. From 193 in 1988. During 1988-1996. with all its regulations. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. But these benefits are few and often dubious compared to the high costs of concentration. foreign ownership increased to 21 percent. However. Among the top 300 conglomerates. the proportion of foreign ownership declined from 27. 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. In 1993. and Padang. In Indonesia. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. the Government allowed foreign investors to buy up to 100 percent of listed shares. Coordination is easier because informal communication channels exist. it rose to 30 percent. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. Vol.20 Corporate Governance and Finance in East Asia. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. the onset of the crisis negated this development.

1 52.1 21.0 15.9 35.7 28.8 25.6 34.4 trillion in 1996.0 58.6 114.1 87. the number of mixed groups declined from 86 in 1988 to 68 in 1996.2 33.1 58. Meanwhile.8 12.8 36.7 106.7 40.2 12.3 20. For instance.1 percent of total .9 billion.0 31.4 48.8 57.6 95.8 28.9 trillion.4 18.4 86.4 22.1 46.10 Anatomy of the Top 300 Indonesian Conglomerates.0 18.8 38.1 179.6 trillion in 1988 to Rp137. more than five times its 1988 level.4 16.5 106.2 23.3 36. In 1996.4 19.7 89.3 80.7 64.4 59.2 48.0 116.4 68.3 134.7 24. Their total sales also increased from Rp38. While they supplied 20.2 30.5 21.8 30.9 73.5 22.9 13.7 95. 204 in 1996.6 17.9 137.2 159.6 12.4 59.3 101.1 33.5 120.4 37. sales of the Bakrie group before it went public in 1990 were only Rp369.4 32.9 42.8 68.9 14.4 69.7 49.1 103.0 58.4 31.4 81. 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 9.0 28.9 47.0 44.1 25.6 77. Conglomeration Indonesia 1997.4 57. due to their “go public” activities.3 120.6 54.2 76.8 Source: Indonesian Business Data Centre.4 52.2 29.1 41.4 15.9 77.1 42.3 43.Chapter 1: Indonesia 21 Table 1. its sales reached Rp1.8 49.1 46.4 31.

for instance. and Wisnu Suhardhono of Apac-Bhakti Karya. which is the largest conglomerate in Indonesia. owns four groups with many subsidiaries and affiliate companies. there were 175 groups that originated from a family business. Bambang Rijadi Soegomo. Conglomerates were also classified into nonofficial. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Most of the top 300 conglomerates were established by ordinary citizens. average sales of official-related conglomerates reached Rp1. collectively controlling . and Ibrahim Risyad of the Salim group. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. The Salim group. their contribution declined to 13. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. Out of 174 companies. Prudential credit analysis tends to be ignored. Only about 13 percent were formed by official or ex-official families. including Indofood Sukses Makmur (food industry). But listed companies within conglomerates were few. In 1996. and Fast Food (restaurants). most of the 16 liquidated banks had violated the legal lending limit set by the central bank. Bank Indonesia.2 trillion. compared with the less than Rp700 billion of a nonofficial-related conglomerate. The Suharto family is the largest stockholder in Indonesia.7 percent in 1996. 117 are jointly owned by the family and 57 are owned by individual family members. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). In 1997 and 1998.and officialrelated groups. In 1996. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. But only a handful of these companies are listed in the market. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). Vol. Indocement Tunggal Prakarsa (cement industry). Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. Djuhar Soetanto. Some of them later became public companies by listing in the stock market. The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice. In November 1997.22 Corporate Governance and Finance in East Asia. II sales in 1988. or have resulted from alliances between entrepreneurs and officials.

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

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

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


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

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

7 112.4 24. because of the restrictions discussed below.6 6. However.3 14.6 percent in 1997. Table 1.3 9. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing. Bank Credit As shown in Table 1.0 93.3 111. stocks.1 Corporate Financing Financial Market Instruments Prior to 1977.5 108.6 4. II 1.2 71.4 1.5 42. and others offered by nonbank financial institutions or finance companies.9 153. 1992 1993 1994 1995 1996 1997 1998 1999 68.5 7.7 18.3 188. remain the major financing instrument for the corporate sector. Private national banks and state-owned banks were the biggest domestic creditors.0 3.2 27.6 3.7 122.9 378. companies considered alternatives to bank loans.4 56.2 6.9 150.3 66. bank credit surged from Rp122.4 trillion in 1998.4 86.0 487.1 Equities In 1977.9 trillion in 1992 to Rp487.4 225. Vol. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).0 6. the share of private national banks in outstanding total loans increased to 44.5 80. . jointly providing almost 90 percent of loans until 1997. this market was not well developed.0 168.14.3 60. private national banks overtook state banks as the dominant credit source. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.7 50.6 150.32 Corporate Governance and Finance in East Asia. however.4.1 220.4 percent in 1992. Bank loans.6 292.6 48.2 5.14 Banking Sector Outstanding Loans. equities became available to the corporate sector. including bonds. Since then.8 193.9 234. Data from Bank Indonesia show that from 1994 to 1997. when the Government reactivated the stock exchange. From 34. new instruments have been introduced to the corporate sector.

6 123. i. . thus increasing the role of the capital market in raising long-term funds.4 207.8 48. allowed to accept deposit accounts from the public. the Government issued regulations to supervise and promote prudential practices in finance companies. factoring.9 406.6 310. finance companies were increasingly used as channels for the inflow of foreign loans. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity.7 14. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy.4 1996 1997 1998 50.0 70. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.9 1999 76.15 Value of Stocks Issued and Stock Market Capitalization. capital adequacy ratio. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia.Chapter 1: Indonesia 33 Some companies went public.1 17.6 91. In 1995. 1992 1993 11. Overall. and net open position). They were not. when foreign investors were not yet allowed to purchase listed shares. shooting up to 18. Prior to 1995.1 1994 26. the stock market has gained a bigger role in corporate sector financing (Table 1. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.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..15). During the 1990s.7 15. It gradually increased again starting in 1991.2 16.0 206.7 percent in 1997. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e. legal lending limit.e. however.5 333..1 18. credit cards. and consumer credit. In 1988.g.7 9.6 859.1 10. 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. Table 1. The ratio reached 8.5 Financing by Finance Companies Finance companies first emerged at the end of 1980.5 1995 35.6 301. offering services such as leasing.0 15.

Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. Table 1.4. While banks had some exposure to these instruments.6 100.4 23. Banks could invest only in commercial papers that were rated by the Indonesian Rating Agency (which was set up only in 1995 to rate debt instruments).6 23. In the second half of the 1980s. Thus in November 1995. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).3 37. 1996. This is in contrast to the lower share of borrowings during the same period.9 16.0 1991-1996 16.34 Corporate Governance and Finance in East Asia.4 8.3 (0.0 3.0 — = not available. otherwise it would be classified as a loss in the banks’ books.7 22.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.5 21.0 39.8 percent.0 1986-1996 17. respectively.5 (0. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.5 percent and 36.16 Financing Patterns of Publicly Listed Nonfinancial Companies. Vol. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases. PACAP Research Center.1) 23.0 100.6 12.6 8. averaging 26. have been popular in Indonesia since 1990. short-term borrowings were greater than long-term debts.1) 23. In terms of composition.6 100. at 81 percent of total borrowings.2 26. they were not rated by a rating agency. 1.4 13. .8 7.3 16.3 14.8 17.5 11.2 Patterns of Corporate Financing Table 1.5 — 26. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. II Commercial Papers Commercial papers.

Of the various financing sources. Hence. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. Two telecommunications companies. with longterm debts increasing rapidly. Bank loans also surged when the banking sector was liberalized in 1988. They also do not want to dilute corporate control and are more likely to finance growth with debt. Indofood registered losses of almost Rp1. Most corporate charters require commissioners to approve debt issues or sign debt agreements.4. This amount doubled in 1997.2 trillion (mostly foreign exchange losses). that ownership concentration may be associated with heightened risk-taking by companies. also suffered from foreign exchange losses but managed to post profits of Rp0. 1. the corporate sector’s high leverage. corporate debts accounted for 39.2 trillion. respectively.3 Corporate Financing and Ownership Concentration It has been suggested.17 compares the DER of listed firms by degree of ownership concentration. which managed to post significant profits due to low exposure to dollar-denominated loans. 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. except Semen Gresik (an SOC). reaching Rp229. The analysis of ownership patterns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. was due largely to a rapid rise in long-term debts.1 trillion.6 trillion and Rp1. These liabilities grew significantly because corporate expansion was largely financed by debt. in the context of Indonesia and some other countries. . Indosat and Telekom. which was masked by the rapid growth in investments. The results indicate that firms with higher ownership concentration tend to have a higher DER.4 trillion in 1993 to Rp112.Chapter 1: Indonesia 35 In the 1990s.9 trillion. rising from Rp54.9 trillion in 1996. the pattern changed. For instance. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. Corporate debts grew over time. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. All companies in the cement industry suffered from foreign exchange losses. while Semen Cibinong’s losses reached Rp2. Table 1.3 percent during 1991-1996.

heavy reliance of companies on bank credits to finance investments.0 351. Controlling parties rely on external financing to maintain their equity share and.5. In addition. The test of the difference between the two means found the t-value of 1. 1.56 significant at the 10 percent level. the borrowings swelled. Table 1. Source: Author’s estimates.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. Between 1987 and 1996. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital.0 386.5 1. the private sector borrowed heavily in unhedged dollars.358. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. aided . 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. to maintain control of the company. decisions on debt are made with the implicit endorsement of owners. Vol. As a result. since commissioners represent the controlling party. ultimately.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. 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. and high ownership concentration among families with political affiliation.0 1. II However. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders.36 Corporate Governance and Finance in East Asia.

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

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

The consumer goods industry reported the lowest ROE.1 5.4) (0. indicating a rapid rise in .18 shows that growth in most sectors significantly fell in 1997.7) (8. and Restaurants Transport and Communications Financial.0 2. Table 1.58 trillion (meaning their losses were greater than the paid-up capital).5. and Fisheries Mining and Quarrying Manufacturing Electricity.3 Source: Central Bureau of Statistics (Biro Pusat Statistik. DER and ROE were calculated per sector. Livestock.2 (1.370 percent. and Water Supply Construction Trade. Forestry.0 3.18 GDP Growth by Sector.6 12.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.1 6. and building construction.6) (3. The average DER was found to be 1.6) (0.0) (15. followed by property.8) (11.8) (13.3 11.7 6.8 0. Most sectors showed significant increases in leverage.5) (18. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. followed by the finance and trade sectors.7) (2.6 13. The construction sector was the worst hit.6 4. when all sectors. 1996-1999 (percent) Sector Agriculture.1 (1. Real Estate.0) 1999 2.2 8. and Business Services Other Services GDP 1996 3.1) (26. real estate.9 3.24 trillion for the first six months of 1998. Only 86 companies reported profits. Using the financial statements as of 30 June 1998 of 161 publicly listed companies. as shown in Table 1. Hotels.4) 2. much higher than the 307 percent registered in December 1997. Gas.4 5. BPS).7 1998 (0.7) 2. 53 companies reported negative equity of Rp6. and 128 companies reported a total loss of Rp46.0 5.Chapter 1: Indonesia 39 1.6 (36.8 8.6 8. except utilities.19.4 7.3 12.8 7. Sectors with lower ROE generally had higher DER.1) 1. This continued in 1998.52 trillion.4 7. posted negative growth rates.8 1997 1.

0 205. but annualized to approximate full year values.4 (6.0 65. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999. foreign exchange losses came about with the use of unhedged foreign debt. and would have kept on increasing if interest rates had not declined.1 (124. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. Financial and banking analysts estimate that by September 1998. Source: JSX Monthly. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.8 17.0 12. small foreign banks enjoyed the highest profits. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104.370.0 158.4 5.0 a ROE 1996 1997 1998a 14.6) (115.7 percent in July 1998.9 12. as shown in Table 1.40 Corporate Governance and Finance in East Asia.7 1.0 635.2 13.0 307.0 92.19 DER and ROE of Publicly Listed Companies by Sector.5 8.0 864.4) 8.20 reveals that the banking sector’s ROE decreased significantly in 1997.1 30.0 108.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.8) 36.0 191. First. losses in operation were due to declines in sales and increases in the cost of imported inputs.0 2.0 229.6) 15. private banks posted negative ROEs in the same year.21.625.0 1998 186. .0 108. As the rupiah weakened and interest rates increased.2 (4.1 1. the NPL ratio rose to 25.271.8 (373.4) 18.1 (5.0) 10.0 111.1 (92.0 163.0 1.8 percent in 1996. Mostly suffering from a liquidity squeeze. II Table 1. Impact on the Banking Sector Table 1.7) 6.6 (11. This figure further increased to 47.5 percent in April 1998.0) (78. the NPL ratio had reached more than 60 percent.0 219.0 631.097.0 1. Second.0 105. several publications.3 7. Third.0 177.2 23.1) 7. a Actual data for 1st semester only.0 97.2) (264.0 193. from only 8.0 1997 234.1 (3. Vol.0 1.395.0 177. The huge losses suffered by most companies were caused by three factors.0 2.0 697.0 72.

7 — 1.07 13.6 6.4 7.20) Table 1.5 57.5 128.5 34.0 — 4. State-owned banks initially had the highest NPL ratio.5 31. July No.2 37.0 — 32.21 Nonperforming Loans by Type of Bank.1 198.9 — 11.6 — 4.44 15.25 22.1 30.2 — 8.6 — 13. 230/1998.81 13.45 — 1993 15.67 8.34 16.8 14.0 622.70 1995 7.69 14.8 8.47 20.1 13.06 20.1 47.2 47.9 Regional Foreign and Development Joint Venture Banks Banks — 9. .7 Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998 Total 331.7 29.5 2. coupled with negative spreads (deposit rate was higher than the credit rate).Chapter 1: Indonesia 41 Table 1.09 (11.50 9.68 1996 1997 8.86 11.8 3.39 13. however.8 187. put pressure on the banking sector.2 10. private national banks overtook State-owned banks when their NPL ratio jumped to 57.73 30.7 — = not available.20 ROE of the Banking Sector.28 5. The high and increasing NPLs.84 27. 227/1998 and October No.0 129.72 16.2 8.6 — 1.24 15.9 297.24 (4.2 48.2 8.37 19.2 1.30 5. Source: The National Banking Association. In July 1998.09 11.7 4.38) 11. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.91 21. Source: Infobank. 1996-1998 (Rp trillion) State-Owned Banks — 140.3 361.8 11.43 10.9 11.2 — 19.9 percent.3 22.07 1994 14.1 274.3 445.5 222.7 106.12 15.89 27.1 1.15 20.45 21. 1992 7.3 Private National Banks — 179.

the corporate sector had more than Rp600 trillion ($75 billion at Rp8. 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. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. The scheme encourages negotiation between creditors and debtors. On 9 September 1998. assembling the legal and policy framework to facilitate corporate restructuring. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring). 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. about 80 percent of which was private. the committee launched the Jakarta Initiative.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997.6 billion) of Indonesia’s total external debt in March 1998. II 1. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Thus. particularly in terms of debt resolution. While the process of restructuring was in progress. Unfortunately. by mid-September 1998. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. In June 1998. a number of prominent companies. the Government and private sector formed a committee to help corporates deal with the crisis. In November.7 billion of foreign exchange debt. few companies were in a position to resume interest payments. a more comprehensive scheme to tackle domestic and foreign corporate debt.000 eligible firms had signed up for the scheme. only a . have been subject to restructuring deals under the initiative.5. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. and Ciputra (property business). Since September 1998. none of the 2. Corporate debt accounted for 46. However. Aside from being described as overly complicated. Astra International (automotive). Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1.42 Corporate Governance and Finance in East Asia.2 billion debt.4 trillion of domestic debt and $6.000/$1) in debt from domestic commercial banks. Vol. companies were not servicing their debts. In addition. such as Garuda (a national flag carrier). the scheme failed.7 percent ($64. By end-November.

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

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

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

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

21 trillion in 1996.1 percent in 1997 to -124. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision.370 percent in 1998. and the rapid decline in equity due to losses. DER increased to 307 percent in 1997 and further surged to 1. the corporate sector was in quite good shape in terms of growth and profitability. As the rupiah weakened and interest rates increased. The financial crisis led to the closure of several dozen banks. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). NPLs rose and capital adequacy ratios fell.1 percent in 1998. Impact of the Financial Crisis Prior to the crisis.24 trillion in the first half of 1998.1 trillion in 1997 from Rp13. particularly those with large short-term foreign loans.Chapter 1: Indonesia 47 without diluting their control. Sales of conglomerates as well as those of publicly listed companies were increasing. ROE dropped from 1. To restructure the corporate sector. The Government and the private sector responded with measures to mitigate the negative effects. and registered a net loss of Rp39. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. At the height of the crisis. The Government introduced reforms to improve bankruptcy procedures. Total profits of publicly listed companies dropped to Rp3. corporate-initiated debt restructuring . followed by the property sector. Meanwhile. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. were the most adversely affected. When the crisis hit Indonesia. the highly leveraged companies. Bank Indonesia extended emergency loans to many banks. financed by issuing nearly $80 billion worth of bank restructuring bonds. although at a declining rate. and strengthen prudential regulations and supervision of the financial sector. facilitate debt restructuring. the consumer goods industry was the worst hit. the high domestic interest rates that prevailed from 1998. On the other hand.

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

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

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

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

David Edwards. Business managers and controlling shareholders were maximizing firm size at the expense of profits. The authors wish to thank Juzhong Zhuang. and Graham Dwyer for his editorial assistance. 1 Professors. the Republic of Korea. As the Korean currency. banks as major creditors had governance problems of their own and failed to monitor or exercise the control rights generally afforded to lenders via loan agreements. and corporates were sent reeling. markets.1). timely exit of poor performers from the market. and David Webb of the London School of Economics for their guidance and supervision in conducting the study.2 Republic of Korea Kwang S. the Government and business sector had good reason to reflect on the causes of the crisis. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. a practice that was not checked by creditors. Further. both of ADB. or capital market discipline. Department of Economics. 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. Korea) in November of that year. . the Korea Stock Exchange for its help and support in conducting company surveys. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. The country’s winners would then emerge based only on economic efficiency. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. Chung-Ang University. This has been the crux of the corporate governance problem in Korea. Chung and Yen Kyun Wang1 2. Seoul. internal control mechanisms.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. A national consensus is emerging that a democratic system based on free market principles should be firmly established to promote more intense competition in every sector of the economy.

Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. and J Murrin (1995). This broad perspective can help clarify the ongoing reform efforts of businesses and the Government.1 1998 490 164 33.1 1997 518 104 20.4 1993 513 174 33. T. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange. June 1999.1 1996 561 163 29. 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.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. This study collects and analyzes data on the Korean economy. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital.9 1994 531 165 31.1 Listed Firms with Positive Economic Value Added.1 1995 560 163 29. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. accountability of controlling shareholders and boards of directors. and individual companies. II Table 2. Source: Korea Stock Exchange. and improvement of bankruptcy procedures.54 Corporate Governance and Finance in East Asia. the corporate sector. Many firms left some questions unanswered. capital market discipline. Koller. Government reform goals for the corporate sector include enhancement of corporate transparency. Weaknesses in the overall corporate governance system in Korea had many ramifications. which distributed and collected the questionnaire. especially chaebols. Vol. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. Copeland. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms. . The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. The EVAs are the same as the economic profit as explained in T.

2. Section 2.2.4 contains analyses of corporate financing and its relationship to performance. Major economic indicators for some of these periods are shown in Table 2. Section 2. The Government tried to produce food.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. reviewing government policies responsible for the development of the modern corporate sector.2 2. and Yim (1998). 2. It traces the country’s economic development. and other necessities domestically.2 presents an overview of the corporate sector. corporate control by the Government. Yang. It reviews such elements as shareholders’ rights. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. It then presents recommendations for further reform in corporate governance and financing. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. Section 2. and employees and their role in shaping corporate governance practices. 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. This chapter is composed of six sections.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.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. clothing. creditors. In the period 19481961. From 1948 to 1961. the board of directors system. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. Section 2. which account for a substantial portion of the Korean economy. . and naturally adopted an import substitution policy. The evolution of the modern Korean economy can be divided into four periods.

II Table 2.1 — = not available. and large current account deficits.9) 1.332. lack of strong drive.949.2 452.1a 21.1 35.2 Key Macroeconomic Indicators Annual Average (percent. a Refers to 1971.8 15.6 11. c Refers to 1989. and implementing new budget and tax measures.4 29.9) (7.0 27. This goal required very high savings and investment rates.855.5) 8.4 (1.8 (8.753.2 32.2 30.3 8.2 757.4 1990-1997 7.4 29. unless otherwise indicated) Indicator GNP Growth Rate Inflation Rate Savings Rate Investment Rate Manufacturing/GDP Interest Rate on Time Depositse Exchange Rate (won/$) Export Growth Rate Import Growth Rate Trade Balance (million $) Current Account (million $) Capital Account (million $) 1962-1971 1972-1979 8.2 31. the Government called for an unprecedented average annual economic growth rate of 7. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).102. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.56 Corporate Governance and Finance in East Asia.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.5 250.265.1d 9. The Government tried .8 12. However.4 24.5) (1. Vol.1 29.1 9. and inconsistent economic policies.2 1980-1989 8. IMF. International Financial Statistics. d Refers to 1997.0 41. the Government was not successful in solving the problems of slow growth.0) 492.9 — — 21.5 38. Export Drive: 1962-1971 Between 1962 and 1971. 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. modernizing the industrial structure.9b 15. e For maturities of one year or more. largely because of political instability.9 794. Economic Statistics Yearbook. In the Plan.7c 11.447.8 (724.7 37.0) (297. high unemployment and inflation.1 15.2 1. b Refers to 1979.4 10.2 6.2 314.7 30. Source: Bank of Korea.7 14.8 24.

The well-educated. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). which laid a solid foundation for a steady growth path. In 1971.4 percent. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. boosting internal investment resources. due to continuous current account deficits.2 billion in 1972. channeling funds from curb markets into the banking sector. but tariff rates were raised to 40 percent in the 1960s. But the liberalization trend turned out to be short lived as current account deficits continued. 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. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. abundant. The exchange rate system was a kind of crawling peg until 1974.3 percent average between 1954 and 1959. the Government tried to provide exporting firms with a free trade environment. In 1964. while the average tariff rate was 39 percent. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. During the first five-year plan period. up from 30 percent in the late 1950s. and maximizing mobilization of domestic savings on the other.5 percent. and cheap labor force was well utilized by the export-led growth strategy. imports of consumer goods and luxury items were highly restricted. but the average growth rate for 1965-1969 shot up to 10 percent. . During this period. However. resulting in high real interest rates. the import liberalization rate was 55 percent. The average growth rate of the economy from 1960 to 1964 was 5. a modest improvement over the 4.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. the growth of gross domestic product (GDP) raised domestic savings. In 1963-1964.3 percent to 60. This change raised the import liberalization rate from 9. Exports increased sharply from $41 million in 1961 to $2. Bank deposits increased rapidly. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. Also.

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

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

while continuous and large current account surpluses saved Korea from the foreign debt problem.2. . and declaring that it would follow Article XI of GATT. 45. The official rate fluctuated within a band. the import liberalization ratio reached 98. and low oil prices. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. The low value of the dollar led to a low won and high yen.” A large-scale business group is called a chaebol.2 percent. II world interest rates. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. The most important element characterizing chaebols is the concentration of ownership. Meanwhile. 13. giving up its foreign exchange controls related to the current account. whose business activities are controlled by an identical person. 2. which gradually widened. 4. further increasing its pace of import liberalization. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. total assets. total debts.3 percent. but it chose to liberalize gradually. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. and acceded to the World Trade Organization (WTO) in 1994.9 percent. In 1993. Vol.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. 47.9 percent. Korea began participating in many multilateral trade negotiations during the Uruguay Round. 46.1 percent. 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). with the 30 largest in the total economy in 1997 standing as follows: value-added.1 percent and average tariff rates 8. and total workforce. the Government committed itself to further liberalization of the goods and capital markets. Industrial and trade policies were modified to be consistent with WTO. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. total sales. the importance of chaebols was increasing. Korea adopted a market average exchange rate system.9 percent.60 Corporate Governance and Finance in East Asia. 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 1988. The Government tried to adjust economic policies and regulations to meet global standards. In 1990.

1993-1996 Year 1993 1994 1995 1996 No. From the standpoint of the Government.when the Government put a great deal of emphasis on development of the HCIs. of Subsidiaries 604 616 623 669 Average No.1 20. Chaebols have a history of substantial concentration of ownership.3 Source: The Fair Trade Commission. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. Chaebols are also excessively diversified. One reason for this controlling power is inter-company shareholding among subsidiaries. after the financial crisis. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. reaching 669 in 1996. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. Table 2. This policy contributed greatly to the expansion of chaebols.5 20. and they are aided and supported by one another. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources.Chapter 2: Korea 61 War II. Table 2. it was more effective to deal with a small number of companies to secure tangible outcomes. chaebols that maintained a close relationship with the political authorities were able to grow fast.3 Subsidiaries of the 30 Largest Chaebols.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. In this sense. . This galvanized the fast growth of chaebols. the ownership and management of a chaebol’s subsidiaries are not separate. Since the Government controlled most business activities. and tax breaks to key industries to promote exports and industrial upgrading. the number of subsidiaries declined drastically due to corporate restructuring. Since the 1960s. However. financial assistance. Important managerial decisions are made primarily by owners. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. In the mid-1970s. of Subsidiaries per Chaebol 20.8 22. The Government provided subsidies.

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

370 70. the Government announced the gradual opening of the capital market to foreign investors in January 1981.4 40. was established to invest in domestic shares beginning in September 1985. The policy to expand the size of the stock market.9 34.476 79.217 141. 1985-1998 No..0 965. however. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused.798 Market Capitalization as a Ratio to GDP (%) 8.151 117.9 918. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. Third.1 16. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues. 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. As shown in Table 2. a country fund.Chapter 2: Korea 63 During the 1980s and 1990s. Also that year.1 30. especially those paying small or no dividends. Because of government policies and the booming economy.0 49.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. several important policy measures were implemented to promote the development of the stock market.570 95. the number of firms listed on the Korea Stock Exchange almost doubled in the five-year period from 1985 (342 firms) to 1990 (669 firms).4 654. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.020 151. continued until 1989. In this regard. First.989 137. Beginning 1990.0 79. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.4.5 406. Inc. Second.9 833.6 747. The aggregate Table 2.7 934.4 Development of the Stock Market. The Korea Fund.2 44. the stock market grew rapidly during the 1980s. .1 Market Capitalization (W billion) 6.

86 percent of GDP in 1997.414) 5. The relative size of the stock market diminished to 44 percent in 1990.658) (3.338 4.352 471 3. II market value of all listed firms represented only 8 percent of GDP in 1985.001 4.553 8.875 21.2 percent by 1989.296) (6.785 (1. Vol. due to declining stock prices.382 Permit basis. Other investments include loans.326 1.126 (1.453 (2.714 1.085 2.924 (1.852) (2.239 19.59 percent in 1998 and to more than 50 percent in the early months of 1999. The growth in the number of listed firms also slowed in the 1990s.642 21. The aggregate market value of listed shares bottomed at 16. . The number shrank for the first time in 1998 to 748 firms from 776 the previous year.008) (3.858 4.500 7.339) (9.571 2.255 2. 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. currency and deposits.737 (333) (297) (607) (2) 218 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. However. and 1993.953 10.450 24.870) (1.64 Corporate Governance and Finance in East Asia. Source: Balance of Payments.017) 1. and other liabilities.910) 2.583 25 10.5 Private Capital Flows to Korea.650 (1. Bank of Korea.868 (518) (418) 63 1.817 16. trade credits.141 4.433) (9.455) 13. and stayed at the 30-40 percent level up to 1996.183 12. but rose again to 34.944) 8. Table 2.546 (2. Table 2.542) (1. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis. but increased sharply to 79.942) 42.264) (3.440 1.413) 56.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.800 (7.123 3.742 (3. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.150 5.347 3.534) 1.287 (340) 73.694) 2.149 13.

The same categories will be analyzed in later sections. (ii) listed firms. Between 1986 and 1989. equity.9 billion. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. Net private capital inflow. and (iii) chaebols. but between 1988 and 1993. The growth rates of total assets. other net private capital inflows amounted to $130 billion during 1985-1998. but dropped in 1996 and were negative by 1997.5). The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. Korea had substantial current account surpluses and experienced net private capital outflow. following the sharp depreciation of the won.2.6 percent in 1997. Corporate sector net proft margins increased from 1993 to 1995. weak incentives for attracting FDI. Profit rates of Korean firms were relatively low compared to those of Taipei. Taipei. the growth rates of equity and sales dropped sharply in 1996 and 1997.Chapter 2: Korea 65 Complicated government regulations. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. Return on equity (ROE) and return on assets (ROA) showed similar patterns.7 billion and loans $42. However. The contribution of the corporate sector to GDP was 73.China. Table 2. The dismal performance of the Korean corporate sector compared to the . increasing to 76 percent in 1997. Japan’s was consistently higher. and US. In addition to FDI.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. excluding FDI. Of this. 2. The ratio is generally in the same range for Japan and Korea. This indicates that a substantial proportion of debt was denominated in dollars.6).7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. and sales of the aggregate sector during this period were very high (Table 2.2 percent in 1987. and high production costs were the main reasons for low FDI in Korea. This would lay the foundation for evaluating the effect of corporate governance on performance.China and the US. portfolio investments amounted to $73.

Source: Bank of Korea.6 9.1 — — — = not available.9) DER = debt-to-equity ratio.4 1.0 7. Note: Ratio of ordinary income to sales = (ordinary income/sales).3 14.8 2.9 2.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.4 4.9 8.1 8.2 9.9 5.2 1.7 3.0 4.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei. Table 2.4 1.3 17.9 3.5 2.6 318.6 1.4 19.8 22.3 11.6 (4.1 2.9 3.5 1.1 2.8) 297.0 13.3 3.7 4.3 312.9 2.9 18.9 13.9 16.3 1.4 2.3 6.2 13.2 13.3 — 3.4 2. ROA = return on assets (ratio of net income to total assets).9 5.0 0.7 15.6 4.4 1.6 1.8 3.9 18.5 4.7 1.6 13.0 305. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).4 — 6.2 19.2 1.6 3.0 6.5 3.7 3.5 1.8 1.0 10.7 2.3 308.2) (0.8 21. Source: Bank of Korea.3 21.0 3.3 335.7 325.9 5.9 2.5 1.2 18.1 5.3) 5.9 4.8 1.7 15.0 13. .1 2.2 1.4 10. Financial Statement Analysis Yearbook.8 8.5 7.6 Growth and Financial Performance of the Nonfinancial Corporate Sector. Net profit margin = ratio of net income to sales.6 424.4 2. ROE = return on equity (ratio of net income to stockholders’ equity).0 (0. 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 23.5 0.Table 2. Financial Statement Analysis Yearbook.0 8.6 2.1 6.3 21.5 4.9 16.5 (0.7 4.7 4.

but higher than that of small firms. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. Net profit margins. All sectors experienced a sharp decline in equity and sales growth in 1997. Growth rates of total assets are generally high. sales of listed firms grew 18. and steam supply industry.4 percent. The growth performance of large firms for the 1988-1997 period was better than that of medium. However. with the wholesale and retail trade sector and the construction sector having the highest figures. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. a year ahead of the other industries. trade. In most years. while their average net profit margin was lower than that of medium firms. the exception being the electricity. The other financial ratios follow the general pattern of the aggregate corporate sector.8). It is notable that the construction sector’s profit rate began its decline in 1995. and transport sectors recorded negative profit rates in 1997. Small listed firms were hardest hit by the financial crisis. The manufacturing. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. The profit margin of listed firms was generally higher than that of the aggregate corporate sector. both ROA and ROE were lower for the listed firms compared to the latter. However. ROEs.9). A comparison of performance by firm size reveals some interesting results.6).10). This may be related to its having the lowest DER. 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. gas. Again. followed by mediumsized firms and large ones. this may be an indication of the bias toward large firms in terms of access to credit. In 1997.5 percent while the aggregate sector recorded only 13.and small-scale firms (Table 2. the average ROE was lowest for large firms.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. Profit rates of most industries are also quite low. This preference of Korean firms has its roots in the structure of corporate governance. with equity in wholesale and retail trade even contracting. construction. Performance followed similar patterns across different industries (Table 2. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. .

2) (0.8 14.9 10.7 (0.3 15.4 740.4 10.3 18.4 291.8 10.9 0.4 2.8 526.7 514.2 16.0 18.0 37.2 241.5 306.6 655.6 14.0 19.6 7.6) 3.9 10.3 15.6 1.5 1.0 1.4 10.2) 15.4 3.0) 4.1 396.3 288.1 21.0 1.8 2.0 21.9 16.8 302.3 8.2 0.7 294.5 1.7 9.8 0.7 4.0 1.0 245.0 12.5 432.0 2.3 8.1 7.8 24.2 36.2 0.0 2.6 2.5 28.1 1.5 27.6 24.7 317.3 15.3 31.7 228.2 20.5 3.9 (0.7 1.6 12.1 2.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.9 (0.0 22.5 (0.7 0.5 13.8 2.9 538.0 5.8 461.1 10.1) 3.1 20.8 1.9 (0.8 13.3 11.8 3. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.4 17.5 286.9 2.4 2.5 473.4 14.4 2.0 22.8 14.3 15.5 239.6 17.4) 0.1 0.8 23.5) 0.4 (0.2 6.5 1.2 20.0 5.8 16.2 7.8 16.3 1.6 11.0 1.7 22.0) 1.4 1.0 (0.4 474.0 22.6 14.5 14.1 16.1 1.6 3.1 28.4 .6 12.2 12.7 30.2 5.9 14.4 2.9 16.6 3.8 24. Renting.5 5.4 15.4 4.0 1.7 10.2 (1.1 0.0 3.9 29.0) 0.1 22.0 2.0 254.3 25.6 0.1 (0.1 296.5 4.9 2.1 17.4 10.8 Real Estate.5 270.0 15.3 1.9 5.0 (0.5 569.0 9.0 7.2 25.0 15.8 1.9 25.0 16.8 7.0 (4.6 15.5 30.3 11.3 13.8 345.8 16.7 (3.5 483.7 21.5 338.3 10.4 5.Table 2.3 10.5 5.3 14.5 19.5 1.5 (1.2) 22.6 6.8 34.0 2.2 16.4 12.7 7.8 22.4 5.7) 2.5 16.8 17.2 5.9 13.2 15.2 0.1 290.8 12.0 18.0 1.1 27.3 285.2) 6.1 (0.0 24.4 458.8 35.6 1.5 1.9 428.4 350.0 16.1 1.7 16.3 2.5 1.1) (3.3 2.2 315.4 348.1 0.4 2.0 24.8 616.8 10.6) (6.6 0.8 22.9 340.4 1.9 19.3) (1.7 520.2 24.9 3.1) 0.4 0.3 14.0) 0.2 18.2 423.2 2.9 1.6 318.4 9.4 10.7 17.2 6.4 5.5 6.1 1.8 2.8 3.9 31.1 2.6 5.9 9.6 17.8) 0.5 23.5 6.8 0.3 8.8 32.0 23.6 375.8 562.9) 1.0 1.7 5.9 16.8 Growth and Financial Performance of Selected Industries (percent) Growth Performance Year Assets Equity a Financial Performance NPM b Sales DER ROE ROA Manufacturing 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 13.3 8.8 12.6 16.4 0.5 (5.6 14.2 5.

6 21.9 8.3 23.0 5.4 — — — — — 448.9 12.3) 15.7 0.6 16.3 4.7) (4.4 1.7 2.0 5.5 15.3) 4.9 9.9 9.3 4.4 14.3 543.8 4.6 512.2 10.6 8.5 15.8 111.0 1.5 2.0) (0.2 18.8 6.0 2.3 1. b NPM denotes net profit margin.3 0.5 539.8 12.3 (2.1 21.3 18.6 1.6 2.1 17.8 11.4 10.4 2.6 6.5 0.4 21.0 (15.4 12.0) 1.5 344.8 12.4 15.1 3.2 2.6 19.1 323.0) 1.0 14.7 — — — — — 14. .8 9.4 (0.3 12.3 0.2) 13.2 698. Gas.4 169.0 1.2 10.2 18.9 18.4 367.7 12.7 11.5 14. Source: Calculated using data from Bank of Korea.3 8.5 12.9 (10.5 4.8 8.6 18.4 2.4 0.3 3.4 341.2 14.5 8.4 1.4 1.4 633.1 (2.1 4.6 3.4 7.9 17.8 3.7 0.2 14.0 14.4 3.4 7.1) 1.1 16.6 4.9 8.0 (1.4) (1.2 122.3) (1.1) (0.6 — — — — — 17.2 18.7 11.0 21.1) 5.1 15.6 — — — — — 0.8 15.0 98.3 8.6 (2.2 15.0 7.5 (2.4 9.1) (0.3 740.3 4.6 20.7 187.4 (2.3 112.7 — = not available.2 7.0 89.7 7.6 9.8) (12.4 12.6 4.1 8.5 30.3 524.2) 9.4 11.9 4.2 3.6 34. Storage.7) 0.2 143.6 6.1 (11.6 (2.8 7.5 47.9) (8.9 Electricity.Table 2.1 11.5 26.1 1.1 11.3 18.7 7.6 9.4 13.8 (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 — — — — — 31.8 0.5 11.9 6.1 14.8 6.3 1.8 14.3 2.0 1.5 11.9 456.1 2.5 13.2 — — — — — 2.5 307.7 11.9 12.1 (0.6 172.6 8.4 6.7 116.6 12.5 16.2) 0.6 9.4 3.9 18.062.7 510.7 19.6 8.4 16.7 2.9 10.6 1.5 612.5 462. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.3 17.4 3.9 7.9 (11.8 0.3) 11.9 10.9 1.1 6.4 6.2 11.9 17.7 14.4 30.1 12.6 0.5) 22.9 4.8) 1.5 14.0 2.6 6.2 10.8 14.5 482.5 14.3 125.1 15.4 0. a New equity does not include capital surplus.9 3.3 19.3 34. Financial Statement Analysis Yearbooks.7 16.5 117.3 — — — — — 10.9 321.0 106.7 20.2 90.4 0.6 19. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.6 14.0 921.1 15.6 15.7 15.9 332.2 1.8 3.0 Transport.3 9.6 12.5 14.8 529.0 13.

In 1997. 1998. debts (47.6 and 2. The top five chaebols registered the highest growth rates. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10.8 24.8 6.6 3.7 1.8 0.4 0.3 20. Between 1993 and 1997. it is the chaebols’ large firms that are listed. followed by the top 6-10 (Table 2. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.6 23. but the number of designated groups has been fixed at 30 since 1993. II Table 2.3 (0.5 0.1 1.0 18. The criteria for selection of largest chaebols have changed a few times. the top 11-30 chaebols experienced a decline of . In 1995.0 3.9 2.1 percent of the economy’s total value added (excluding the financial sector). unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No. had 46 member companies.7 1.9 21.1 6.3 0. the largest chaebol.3 2.9 1.2 6.3 15.4 22.3 percent).4 1.4 1.7 percent) of the corporate sector. and close to half of total assets (46. Performance of Chaebols This section uses available data on the top 30 chaebols.2 0. Chaebols have been the most important actors and engines of growth in the Korean economy.9 6.5 ROA 0.2 9.5 19.6 2.6 0.5 ROE 3.5 19.9 Source: Constructed using data from Korea Investors Service.3 4. of which 16 were publicly listed (Table 2.6 (1. and net profits (46.9 11.9 Growth and Financial Performance of Listed Companies.70 Corporate Governance and Finance in East Asia.11). It should also be noted that when the financial crisis struck in 1997. Generally. The number of Hyundai member companies rose to 57 in 1997.7 (5. The smallest group had 16 members in 1995.0 0.9 26.9 2.8 5.6 1.2 9.6 22.9 0. the 30 largest chaebols accounted for 13.4) 1.12). Hyundai Group. sales (45. Kis-Fas.12).4 2. Vol.9 percent).2 2. 1985-1997 (percent.1) 4.5 5.1 1.9 percent). of which four were listed.7) 0.7 Net Profit Margin 0.4 1.

6 0.9 0.6 2.2 0.3 11.6 (1.6 1.4 3.6 13.4 3.9) (6.7 (1.8 0.5 5.0) 0.3 (0.3 6.0 4.7 3.1 2.5 17.8) 6.2 13.1 8.0 1.0 1.8 10.3 (0.5 (1.2 (0.8 6.5 1.9 0.0 6. Source: Korea Investors Service.0 19. 1998.5 3.4 2.5) 1.9 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.2 3. 1988-1997 (percent) ROE Large 9.2 12.8 16.6 8.7 2.8 6.3 Medium 14.8 0.5 5.4 16.1) 5.3) 0.9 (0.9 14.Table 2.7 18.3 15.1 11.1 1.4 11. Kis-Fas.2 13.0 17.4 6.6) 0.4 Medium Small Large Medium Small ROA Growth Performance Large 17.6 3.0 (4.3) 5.6 5.9 6. .2 2. Others are medium firms.6 (0.8 17.3 15.9 5.2) (1.3 9.6 7.8 (5.6 2.9 2.8 7.4 1.4 5.6 2.8) 1.9 1.6 1.5 0.2 7.2) (1.9 1.0 1.8 0.2 10.10 Growth and Financial Performance of Listed Companies by Size.2 Small 13.2 1.6 6.8 1.2 2.7 (1.0 10.7 2.6 1.9 22.5 25.0 1.0) 1.3 3.2) 0.1 0.9 6.9 25.6 0.6 3.9 3.8 3.3 1.7 4.6 9.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.1 2.9 0.4 1.5 2.7 1.0 16.8 0.5) 1.7 (0.4) 1.9 2.0 15.

131 3.924 2.177 — 6.346 3.996 1.597 351.376 35.423 5.445 4.433 3.766 3.967 7.090 6.929 12.455 22.756 5. 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.910 3.158 7.853 1997 53.651 38.677 3.873 2.995 2.287 10.427 9.364 5.574 3.147 5.309 14.475 2.398 — 2.370 6.313 14.951 3.458 6.690 3.774 7.927 16.395 31.303 3. Source: Fair Trade Commission.Table 2. .956 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.246 11.798 — No.486 6.117 4.129 2.501 13.640 4.457 14.743 40.180 2.990 2.11 Features of the 30 Largest Chaebols Total Assets (W billion) Name Hyundai Samsung LG Daewoo Sunkyung Ssangyong Hanjin Kia Hanwha Lotte Kumho Doosan Daelim Hanbo Dong-A Halla Hyosung Dongkuk Jinro Kolon Tongyang Hansol Dongbu Kohap Haitai Sammi Hanil Keukdong New Core Byucksan 1995 43.761 31.599 — 2.935 2.158 1.

5 (0.2 1.2 (2.3 3.3 0.9 3.6 4.5 2.1) 0.3 27.3 0.4 12.9 1. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.3 11.5 19.2) (2.9 3.9 20.1 (2.7 10.2) (0.8 Assets 12.12 Growth and Financial Performance of the 30 Largest Chaebols.4) 1.3 1.7 0.2 (2.6 18.2 3.3) 0.8 18.7 10.7 1.8 0.5) (0.0 19.2) 1.6 1.3 14.5 5.0 0.1 (1.8 27.4 (2.5 20.1) (0.7 15.2 11.7 4.1) 0.1) (0.Table 2.2 0.9 24.1 10.5) (0.5) (0.9 17.2 (16.0 2.1 19.0 17.0 0.6 (0.0 2.2 0.0) 3.4) (0.1 (3.0 31.3 1.0 2.5 27.4 30.4 0.2 0.6 25.9 20.2 (5.6 Financial Performance Net Profit Margin 1.1 27.3 9. .5 32.2 20.4) (14.7) Source: Bank of Korea.7 15.1 2.3 15.9 18.1) (1.6 19.0 1.7) ROE 5.0 6.4 26.0) ROA 1.7 13.4 38.3 19.3 16.0) 12.

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.” in Korea’s legal and regulatory framework.7 percent growth in total assets. However. in this instance. Their worst year was 1997 when ROE hit -15. includes the largest shareholder. his/her relatives. and government intervention interacted through a set of laws and regulations to bring about the existing structure.5 Founding families are mostly still the largest shareholders and. weak corporate control. . II 2 percent in their sales and a very low 4. the average DER of the 30 largest chaebols reached 519 percent. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector.13). There has been a wide range in DER among chaebols. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols.765 percent (Table 2.74 Corporate Governance and Finance in East Asia. from 190 to 3.” This “identical person.3. Ownership patterns. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. a pyramidal structure of corporate ownership is prevalent. technology. The absence of a well-developed equity market and the provision of subsidized credit. and access to credit. loopholes and inconsistent policies spawned strategic behavior and agency problems. By the end of 1997. 5 While “ownership concentration” can be defined and measured differently in different contexts. except for 1995. coupled with weak corporate governance. The Commercial Code stipulates the basic governance framework and applies to all corporations.95 percent. more important. However. chaebols had a higher average DER than the corporate sector as a whole.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. internal and external control mechanisms. resulted in the chaebols’ excessive leverage. The better showing of the top five chaebols was a direct result of their dominance in human resources. 2. 2. Only the top five chaebols registered a positive net profit margin in 1997.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. and led to a high concentration of ownership. In general. it refers to the degree of concentration and shareholdings in the hands of an “identical person. and vulnerable balance sheets. Vol. and the companies that are under the control of the largest shareholder.

13 The Top 30 Chaebols’ Debt-to-Equity Ratio. Ssangyong 7. Kohap 25. Kukdong Construction 29.2 423.7 620.1 674.6 516. Sunkyung 6. Dongbu 24.6 936. Doosan 13.2 924.2 471.3 328.5 2. 1995-1997 (percent) Chaebols 1995 1. Byucksan 1996 1. Hanbo 15.7 688.7 267.9 751.5 3.7 621. Hyosung 18. Kolon 21.5 464. Ssangyong 7.6 409. Hyosung 18.8 313.4 205.1 3.4 622.1 190.7 354.2 292. Hanil 28.4 556.3 315. Hanwha 10.0 486. Daelim 14.0 436.0 218.4 192.2 346. Hyundai 2. LG 4. Tongyang 22. Newcore 30.6 . LG 4. Kia 9.3 297. Daewoo 5.9 321. Dongah 14.7 416.Table 2.855. Doosan 15. Hyundai 2.8 312. Kumho 12. Samsung 3.8 336. Jinro 20. Hanwha 10.1 477. Hansol 17. Halla 17.0 506.2 2. Samsung 3. Dongah Construction 16.1 385. Dongkuk Steel 19.244. Hanjin 8.4 175. Haitai 26. Daewoo 5.2 328. Sunkyung 6.441.5 383.1 278.5 337. Hanjin 8. Kumho 12.065.6 2. Jinro Debt-to-Equity Ratio 376. Sammi 27. Kia 9. Hansol 23.5 343. Daelim 16. Lotte 11. Lotte 11. Halla 13. Dongkuk Steel 19.764.3 572.0 370.

13 (Cont’d) Chaebols 20. Financial Statement Analysis Yearbook.1 438. Dongbu 21.214.6 Sources: aFair Trade Commission.0 907.0 419.3 676. Hanjin 7. Kamgwon Industrial 30. Keopyong 29.6 335. Shinho 1997 1.1 472.784.9 578. Hyundai 2. Newcore 26.5 576.3 347.9 465.9 216.3 1.9 490.7 370.6 478. Dongkuk Steel 20. bBank of Korea.7 944. Lotte 12. Daelim 14.8 399. Haitai 25.9 472. Hanil 28.5 (893. .6 590. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Dongbu 23. Kolon 19. LG 5.498.5 519.225.9 1.Table 2. Anam 27. Newcore 28.5 261. Kohab 18. Hansol 16.0 305.6 424.1 375.8 347.8 468. Daewoo 4. Dongah 11.0 505.1 359. Shinho 26.8 338.3 399.8 590. Halla 13.8 307. Anam 22. Ssangyong 8.7 1. Tongyang 24. Miwon 30. Doosan 15. Tongyang 24.6 416.4 1.8 647. Kohab 22. Hyosung 17. Kolon 21.4) 513. Jinro 23.8 658.5) 404.5 323. Hanwha 9.600.501. Samsung 3. Keopyong 29. Daesang 27.5 386.5 1.5 (1. Kumho 10. Haitai 25. SK 6.1 433.

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

0 5.1 10.5 1989 498 0. Listed Nonfinancial Companiesd 1988 406 0.2 B.9 4.1 17.3 2.6 13.5 6.9 1. b “Banks.2 8.3 5.8 5.3 1.7 18.6 16. a The State covers the Government and state-owned companies.1 2.4 Insurance Firms Other Corporations Foreigners Individuals 39.4 5.3 1994 521 1.3 17.3 1.9 37.5 7.3 18.8 59. of Firms The Statea Banks.4 18.5 Note: Ownership is based on number of shares.6 2.4 34.6 20. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.9 17.0 28.0 5.1 18. .1 8.1 1.4 1997 551 1.3 39.1 18.7 3.b A.5 18.2 5.7 9.” includes commercial banks.0 8.1 11.3 26.5 60.0 27.0 4. d Constructed from data files of the Korea Listed Companies Association. and finance companies.2 5.1 3.1 68.9 5.8 4.7 14.3 8.9 1.4 13. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.8 59. etc.4 14.9 26.4 6.9 15.6 8.4 13. c Data from Korea Stock Exchange.8 2. merchant banks.7 1990 531 0.2 9.8 5.3 18.7 9.1 4.8 1995 548 2.2 4.2 2.3 1996 570 2.0 7.14 Ownership Composition of Listed Companies.9 2. investment trust companies.2 1.7 6.6 36.5 1.8 2.2 8.6 19.4 5.9 19.6 22.6 9.6 1991 505 0.7 4.9 2.5 12.8 69.0 60.2 17.6 16.2 1993 511 2.1 60.1 8. mutual savings.Table 2.7 7.5 1. etc.0 59.7 59.9 36.0 9.3 5.6 9.5 6.1 21.8 17.5 7.5 1992 508 2.2 9.5 16.2 7.5 62.6 Year No.7 8.6 12.1 21.3 17.2 18.2 3.6 16.5 4.8 17.

Before such liberalization. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. and service of motor vehicles (Table 2.18).8 percent of listed shares in 1997. foreign holdings were derived from purchases through country funds and direct capital investments. This is low compared with those in Japan. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. Corporate holdings averaged 16 percent throughout 1988-1997. The holdings of other corporations are mainly equity investments in affiliate companies. electricity. indicating their heavier reliance on inter-firm financing investments. and small companies. Individuals held the majority of the shares in all industries except in telecommunications. government ownership in nonfinancial companies was remarkably smaller and more concentrated. financial institutions had more shares in the manufacturing sector than in primary industries. However. UK. The ownership distribution in listed nonfinancial firms. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms. 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. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions.16). categorized into large. other corporations’ holdings shifted toward service industries. held 26. In 1998. as distinguished from individual and foreign investors.Chapter 2: Korea 79 ascribed to prudence in staying away from the stock market—as part of their risk management strategy—as the stock market was in doldrums throughout the 1990s. medium.15). of some banks. did not vary significantly (Table 2. and US (Table 2. In general.17). Over the years. indicating their increased investments particularly in the service industries with high growth rates. whether partial or absolute. Compared with its holdings in all listed companies. In most instances. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . This trend can be explained by government ownership. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. the Government was the sole owner. Institutional investors.

5 85.4 8.9 42.0 0.8 3.7 14.0 2. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.1 27.5 4.4 1.5 — 1.7 2.9 52.8 Individuals 83.1 1.4 1.3 1.1 7.2 9.8 7.7 2.7 1.2 9.8 7. and App.2 1.5 0. Elecl Mach.3 4.1 65.1 8.9 0.0 7.8 7.5 7. Paper.7 63.9 60.4 0.3 38.4 5.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.6 5.4 2.7 2.2 1.2 54. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.9 15.0 9.9 16.3 9.3 0.3 57.8 3.0 8.3 0.0 9.8 6.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.1 0.1 88.1 8. 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 . Etc.5 — — 0.1 0.3 1.4 56.5 — 0.1 19.4 62. Rubber.4 56.6 1.Table 2.9 19.0 9. Motor Vehicles Electricity.2 9.9 1.9 23.3 2.7 6.2 0.2 7.3 0.6 11.2 0.3 10.9 66.4 Banks.5 0.3 13.7 59.9 55.9 1.8 1.3 6.5 3. and Printing Pulp.2 64.7 22.15 Ownership Composition of Listed Nonfinancial Firms by Industry.9 59.8 7.2 22.9 10.8 5.0 — 0.4 — 0.3 7.8 7.1 4.3 2.6 24.5 6.2 0.2 0. and Printing Chemicals.3 11.9 4.3 62..0 1.0 10.7 29.5 12.2 2.0 — 39.5 0.8 8.4 7. Gas.2 17.0 20.1 10.5 19.7 20.6 8.4 8.7 17.4 8.7 20.5 17.7 22. Paper.6 — — 2.0 9.1 0.4 14.2 — — 0.7 14.6 3.9 8.8 73.1 0.2 — 0.5 0.7 64.6 18.

2 0.9 7.6 1.6 6.0 60.1 1.7 23.6 14.2 4. Note: Ownership is based on number of shares.2 1.2 1.6 0.0 11. and Printing Chemicals.3 65.8 57.9 6.3 7.5 59.2 13.8 27.0 3.5 3.6 75.5 3.7 2.9 6.5 0.9 5.1 4.7 2.4 1.7 5.5 3.9 1.1 9.5 6. etc.7 6.2 4.1 — 1. a The State covers the government and state-owned companies.2 5.4 4. .4 2.9 2.9 1.5 12.0 1.3 57.6 60.2 5.9 69.4 43.9 2.8 3.1 25.1 3.1 2.1 2.6 2.3 6.8 2.5 — 2.0 8. Gas. and finance companies.8 0.5 1.1 18.4 1.4 58.4 68.4 9.8 0.4 1.2 4.2 23.0 7.3 31.4 — 1.1 54.1 1. merchant banks.3 2.9 57.5 4.6 0.5 5.9 18.4 76.4 4.8 12.3 60.1 9.3 15. Elecl Mach.6 20.5 4.2 4.7 17.4 2.9 1.9 2.8 54.1 6.8 11.6 3.3 1.9 20.2 49.3 1.3 8.6 18.7 19.3 6. and App.6 59.5 3. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.4 58.9 20.7 2. and Printing Pulp. Paper.9 7.4 16.7 2. b “Banks.7 4.4 2.4 3.2 0. Motor Vehicles Electricity.9 5.” includes commercial banks.8 2.3 0.4 0.2 8.0 6.0 6.0 43.7 1.6 6.2 3.6 5.0 5.0 4.78 81. Paper.5 7.2 6. investment trust companies.6 7.6 2.9 78.9 0.5 63.9 2.8 4. mutual savings.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood. 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 2.4 20.1 — 0.4 45.6 2.8 5.2 7. Source: Constructed from data files of the Korea Listed Companies Association. Rubber.4 6.1 3.8 5.8 6.6 — = not available.

b Table 2. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.4 2.9 4.4 61.7 1.5 19.4 5.8 3.8 1.5 2.4 4. merchant banks.4 1. Securities Firms Insurance Firms 2.0 6.8 2.8 4.5 6.7 Foreigners 4.1 Banks. 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.7 8.5 62.4 5.9 2.4 61. etc.5 4.5 16.8 4. investment trust companies.16 Ownership Composition of Listed Nonfinancial Firms by Size. .3 Banks.1 6.8 6.7 Control Type No.0 Other Corporations 16.8 60. 1997 (percent) The State 1.5 Individuals 60. etc. 1997 (percent) The Stateb Foreigners 4.7 4.9 5. mutual savings.6 60.7 0.7 6.4 17.5 8.4 21.1 8.1 2. The State covers the government and state-owned companies.4 2.0 1.Table 2.4 Firm Sizea No.6 16.” includes commercial banks.5 18.3 6. etc. and finance companies. c “Banks. Others are medium firms.c Securities Firms Insurance Firms Other Corporations Individuals 58.2 1.17 Ownership Composition of Listed Nonfinancial Firms by Control Type. Source: Constructed from data files of the Korea Listed Companies Association.

defined as those holding less than 1 percent of shares. investors (Table 2.18 Ownership Composition of Listed Firms in Selected Countries. This has had profound implications for corporate governance and the market for corporate control in Korea. 1997 (percent) Country Japan Korea Taipei.5 20. rather than the individual.3 54. only closed-end investment companies and traditional investment trust companies are allowed. his/her family members.1 financial institutions’ establishment of corporate pension fund accounts. the majority shareholder group in all listed companies consists of the corporate.6 Foreigners 9.20). In 1997.3 47. and the companies under the control of the largest shareholder. Foreign holdings of Korean shares were 9.5 45. At the moment. Institutional Investors 42.8 10. minority shareholders. Among nonfinancial listed firms.19). Generally.China United Kingdom United States Source: Stock Exchange of Korea.6 39.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.4 26.8 9. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. 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. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. corporations held 70 percent of the controlling blocks of shares. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. But these may .6 Individuals 23.8 56.1 8. including those of the largest shareholder.7 16.3 6. for example. while family members accounted for only 30 percent.

0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.4 3.8 73. 1992-1997 (percent) Majority Shareholders Corporation 15.1 15.3 30.6 5.3 18.9 2.0 1.9 Individual 2. Minority shareholders are those holding less than 1 percent of shares.2 Minority Shareholders Subtotal 71.6 46.0 4. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.3 2.6 22.6 73.0 69.7 6.3 Subtotal 5.8 8.1 14.Table 2.6 2. .1 21.4 5.9 3.8 72.7 16.1 23.1 5.9 6.0 22.1 28.1 4.0 29.4 7.0 25.19 Ownership Concentration of All Listed Firms.9 32.2 26.1 37.1 32. his/her family members.9 33. and the companies under the control of the largest shareholder.5 43.7 44.7 18.0 66.0 2.2 2.8 Individual Subtotal Other Shareholders Corporation 3.1 5.7 Note: The majority shareholder includes the largest shareholder. Source: Stock Exchange of Korea.7 7.6 26.9 7.2 2.

Majority ownership is also high in the chemicals.9 29.9 48. In such cases. and mining categories.1 50.3 25. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.8 28.21]).6 57.6 58.9 Other Shareholders 18.20 Ownership Concentration of Listed Nonfinancial Firms. In telecommunications.0 20.9 25. The practice of hidden shares seems to have been less prevalent in recent years.8 Majority Shareholders 27. It was highest in medium-sized firms before 1993 and.8 25. which held less than 1 percent of a company’s outstanding shares as of 1997.6 11.5 60.5 12.9 12. 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.0 58.8 12. in the small firms. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.9 27.7 18.22). Besides. hiding shares offers no additional tax or other benefits.2 15. Meanwhile.5 23.8 54.0 22. the Government has retained a large number of shares. ownership was relatively diffused due to government regulation. thereafter. Across industry. 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.Chapter 2: Korea 85 Table 2.8 57. Ownership concentration tended to be lower in large compared to medium and small listed firms. In most industries.5 13. 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. minority shareholders. rubber and plastics.3 62. collectively owned less than 50 percent of an average firm.4 28.4 Source: Constructed from data files of the Korea Listed Companies Association. . the majority owner held more than 20 percent of an average firm.4 23.

and Printing Pulp.7 17.8 41.3 39.9 10. Paper.2 19.7 29.21 Ownership Concentration of Listed Nonfinancial Firms by Industry. and App.5 20.7 21.7 24.7 36.7 27. 1997 (percent) Number of Firms 3 2 43 49 12 16 90 39 31 71 34 8 9 49 40 15 1 10 29 551 36.2 48. 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 44.8 24. Elecl Mach.6 25.4 11.6 19.4 16.4 53. and Printing Chemicals.9 44. Rubber.2 46. Gas.1 49.2 20.0 51.6 38.2 22.8 51.5 47.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.2 23.0 21.5 41.2 26.9 Minority Shareholders Majority Shareholders Other Shareholders 12.1 17. Motor Vehicles Electricity.Table 2. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.3 26.5 23..5 52.7 26.5 16.9 26.8 29.1 19.0 30.3 19.0 39.6 34.8 21.8 55.2 34.8 44.1 43.6 53.5 21.5 19.6 50.8 31.2 37. .0 54.8 25. Paper.

9 55.5 19.8 52.3 25.6 15.0 55.8 50.0 26.9 16.5 49.7 31.3 21.4 30.4 21.9 17.7 16.2 21.2 32.2 56. .8 11.4 47.5 26.6 24.4 30.1 20.5 21.8 52.1 27.2 12.0 66.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.2 52. 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.4 29.9 12.5 51.5 12.5 12.8 28.6 11.0 24.8 62.6 31.1 48.9 21.9 56.4 30.2 11.6 27.5 19.3 26.7 57.0 59.6 55.5 10.9 53.2 Majority Shareholders 26.5 33.7 22.9 60.2 26.8 17.2 50.5 27.7 57.9 26.2 21.9 23.5 Other Shareholders 19.1 16.8 56.4 51.7 15.2 Source: Korea Listed Companies Association.7 28. 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 53.3 27.8 27.2 55.5 28.2 18.1 15.1 58.9 28.6 59.6 65.9 22.6 62.7 17.2 21.3 19.7 14.Table 2.3 55.

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

Chapter 2: Korea 89 guarantees from other members of the group at no cost. for example. 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. Among the subsidiaries or firms receiving investments. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. and 319 foreign subsidiaries. 62 percent (16 out of 26) had a corporation as the largest shareholder.5 percent. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. Until recently. Of the 81 respondents. In the case of the 30 largest chaebols.5 percent as of 1997. or an average of 13 firms per company. Thus. the average shareholding of the controlling owners and their families was 8. 59 parent companies collectively had investments in 759 firms. together owning an average of 37. For the same year.5 corporations and two individuals.23.14. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place.4 corporations. although they are likely to be insignificant. 34 percent were foreign companies. Thus. In Table 2. or about four firms each. 59 were parent firms with one or more subsidiaries. not individuals. The extent of pyramiding can be seen in some of the previous tables. For the whole sample. Among the 81 listed firms in the ADB survey. standalone setups. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. If we define the internal shareholdings of a .9 percent of shares. Among chaebol affiliated firms. the top 30 chaebols’ shareholding by subsidiaries was 34. Partial results are shown in Table 2.5 percent of shares. Twenty-two of the 81 respondents were independent. there are instances of direct cross-shareholding in Korean firms. and about 11 percent were domestic financial institutions. together having a total of 292 domestic subsidiaries. or about five subsidiaries each. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. 53 percent were domestic nonfinancial firms. together owning an average of 38. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. The fact that corporations. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. In many instances. the top five shareholders consisted of 2.

1 22.3 12.3 26.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.0 3.5 1.8 8.5 4.6 16.2 37.9 21.6 3.5 4.5 2.0 1.8 31.0 17.4 42.4 25.4 1.5 2.7 39. a Number of shareholders.5 2. b The chaebol affiliated firms are those belonging to one of the 30 largest groups. .23 Ownership Concentration in the Survey Sample of 81 Listed Firms.7 19.6 3.7 0. 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 25.4 21.1 1.0 2.6 34.Table 2.5 2. A few companies reported less than five largest shareholders.8 38.7 5.8 37.8 18.0 21.7 37.9 34.5 24.6 3.4 11.9 5.0 3.5 31.4 38.0 1. 1999 Five Largest Shareholders No.4 2.4 18.0 13.1 3.9 29.5 18.5 38.

2 12.5 percent and member companies.5 Judging from the historical record. “Japanese Zaibatsu and Korean Chaebols.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group.6 33.4 13. pp.2 1994 42.” Paper presented at the Annual Conference of Financial Management Association. New York: Praeger. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. Lee. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. 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. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.4 1993 43. H.5 34. As of 1997. Chung and H.7 9. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. the controlling families owned 8.24 Internal Shareholdings of the 30 Largest Chaebols. Hattori (1989) identified three patterns based on data in the early 1980s. edited by K.7 1992 46. the ownership patterns can be described as follows. 1998. . 15 October 1998. 1989.8 33.8 40. Based on these studies.4 1990 45. Ungki Lim. 6 7 Hattori. 34.1 1997 43. C. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. The family and member companies’ shareholdings have been declining over time. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. Tamio. Lee. Jae Woo. 1987 56. Table 2. it appears that the chaebol families have had a strong desire to expand their business bases.0 8. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols.24 shows the average internal shareholdings in the 30 largest chaebols. Chicago.2 33. 79-95.7 31. 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.2 15.” In Korean Managerial Dynamics.4 10.5 percent. 1997. Table 2.

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

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

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

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

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

a blue-ribbon committee.2 percent and the CEO 14. Directors were also chosen on the basis of their relationship with the controlling . Meanwhile. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. this committee adopted the Code of Best Practice in Corporate Governance.5 percent of the shares. having no controlling shareholders. the Corporate Governance Reform Committee. ADB Survey Results on Boards The ADB survey results confirm the above assessments and provide early indications on the effects of the reforms.9 percent on average. the chairperson of the board was also the CEO and on average held 10. inside directors owned 16. 88 percent had plans to hold elections in the near future. These results are in accordance with the new listing rules introduced in 1998. Among the firms with no outside directors. In September of the same year. Where the two were separate. the Korean Code recommends that large listed firms should have at least three independent directors. an audit committee. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. which had extended financial support in their recent recapitalization efforts.1 percent and outside directors 1. The Securities and Exchange Act will require large listed firms with W2 trillion or more in total assets to adopt the audit committee system. In 78 percent of the responding firms. On average. The average board had 8. Where the chairperson was not the CEO. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. they had a parent/child relationship in 20 percent of the cases. This is because most banks.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies.1 percent of outstanding shares of a listed company. In March 1999. although some banks recently have established board committees. who would comprise at least 50 percent of the boards. The controlling shareholder of some banks is the Government. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). he or she held 6.4 directors. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. Among others. and a nominating committee. are required to have a majority of outside directors.

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

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

One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. This action was in response to calls by international investors and. from IMF and the World Bank. 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. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. Vol. Senior managers were even often called directors although they were not official members of the board.100 Corporate Governance and Finance in East Asia. and accounting standards. in particular. 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. it was common for all senior executives to be elected as directors at the shareholders meeting. However. but in practice is fixed and understood as part of a fixed salary. executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. and . disclosure. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. The commission has played an active role in introducing new rules on corporate governance. 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. Penalties for fraudulent financial reports were increased. Korean firms have rarely used shares for executive compensation. II Senior Executives In the past. The bonus is supposed to be linked to company performance. (ii) establishment of accounting standards for financial institutions. Incentive stock options have become a popular compensation method since the Securities and Exchange Act was amended in 1996 to allow the issuance of stock options to managers and other employees. 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.

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

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

or telephone. Approval of mergers and major divestitures. However. The Depository represented 20 percent of the shares attending the meetings. corporations cannot issue common shares without voting rights. Thus. However. One common share should have one vote. respectively. 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. A total of 326 shareholders per firm. The securities companies and banks are the second and third. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. Internet. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. No companies have so far introduced voting by mail. The management is the most important proxy.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code.79 percent of the shareholders. for some firms. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management.3.21 percent of total shares issued. Under the Commercial Code. the Depository is instrumental in getting resolutions passed. These voters represented only 5. The Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally. and dismissal of directors and internal auditors require a “special resolution.77 percent of the shares. charter amendments. amendments of the articles of incorporation require a “special resolution.53 percent of the total shareholdings. attended the last annual general meeting. or 10. in general.Chapter 2: Korea 103 2. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). small shareholders do not attend the annual meeting and that. The above results indicate that.” The survey shows that the Korea Securities Depository holds 69. the Depository is subject to “shadow voting.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. About one fifth of the listed firms issued nonvoting preferred shares. representing 62. This shows that a relatively larger number of shareholders send in their proxies.93 percent of the shareholders but 26.” Companies can increase the number .

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

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

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

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

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

turning to white knights. For takeover defense. Takeover Activity As soon as the Act was amended. more than half of these attempts failed. However. Unlike the UK. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998. Companies have also utilized share repurchases. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. Unlike Germany. a total of 13 hostile takeover attempts occurred. As far as institutional arrangements are concerned. and announcing competitive tender offers by the controlling shareholder. Between 1994 and 1997. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. . It was generally believed that the securities authority would use its power to review and order revisions of the tender offer statement to halt any hostile takeover attempt. an acquirer of shares wishing to own more than 25 percent of the issued shares was required to make a tender offer to buy at least 50 percent). In one case. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. hostile takeovers by tender offers began to appear in the capital market. it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. but were completely eliminated in 1998. 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. listed firms rely mainly on shareholdings by the largest shareholder. The reasons for failure are diverse. 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. Privately placed CBs cannot be converted into shares in one year. Stock purchases by tender offer were also exempted.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. A company cannot issue new shares to a third party without first amending the corporate charter. In the early 1990s the Government shifted its policy toward freer activities in the market for corporate control. Publicly issued CBs require three months before their owners can convert them to shares. corporations cannot limit the voting rights of large shareholders to a given maximum.

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

Meanwhile. especially those belonging to chaebols. Labor is not represented in corporate boards. It was abolished before the economic crisis but another regulation. only qualified firms could issue new shares. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. Even where employees hold . The Government’s right to send public officials to the boards was eliminated. 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. administering through a self-regulatory committee of the securities industry. The Government has frequently imposed restrictions on the use of capital markets by large companies. each of the 10 largest chaebols was allowed to raise funds no more than 4 percent of the total market capitalization of the member firms. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. But this rule. which limits the total amount of bonds issued by the five largest chaebols. more state-owned corporations became subject to this new board structure. as applied to four large corporations. the main bank system. In addition. For example.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. There is no active debate or discussion going on about this potentially difficult issue.1). The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. and approved by the Chairperson of the Planning and Budget Commission.3. The nonexecutive directors are now recommended by a committee. 2. Beginning in 1999.3. the Government. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. which was introduced in 1996. Further. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. nominated by the minister in charge of the company in question. There were also limits on the amount raised and the number of issues per year. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market.

Two thirds of the respondents had an organized union. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. and 2. of which 2 percent were senior managers. Local unions in the same industry have established industrial labor federations. Under another law enacted in 1972 to induce private companies to go public. in principle. The union had no influence on the management in 17 percent of the firms. In actuality. II shares of their companies through employee stock ownership plans. employers are required to meet with representatives of labor unions at least once every three months.9 in 1980.654 employees per firm on average. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. which were generally much lower than estimated values. In 1987. In 70 percent of the firms with organized unions. Under the Labor Management Council Law. The respondents of the ADB survey had 2. but 27 percent of them felt that it was strong. Vol.5 in 1990. . Under the Capital Market Development Act of 1968. there are two federations of labor unions. 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. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices.1 in 1997. operation. carried out at the enterprise level. they delegate their voting rights to plans’ representatives. At the national level. Collective bargaining is.112 Corporate Governance and Finance in East Asia. the council meetings have been superficial. and 66 percent manual workers. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. 2. The relevant regulation was amended recently in order to facilitate voting by individual employees. union members account for 54 percent of the employees. and development of the company. The typical collective bargaining agreement has a one-year duration. About half of these firms considered the influence of the union on the management of the company to be weak. the management usually consults the union on major issues relating to the management. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. In these firms. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. 32 percent technicians and professional staff. The percentage of shares held by the employee stock ownership plans in listed companies was 1. Trade unions are organized on an enterprise basis.

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

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

This means that internal funds after dividend payment were insufficient to finance growth in total assets. and 1997. was 71 percent during the period. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. but it remained less than 10 percent of total financing. 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. In 1988 when the stock market boomed.Chapter 2: Korea 119 and net capital transfers from the Government. Financing Patterns of the Aggregate Corporate Sector Table 2. Securities finance became a more important source from 1988 onwards. The corporate sector used . particularly in the 1990s in response to the liberalization of the capital market. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets. except for the stock market boom of 19871988. The SFR averaged 28. including all sources other than retained earnings. depreciation. capital surplus.26 shows the four measures of corporate financing calculated from Table 2. 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. Table 2.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. the corporate sector’s most important source of external finance was bank borrowings. financing by corporate bonds and CPs was more significant than by new equity. The share of external financing. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. Meanwhile. and allowances) and new equity capital. the proportion of foreign borrowings in total finance rose steadily. It measures the degree of financing growth in total assets by additional equity. Before 1988.4 percent in the precrisis period 1988-1997. depreciation. 1994. Equity capital represents the shareholders’ commitment to the business. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. comprising internally generated capital (retained earnings. particularly in the short term. and government transfers. In securities finance. It measures the degree of financing growth in total assets by additional debts. on average. except in 1991.

1 17.0 3.0 22.1) 6.4 0. 1988-1997 (percent) 1988 43.7 — — — — 9.5 0.4 27.7 14.7 10.3) 11.7 73.8 0.4 2.7 11.7 15.8 8.7 10. .2 34.8 4.5 2.8 1.3 2.5 16.2 (0.1 3.6 14.6 3.5 2.9 10.0 70.9 9.1 27.3 3.9 2.2 1.2 — 28.1 0.1 0.0 — — — — 8.5 13.6 9.0 9.0) 12.6 8.4 11.7 2. which is the excess of current value over issue value of stock.2 0.6 25.3 6.1 1.7 6.2 13.9 34.3 5.4 9.6 0.3 72.7 12.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.7 32.0 5.6 1.8 56.1 2. a Includes retained earnings.8 1.1 72.9 28.3 10.0 (0.7 1989 1990 1991 1992 1993 1994 1995 1996 22.6 3.3 30.1 1.6 4.9 0.4 (0.5 29.4 71.4 27.3 1.1 — 27.7 14.7 13.4 2.0 9.7 71.6 4.0 11.6 77.8 1. 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.7 1.2 15.7 4.8 1.1 12. Source: Understanding Flow of Fund Accounts.2 6.4 2.6 9.1 8.8 30.1 (1.7 1.6 0.2 26.2 2.7) 11.1 36.9 38.4 (2.7 4. depreciation.2 13.4 — 28.6 0.8 15.4 15.7 8.0 3.3 3.5 2.0 2.4 8.1) 4. Bank of Korea.6 10.Table 2.0 17.8 1.0 3.7 7.25 Flow of Funds of the Nonfinancial Corporate Sector.4) 13.1 1.0 0.5 16.4 3. 1994.0 0.3 16.6 4. Bank of Korea.6 (0.0 1.9 72. and Flow of Funds.6 5.2 14.2 6.2 5.1 3. and net capital transfers from the Government.6 11.9 10.6 11.1 2.5 0.1 (0.7 (0.6) 5.4 27.0 16.1 10.5 0.2 — — — — 9.3 6.0 10.6 0.3 — 30.7 2.8 17.6 2.7 10.3 — — — — 8.5 9.4 21.8 27.7 8.2 10.4 1.4 10.7 2.3) 15.4 2.8 (0.6 9.3 27.1 — — — — 12.3 6.8 -2.5 2.9 73.3 25.4 0.1) 4.4 1.3 1.8 — 26.9 6.0 1997 26.1 3.3 1.1 23. b Includes capital surplus.

0 42.6 Excludes capital surplus. Across industry.3 73. and the total debt ratio was much higher in 1996 and 1997 at 62. the corporate sector relied heavily on external financing for its expansion.9 60.3 12. in the manufacturing sector.6 percent over the 10-year period. Source: Calculations from Understanding Flow of Fund Accounts. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.26 Financing Patterns of the Nonfinancial Corporate Sector. average SFR was 37.7 28.3 59. respectively.4 37.2 IDFR 36. 1994.4 NEFRa 20. Bank of Korea.7 9.4 percent (Table 2.8 28.5 68.5 31.9 percent by 1997 when net profit margins were negative. On average.4 percent.5 percent.9 46. 45.6 26.6 62.5 and 76. and Flow of Funds. and IEFRs were declining.1 39.5 12.5 percent in 1997. NEFRs. SFR peaked at 44 percent. Its IEFR and NEFR dropped to 23.1 12.1 percent in 1988 during the stock market boom.27).3 11. Manufacturing financed 54.0 5. higher than the aggregate 40. higher than the aggregate 28. While SFRs.1 53.1 17.3 percent in 1997. dropping to 26.7 40.3 59.6 percent and 1.0 27. additional equity to finance 12.2 percent of incremental asset growth was financed by equity.2 percent of the growth in total assets.9 22.8 10. IDFR reached 73. was financed by additional debts.2 37.1 26.4 27.8 percent of its total asset growth through debts. There were significant time trends.7 40. The balance. declining to 26.7 26.0 11. Incremental financing from equity was 40.6 percent. In periods of high economic growth such as in 1988.4 12. but also continuously fell.7 30. Lower income diminished the industry’s equity position toward crisis year 1997.6 percent. respectively.7 40. but plunged to 5.3 60.9 28. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43. NEFR registered 20.0 57. . It dropped to 28 percent the following year. indicating a high financial risk position.Chapter 2: Korea 121 Table 2. an average of 59. Bank of Korea.3 27.4 percent.7 percent in 1997.8 62.4 IEFR 63.

8 50. Since 1992. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. then increased to 20. II The construction industry showed the most cyclical pattern in annual asset growth.7 37. large firms showed more cyclical patterns in these financing ratios than small. Since large firms were more profitable.2 3.4 46.6 4. and hotels sector and realty/renting/business activities sector were similar.2 5.4 3. Total debt financed an average 74.5 76.4 63.9 percent.6 37.6 53.and medium-sized firms.9 6. this dropped further to 15. the utilities (electricity. the proportion of short-term borrowings in total financing has been high.2 .6 37.7 47. Vol. and steam) and the transportation. retail.8 percent in crisis year 1997.5 23.3 52. On the other hand.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 50.4 54.1 29. which decreased to 8. their average SFR was higher. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.7 percent in 1996.0 3. and communication sector had relatively high incremental equity ratios.4 45.1 percent of total asset growth for the period.6 36.8 4. explaining partly the collapses of several construction companies in 1995. Equity financed an average 25.0 57.7 37. In 1997.3 28.2 21.4 37. It had the highest average SFR in 1988 at 31.8 percent in 1990.6 54.9 percent of asset growth. from 17.7 47.8 IEFR 65.5 1. the two sectors also had low equity financing ratios and high debt financing ratios. one year ahead of the other industries.6 62. gas. and low total debt and short-term borrowing ratios.6 3. and fell to about 10 percent in 1997.2 percent in 1993. Table 2.4 47.0 42. Categorized according to company size.5 7.5 NEFRa 9. storage.6 53.0 42.122 Corporate Governance and Finance in East Asia. Financing patterns of the wholesale.0 30.6 45.2 62.9 IDFR 34.

1 59.7 15.0 60.9 20.9 33.0 65.8 54.5 1996 42.0 1992 24.8 1994 15.1 70.2 3.0 3.1 Trasport.3 4.9 9.7 42.5 20.9 1.9 1989 63.0 34.9 30.1 84.5 12.2 25.5 29.0 40.6 4.1 66.3 8.7 6. and Communication 1988 64.5 21.2 20.2 23.1 1991 14.2 Average 53.8 1991 51.2 46.6 8.5 62.8 9.1 19.2 1995 16.0 17.0 4. Storage.7 7.6 9.1 69.7 53.2 74.9 Average 19.4 IEFR 46.7 80.0 0.8 29.6 7.Table 2.9 16.6 8.27 (Cont’d) Year SFRa NEFRa IDFR 53.9 1992 56.5 23.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.7 1989 26.2 4.2 10.6 2.5 1993 22.3 10.1 25.2 29.0 10.4 2.5 76.3 21.8 74.3 19.8 76.8 70.3 4.6 71.6 37.6 14.6 73. Household Goods.9 80.0 82.7 15.3 1996 16.0 1990 12.1 4.7 1997 8.4 28.7 Wholesale/Retail Trade.2 70.0 74.9 15. Hotels 1988 33.5 87.9 1.2 18.9 29.7 41.0 1.9 52.0 31.9 1993 63.4 1995 53.3 47.3 7.2 8.7 1994 53.3 84.9 1.8 4.5 1.0 68.4) 2.0 .6 1997 29.3 (9.0 1990 50.4 26.8 81.9 47.2 5.7 78.4 62.7 78.8 25.8 2.9 2.5 70.6 9.3 57.6 37.

7 1996 18.8 1990 19.4 (107.3 7.8 1993 11.3 3.27 (Cont’d) Year SFRa NEFRa 6.0 0.3 31. IEFR = incremental equity financing ratio.3 85.8 36.7 69.3 29.4) 3. The large firms had a higher proportion of external financing in 1996-1997. Vol.4 1996 45.4 1995 62.1 34. Financial Statement Analysis Yearbooks.8) 7. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this. and Business 1988 51. NEFR = new equity financing ratio.and mediumscale firms. Gas.8 135.3 81. The trend was reversed in 1996-1997.1 1991 56.0 (0.5 8.8) (35.6 1990 82.9 29.0 33. II Table 2.9 65.4 0 0 0 0 1. Source: Calculated using data from Bank of Korea. Renting.124 Corporate Governance and Finance in East Asia.5 77.4 IEFR 69.0 21.6 1.1 71.9 57.4 7.0 43.2 63.and short-term borrowings of these firms shot up in that period.7 1994 8.9 45.7 18.1 0.9 64. a Excludes capital surplus. Long. .3 92.0 79.0 46.0 56.5 22.4 1.0 0.4 5.0 1992 51.1 54.4 1994 72.9 28.6 1997 23. Their average IEFR was also higher and IDFR smaller.0 53.7 14.9 IDFR 31.2 1992 18.4 47.3 Electricity.6 1991 18. when large firms had much lower equity financing ratios and higher debt financing ratios than small.6 7.4 0.8 17.6 IDFR = incremental debt financing ratio.1 42.0 1.3 62.9 Average 75.1 35. and Steam Supply 1988 118.0 67. SFR = self-financing ratio.7 70.6 1995 17.6 52.3 207.1 1993 55.1 70.8 Average 22.6 1989 118. however.7 37.6 Real Estate.1 1989 34.0 1997 24.

All of the top 30 chaebols relied heavily on short-term borrowings. the IDFR of listed companies increased to 93. .28).1 percent of their equity capital.30).3 percent of their equity capital in 1997 (Table 2. and higher than that of listed companies (Table 2. 91. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. The average IEFR of the top 30 chaebols of 29. the average SFR was 28. but higher than that of listed companies. and the top five chaebols.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2. Financing Patterns of Chaebols For chaebols.4 percent. They were able to borrow easily from banks by issuing corporate bonds and CP.7 percent for all listed companies. the lowest ratio of 58. External financing reached 94. respectively.7 percent. and were large borrowers.5 percent is lower than that of the corporate sector in general. In 1997. The proportion of their short-term financing averaged 72.8 percent of their total finance in 1997. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols.2 percent. compared with 89. about the same as that of the corporate sector as a whole. compared with the entire corporate sector’s 35 percent and 65.3 and 89.8 percent.5 percent and their total external financing. The largest borrowers were the top 11-30 chaebols. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. The average IEFR and IDFR were 10.6 percent of total asset growth.7 percent. In 1997.9 percent. Group-member firms borrowed less. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. In 1996-1997. at an average 70. and using cross-payment guarantees among affiliated companies.6 percent.29). for listed companies. Cross-payment guarantees have been declining since 1993 and reached 91.9 percent. the top 6-10 chaebols. Their shortterm borrowings accounted for 86. The debt financing ratio of listed companies was high since they relied more on external financing. 153. The chaebols’ drive to expand their empires resulted in heavy borrowings. the top 11-30 chaebols had the highest guarantees commitments at 207.

9 7.4 1.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.4 12. Source: Calculated using data of Seung No Choi.6 61.4 88.1 93.1 8.Table 2.1 1.2 36. 1994-1997 (percent) SFRa 41. 1994-1998 (percent) SFRa IDFR 85.9 NEFRa IEFR 14.3 1.4 38.9 6.8 22.8 89. . Korea Federation of Industries.8 76.5 8.7 1.3 IDFR 57.2 23.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.5 2.6 IEFR 42. Largest Business Groups in Korea.29 Financing Patterns of the Top 30 Chaebols.5 91.3 5.7 13.6 70.2 NEFRa 1.5 2.28 Financing Patterns of Listed Companies.3 86.6 1. Table 2.3 28.6 0.4 29.7 12.5 8. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.2 1.6 11.2 10.

the Government applied high tax rates on net profits of corporations. and extended loans based on cross-payment guarantees. Third. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. and reserves and retained earnings. rights issues. Few firms ranked loans from NBFIs as their first preference. Firms now prefer internal funds and new equity capital.9 — — — 1996 105.3 64. Interest payments on debts were considered a loss when calculating taxes. poor financial and corporate governance resulted in overlending by banks.9 153. Second. especially in the 1970s when real interest rates of bank loans were negative. According to the ADB survey. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469.3 200. the Korean economy was plagued with high inflation. These are followed by loans from banks. company preferences in financing investment projects before the crisis were.1 — — — 1995 161. This change implies that firms now give more attention to financial risks. bond issues. and underdevelopment of the stock market.30 Cross-Payment Guarantees of the Top 30 Chaebols. more than half of bank loans were priority loans with low interest rates. . Korean firms preferred debt financing (bank and nonbank borrowings). First. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices.3 58. There were several reasons for this.7 150.Chapter 2: Korea 127 Table 2. Further.1 — = not available. And fifth. loans from banks. Financial institutions did not strictly screen their loan projects and monitor their debtors. so that the firms engaged in lobbying to gain access to them. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees.0 207. Source: Fair Trade Commission and the Federation of Korean Industries. and loans from NBFIs.0 1997 91.9 — — — 1994 258. inefficient investment and excessive diversification of corporations. Fourth. the Government provided implicit guarantees on bank lending and large businesses. Factors Influencing Corporate Financing Choices Until recently. bond issues. in order of ranking.

some (36 percent) thought that a hedging facility was not available or not working properly. The most important reasons why they chose to borrow foreign currency denominated loans were that terms of foreign loans were more favorable and/or these loans were considered cheaper. and futures and other financial derivatives. 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.3 Financial Structure. Other factors include.4. and others (29 percent) expected the local currency to appreciate in value. the percentage of foreign currency denominated debt in the portfolio was 14. Diversification. Among those that never hedged against exchange rate risks. 2.5 percent at the end of 1997. Only a few firms sought foreign loans because domestic loans were not available. Nonetheless. Vol. According to the survey.128 Corporate Governance and Finance in East Asia. For these firms. maintenance of the existing ownership structure. even with a heavy debt burden. in selecting financing sources. Among the responding companies that had foreign currency denominated loans. they survived for two to three . the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). in order of importance. Korea now provides a better environment for financial risk management. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. more than half (53 percent) hedged against exchange rate fluctuations. II In seeking external financing. and reduction in tax burden. A futures exchange launched in 1999 trades foreign exchange options.36 percent on average for these companies. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. 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. ensuring the liquidity of the company. many firms (or 42 percent) never considered hedging. This preference has changed little after the crisis.

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. 1999). Among the main findings were the following. They were also higher than those of the top five chaebols until 1992. (i) In terms of total borrowings to total assets. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. except in 19931995 when semiconductor prices were extraordinarily high. (iv) In terms of EBITDA to total assets. In order to determine the relationship between financing patterns and corporate performance.2. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). as well as lax financial supervision (Nam et al. But since 1992. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt.3. but the ratios of independent firms were much lower.. (ii) In terms of net income to total assets. These findings indicate that independent firms have had a lower leverage and performed better financially. the top five chaebols and the top 6-70 chaebols had similar ratios. Nam et al. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. 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. Table 2. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998.13). Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. the top five chaebols’ ratios were much higher. except in 1991. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. However. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. They were also higher than those of the top five chaebols until 1991.

The diversification of the top five chaebols remained at about the same level within the period. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. Their subsidiaries. second highest in the top 6-30. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. however. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. court receivership. debt guarantees for free. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. too. and lowest in the top 3172 chaebols. II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. 2.31). the degree of diversification was highest in the top five chaebols. or outright transfer of resources due to poor corporate governance practices. Indicators such as increasing debt-to-equity ratios. had easier access to credit than the top 31-72 chaebols. its profit rate declined. rising nonperforming loans (NPLs) and falling . except in the recession years of 1996-1997. The degree of diversification of chaebols that fell into default. Government intervention. In terms of the net profit margin (the ratio of net profits to sales revenue). the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. The more diversified top five chaebols performed better than the less diversified top 6-30 because they were better established in most business areas and have superior personnel and technology. The diversification of chaebols under workout was much lower than that of the top 6-30. Meanwhile. had a significant role. The differences in the degrees of diversification among the three groups are substantial. and easier access to cheap credit. Vol. larger research and development expenditure. During 1985-1997.130 Corporate Governance and Finance in East Asia.

5 1.2 1995 3.6) (12.1 0.5 (0.9) (9.2) (4.9 1.7 1.8) (1.8) (3.3 1.7) (1.8 0.11.2) 2.6 1.7 1.3) (1.3 (0.2 (0.1) 1.7) 0.3 0.4 1.3 1.6 0.6) 0.5 (0.1 0.9) 2.6) (0.4) (0.9 0.5 4.4) (2.6 5.9 (0.6 0.5) (2.8) 0.9) (1.2) (4.7 1.6 0.0 6. 1998. Beyond the Limit.3) 0.8 1.3 1.0) (0.2) 0.4 1.8) (0.3 1.1 0.1 (1.Table 2.4 1.8 (0.3 (0.1) (6.1) — = not available.8) (20.4) (1.1 0.9 0.0 4.6 1.0) (0.3 (3.8) 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 1.4 (1.1) 0.8 (0.7 0.2 (17.0 (2.7 — (0.1) (2. Source: Whan Whang.6 0.0) (4.1 1.5) (7.4 (1.1) 1. Management Research Institute.5 (6.2) (4.3 0.1 (4.0) 0.3) 0.5 (4.4 (1.7 0.3 1.0 (0.0) 0.9 1.5 0.1 1.0) (3.2 1.7) 0.6 7.9) (8.4 (0.1) 0.8) (1.2) 1.2 1.6) (0.4 (0.3) 12.9) 2.2) 1.2) 2.6) 0.8 0.6) 0.1 2.1) (1.8 3.6 0.3 1.2 (0.3) 0.2 1.4) (1.4) (4.8 0.4 (2.6 0.4 1.4) (6.9 1.8 (0.1 4.4 0.3 1.9 0.1 0.2) (3.2) (13.3 0.0 1.1 1.4 0.0 (7.2) (13.6 1.5 (0.5) (1.8 0.2 (1.9) 0.0 1987 1.31 Net Profit Margins of Chaebols.1 (3.8) 1997 0. .3 1.1 0.6 0.1) (5.9 1.7 (0.6 1989 1.0 0.3) 0.3) 1.2 (0.8) 0.2 1.5) (2.3 1.8) 2.8 1.1 1.6 (0.8 0. Court Receivership.7 3.6 (0.3 (0.4 2.7) (0.1) (1.2 (0.8) 0.7 (0.1) 2.7 0.1 1.8) 1.9 8.5) (0.5 1.8 3.1 (0.3 1.2) 1.5 2.1 0.1 1.3) 0.3 0.0 1.6 1.5 (0.1 (4.5 1.7 0.2) (0.8) 0.1 1.3) 0.6) (20.7 1.8) (4.3) (12.1) 2.5) 0.9) 2.2) (0.0 0.3) 0.0) 0.2 1.8 1990 0.6 1.7 0.6 3.3 (0.4) (1.0 1992 1994 1.4 0.6 (10.3 1.1 0.4 (0.3) (0.6) (12.9 0.4 1996 0.2 1.4 0.7 (4.2 4.3) (0.3) 1.7 0.3 3.5 1.5 1.7 (1. p.1 0.6) 0.3 0.8) (11.1 (9.8) (37.2 0.7 2. Background and Task of Structural Adjustment.6 0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.7) (0. Chung Ang University.

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. Thus. Moreover. Vol. A remote trigger in the Thai crisis was all that took to push the economy over the edge. They were then almost automatically elected at the general shareholders meeting. . Ownership concentration also had ramifications on corporate transparency. 2.5. this has led to entrenched management. Thus. a committee composed of internal auditors. Until 1997. the independence and objectivity of the external auditor were often questioned. internal auditors cannot be expected to perform their function independently of management. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope. Meanwhile. and to the development of the market for corporate control.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.132 Corporate Governance and Finance in East Asia. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. Now. But in 1998. 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. after the crisis. 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 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. outside directors. a firm’s board of directors had the power to appoint an external auditor. and creditors should select (recommend) the external auditor. the boards of all listed companies were composed of insiders only. Until 1997.

a large issuance of preferred stocks with no voting rights. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. These included restrictions of shareholdings of institutional investors. These internal dealings made strong firms weak and helped marginal firms survive. has an unsound capital structure and . Meanwhile. however. prevalent window dressing practices. and restrictions on hostile takeovers. Diversification can reduce chaebols’ risks through the portfolio effect. profitable firms within a chaebol tended to subsidize unprofitable firms. Many changes were introduced to promote M&A in the 1990s. usually a member of the founding family. One reason is that the percentage of inside shareholdings for an average listed firm is very high. as well as institutions. corporate accounting information was not reliable due to the lack of independence of external auditors. Representative of the policy was the stipulation under the Securities and Exchange Act that no one other than founders could accumulate more than 10 percent of the voting shares of a listed company unless he or she obtained prior approval of the Securities and Exchange Commission. 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. Traditionally. hostile takeovers in Korea will likely be rare in the future. participated in the stock market as short-term traders rather than long-term investors. Another reason is that firms affiliated with a chaebol are generally regarded as difficult targets as the other members of the group will come to the rescue or act as a white knight. However. when a large diversified chaebol. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. and some differences in Korea’s generally accepted accounting principles from international standards. individuals. as a whole. restrictions of voting rights of shares of institutional investors. There were no effective monitoring mechanisms for its management. Under the direction of the controlling shareholder. regulatory and practical difficulty in implementing proxy voting. the Government maintained a policy of protecting the incumbent management of a listed company.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. In this situation. Many of the takeover targets in the past did not have a controlling shareholder.

II strong financial links among its member firms through investments and cross-guarantees.5.2 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. Financing preferences changed drastically after the crisis.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. 2. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. bond issues. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. The Government’s supervision and regulation of financial institutions were poor. Further. However. financing choices of listed firms in order of preference were bank loans.134 Corporate Governance and Finance in East Asia.5. the typical chaebol firm had an extremely high DER. As mentioned earlier. Such problems may eventually cause ripples through the entire economy. Vol. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. capital. while (non-chaebol) independent firms had much lower borrowing ratios. 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. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. 2. and internal funds. and other individual markets. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. The new preference ordering is as . as the latter are well established in most business areas. and a high degree of inefficiency in the economy.

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

The banks and merchant banks lent to large businesses. the NPL ratio8 of banks and other financial institutions began to increase. then 20.7 percent in 1997. However.1 percent in 1996.000 during January-September of 1998. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. and the pursuit of growth through excessive diversification and inefficient investment. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. the NPL ratio reached 7. especially chaebols. The inevitable result of inefficient investment was a fall in corporate profits. Doubtful loans are those for which interest is not received for six months or longer. The monthly number reached more than 3. excluding the financial sector. starting 1 July 1998. Before the crisis. legal and other barriers prevented the exit of financially nonviable firms. Financial Sector Vulnerability Because of financial losses in the corporate sector. and there is no collateral. In 1997 they became negative. According to the “six months” definition. They utilized mutual payment guarantees among their affiliates and believed that they would never fail.000 in September 1998 (Table 2. total assets. These were the definitions until 30 June 1998. reaching highs of 6 percent in 1997 and 8.000 from December 1997 to February 1998. Further. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. and shareholders’ equity of all industries. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. The Government could hardly help them because of the number and magnitude of business failures. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. and estimated losses. It jumped to 17. Moreover.000 per year starting 1992. and there is collateral.136 Corporate Governance and Finance in East Asia. and returned to about 1. Fixed loans are those for which interest is not received for six months or longer. they are defined as loans for which interest payments are overdue by three months or more. Meanwhile. . Vol. Following the “three months” definition. were low in 1996 and 1997. the NPL ratio of commercial banks increased rapidly from 4. the ratios of net profits to sales. nine out of the 30 top chaebols failed.200 in 1997. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11.32). decelerated from March 1998. 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.6 percent in June 1998.

5. and declined to 4-6 percent in 1994-1996 (Table 2.259 2.159 10.133 3.890 4.769 9.32 Number of Firms with Dishonored Checks.135 1.573 3.759 6.553 3.992 11.751 1.673 Construction 380 354 242 195 294 585 1. 2.517 2.China. The current account deficits in terms .255 13. low efficiency.Chapter 2: Korea 137 Table 2.69 20.250 2.856 7. This speculation was said to be one of the causes of the financial crisis in Korea.386 5. In 1990-1993.589 171. those of domestic banks were lower in the 1990s. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US. European countries.657 3.107 6. and continuous and large current account deficits.265 6. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.472 2.027 Manufacturing 1.33). Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.985 Services 3.855 6.637 6. The difference between the Korean and Western definitions of NPLs left foreign investors with suspicions that the size of NPLs in Korea might be much larger than the government-announced magnitude. As a result they had largely overvalued currencies.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.859 3. Meanwhile. This was mainly due to the high ratios of NPLs. Source: Bank of Korea.502 11.647 8.131 1.850 3.754 3.114 811 706 696 866 1. the ratio reached 7-8 percent. and Taipei.544 2.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.238 4.210 1.457 2. and large government-directed loans. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries. Compared to ROAs and ROEs of domestic branches of foreign banks.979 8.244 3. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.053 5.

6 percent (1995). Mass layoffs became legally possible only after the economic crisis.1 6.929 11.537 10.8 5. and 30 percent in 1996. Vol.954 9.652 29. In addition to the overvaluation of the won.4 5.221 8.6 percent (1995).827 289. and Indonesia -3. because of the rigid labor market. Source: Bank of Korea. Land prices and real estate rents were also high compared to trading partners.1 7. although per capita income in Korea was much lower.556 118.0 7.1 percent (1995).176 7.2 4.077 NPL Ratio (%) 8. The main result of the rigid labor market was a “high-cost and lowefficiency” economy.138 Corporate Governance and Finance in East Asia. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.739 241.484 11.910 1. which led to large corporate losses.390 12.160 11. .562 18.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.705 160.0 8.639 1.997 9.266 10.170 1. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.600 10. Meanwhile large businesses could not legally lay off workers. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997. II Table 2.China. of percentage of GDP were as follows: Malaysia -8. In 1997.8 percent (1996). judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.874 22. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei. Korea -4.430 12. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.832 337.33 Nonperforming Loans of General Banks. Related to this.584 Fixed (A)a 5.520 194.736 8.China.116 1.475 143.192 Doubtful (B)b 952 1.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer. Thailand -8.190 9.0 7. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.584 2.649 375. Businesses served as a social safety net.310 6. the ratio of short-term debt to foreign reserves was very high. even in times of economic slowdown.

‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities.6. . Downsizing by curtailing employment has been prevalent. including banks. Nonviable firms and financial institutions. However.6 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. had been forced into bankruptcy proceedings or merged into healthier entities. the immediate objective centered on restoring the international investment community’s confidence in the Korean economy. To achieve this. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks. 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. 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. Corporations. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed. and subsidizing money-losing units.Chapter 2: Korea 139 2. which were laden with huge amounts of debt and were on the verge of bankruptcy. They have been pressured to stop such practices as providing loan guarantees. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions.1 Responses to the Crisis and Policy Recommendations Corporate Restructuring Activities Restructuring activities in the corporate and financial sectors of the Korean economy were aimed at enhancing their long-term viability and competitiveness.6 2. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. Measures have been taken by several chaebols to streamline operations and improve incentives of managers and employees. Other firms experiencing financial distress were subjected to workout procedures through negotiations between debtors and creditor institutions.

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

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

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

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

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

beginning on 1 April 1999.148 industries remain closed. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. various supporting measures. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. 21 industries were further liberalized or newly opened to FDI (now. Capital Market Liberalization Since 1998. (v) by the end of May 1999. to FDI). either partially or fully. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages.Chapter 2: Korea 145 (as of the end of May 1998. which was passed in August 1998. (vii) by the end of March 1998. administrative procedures for FDI will be dramatically simplified and made transparent. including financial subsidization. and (viii) as of 1 April 1998. A recent case in point is the penalty imposed by the Fair Trade Commission on chaebol subsidiaries found to be involved in unfair transactions among group members. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. Existing cross-debt guarantees should be completely eliminated by the end of March 2000. Foreigners are now able to invest in local bonds and short-term money market instruments without any restrictions. In addition. 514 listed companies had appointed 677 outside directors). According to the law. including tax exemptions and reductions. (iv) during April and May 1998. These new standards are and will continue to be strictly enforced. an additional nine industries will be opened or further liberalized. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. only 31 out of 1. 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. financial institutions could no longer require cross-debt guarantees. have been instituted for FDI: . As for promotion. and (vi) all current laws related to FDI have been streamlined and incorporated into a single legal framework represented by the Foreign Investment Promotion Act. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998.

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

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

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

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

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

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

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

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

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

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

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

the Government continuously revised the enabling law of BOI so that incentives were reduced in number. dominance by large companies. In the early 1990s. Reforms in policies.. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. and import licensing requirements. Exports were not competitive because of the high costs of imported materials. In many industries. i. made less associated with capital investments. BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. The 1980s were marked by a peaceful transition of political power. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government. The Government signaled through the IPP its intent to shape the future industrial landscape. advance notice of areas where the country disallowed or restricted foreign investment. including the reduction of tariffs. and initiated the development of alternative energy sources in response to the oil crises. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. the State took over the generation and distribution of electricity. assumed ownership of the largest petroleum refining company. quantitative restrictions. The high industrial concentration led to practices of price leadership and output restrictions and the rise of industry lobby groups—common features of an oligopolistic . and orientation toward domestic markets. Foreign ownership was allowed only in industries with high technological and market barriers.” 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. In 1991. organizing industries into sectors and picking “winners. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. the “pioneer” industries identified in the IPP. Nevertheless. the legislative body passed the Foreign Investment Act (FIA). and oriented toward exports. Starting in 1981. the top three companies accounted for a disproportionately large share of total sales and assets.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives. It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent.e.

.2) 4.5) 5.8 8.2 Source: ADB.7) 10.5) 3.7 Malaysia 9.3 7. of 9.2 Thailand 11.2 Korea.5 percent per year (Table 3.5 8.7 8.1 8.2 During 1988-1997.0 8.0 (0.7 5. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context.1).4 4. II market.2 7.9 7.4 Philippines 3.8 8. Key Indicators of Developing Asian and Pacific Countries 2000. Vol.2 7.158 Corporate Governance and Finance in East Asia.9 6. which was taken as a representation of the Philippine corporate sector.2) 0. net sales of the top 1.9 (1. This rate of growth was sustained by a comparable 18.5 8. only to be unsettled by the crisis of 1997.7 (13.2 (0.5 9.1 GDP Growth of Southeast Asian Countries.3 8.2. 3.3 9. In this section.1 5. only nonfinancial companies were used. Rep.000 Philippine companies grew 17.1 5.5 (7.0 7.000 Corporations covers financial and nonfinancial companies.3 9.2 8. however.7) (10. Table 3.6 7.8 5. With economic reforms introduced in the 1980s and 1990s.2 9.0 8.2 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.6) 0.0 (6.2).1 4.8 5.8 4.3 2.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.9 5. Its growth rate began to catch up with others in 1996.8 10. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9. 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.

5 119 12.0 900 1.8 77 7.0 148.2 338.1 714.3 941.4 8.9 2.8 618.697.6 426.3 306.6 144.8 902 1.4 3.9 1.4 602.5 508.4 260.8 741.6 896 0.8 26.2 2.8 6.8 22.9 149 6.512.2 Compound Growth (%) 17.8 4.1 51.6 290.341.1 6.9 78 6. Source: SEC-BusinessWorld Annual Survey of Top 1.5 Leverage = total liabilities/stockholders’ equity.2 27.9 96.2 1.1 5.8 411.Table 3.4 63.000 Corporations in the Philippines.5 4.3 68 7.1 4.7 73 6.1 468.9 629.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.7 238.5 1. 1988-1997 1989 519.6 900 1.394.3 121 12. net profit margin = net income/net sales.3 107 13.3 382.2 Growth and Financial Performance of the Top 1.1 95.6 954.2 707.4 776.7 1.5 446.0 1.781.7 443.4 188.9 617.6 102 16.1 615.1 881.1 181 11.4 1.9 480. return on equity (ROE) = net income/ stockholders’ equity.7 218.6 18.1 66 12.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.7 903 0.6 75 6.893.647.131. of Companies Sales per Company (P billion) 899 0.5 570.5 192.7 20.2 900.1 1.5 193.6 149 12.4 898 1.1 Other Indicators No.5 1.6 1.7 28.2 378.9 898 1.5 887 0.6 109 12.5 64.4 411.5 51 4. .4 555.1 33.123.6 5.3 862.1 1.1 54 11.317.225.1 197 14.6 1990 1991 1992 1993 1994 1995 1996 1997 1.2 4.9 896 60 10. turnover = net sales/total assets.9 952.000 Companies.4 861.2 136.6 35.160.9 3.561.5 14.177.7 1. return on assets (ROA) = net income/total assets.1 73 5.5 72 7.5 1.978.3 898 1.3 46.0 1.1 72.2 2.332.8 5.2 Average 146 12.

000 Corporations in the Philippines.4 20. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. various years.6 percent and 5. II assets. but the extent of the increase was not as dramatic as in other Asian countries.979 17.394 1.352 1. and by equity that grew at a higher average annual rate of 26.248 1.8 percent per year.697 1.5 Ratio of Estimated Value Addeda to GDP (%) 17.5 17.427 13. Further. respectively. Net profit margins for the top 1.3 percent.2 percent.3 The Corporate Sector and Gross Domestic Product.5 16. Assuming Table 3.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.1 19.077 1.9 percent for the period.9 23. leverage increased from 109 percent in 1996 to 149 percent in 1997. and the SEC-BusinessWorld Annual Survey of Top 1.3). Key Indicators of Developing Asian and Pacific Countries 1999. . Sources: ADB.9 21. 1988-1997 Top 1.5 Value-added is assumed to be 30 percent of net sales.7 percent.8 17.172 2. Asset growth was funded by debt that grew at an average of 20. These rates of return are high compared with other Asian countries.474 1. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. Return on equity (ROE) and return on assets (ROA) averaged 12. for the 10-year period.906 2.160 Corporate Governance and Finance in East Asia.1 Net Sales (P billion) 465 519 630 741 862 954 1.178 1.4 24.000 companies averaged 7. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. Vol. Total assets grew at an average annual rate of 22. This is high compared with developed countries but compares favorably with other Asian countries.693 1.8 19.

and (iv) privately owned.0 31.2 103 5.8 22.0 28.5 Retained Earnings 30.0 142 22.1 22 10. The premise is that these variables have a direct bearing on corporate performance and growth. size.1 ROA 8. (iii) Government-owned.4 190 5.6 Total Assets 29. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. A study of company performance by ownership type. corporate control structure. these figures suggest a significant and increasing contribution of the corporate sector to GDP.2 9.1 12.3 9.0 5.8 14.8 3.5 GovernmentOwned 4.8 606 0.1 Financial Ratios (%) Leverage 89 ROE 15. .000 Corporations in the Philippines.3 146 6.7 22.Chapter 3: Philippines 161 a constant ratio of value added to sales.9 17.8 Growth Indicators (Compound Annual Growth Net Sales 20.8 percent of the corporate sector’s total sales between 1988 and 1997.4 Growth and Financial Performance of the Corporate Sector by Ownership Type. of Companies 73 Sales per Company (P billion) 2.3 22.8 ForeignOwned 21.4).8 2.0 4.3 27.9 26.4 28.9 22.5 Source: SEC-BusinessWorld Annual Survey of the Top 1. privately owned companies constituted the largest group (Table 3.5 Other Indicators Share of Sales (%) 17. %) 17.0 Turnover 53 Net Profit Margin 15. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.8 No.7 2.0 Net Income 19.4 Fixed Assets 19. 1988-1997 Indicators Publicly Listed Privately Owned Rate.5 27.4 Total Liabilities 26.9 196 1.3 11.5 23 4.3 42.3 22.9 158 13.4 Stockholders’ Equity 32. The foreign-owned companies were the Table 3. (ii) foreign-owned. various years. Averaging 42.0 5.

these companies were comparatively large. but lower than those of foreignowned and publicly listed companies. It should also be added that the profit margin of Government-owned companies is distorted by the presence of holding companies such as the Philippine National Oil Company.2 percent and ROA of 9.5 percent. they generated the highest return on investments. foreign-owned companies borrowed more than publicly listed ones. Their ROA and ROE were both more than twice as high as those of government-owned companies. with an average ROE of 22. However. and the second lowest asset turnover. exceeding the 17.5 percent average growth rate of the entire corporate sector. But by being most efficient in employing assets. or 38 percent. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. although small in number. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies.75 billion per company for foreign-owned companies.000 list. registered the largest per company sales at about P9 billion in 1997.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. These were mostly large public utilities. and low return on investment is the norm. were among the top 1. a level high by Western standards but at par with those of other Asian countries.3 percent. The privately-owned companies had a high average leverage ratio of 158 percent. The compound annual sales growth rate was 21. meaning that the remaining 62 percent were relatively small in sales and assets. followed by publicly listed ones. . the highest net profit margin of 15. II second largest at about 27.000 companies in 1997. selling an average of P4. Publicly listed companies had the lowest leverage at 89 percent. while there were few of them.1 billion per company in 1997. Governmentowned companies in the top 1.162 Corporate Governance and Finance in East Asia. the second best ROE and ROA. With an average leverage ratio of 142 percent. Bases Conversion Development Authority. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). the asset base is large. Vol.9 percent. Privately-owned and Government-owned companies grew at slower rates. compared with P2. Publicly listed companies had a minor though steadily increasing share in total sales. 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.

7 2. Table 3.0 55.000 Corporations in the Philippines. But the conglomerates were larger measured in sales per company.2 Fixed Assets 25.Chapter 3: Philippines 163 Performance by Control Structure By control structure. various years.3 Total Liabilities 30.0 166 15. Sales and resources of the .0 25.8 6.5).2 Net Income 21. a company can be a member of a conglomerate or independent. and small companies. compared with 32.7 Total Assets 32.3 No. had a lower leverage ratio.8 ROA 8.6 26.4 24.1 Source: SEC-BusinessWorld Annual Survey of Top 1.3 Other Indicators Share in Sales (%) 32.0 22.6 715 0.3 Financial Ratios (%) Leverage 98 ROE 15.2 23.1 Retained Earnings 32.5 Growth and Financial Performance of the Corporate Sector by Control Structure. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997. 1988-1997 Indicators Group Member Independent 18. and achieved higher returns on invested assets than independent companies (Table 3. of Company 159 Sales per Company (P billion) 2. Performance by Firm Size By firm size. the corporate sector is divided into large. medium.7 Stockholders’ Equity 34.0 Turnover 67 Net Profit Margin 12.8 Growth Indicators (Compound Annual Growth Rate. %) Net Sales 20.1 124 5. grew faster.3 percent for the conglomerates. depending on assets and sales.

4 billion in 1997. of Companies 79 Sales per Company (P billion) 7. Table 3.7 44.1 ROA 5.5 25. averaged a far less P3 billion in per company sales. Large companies accounted for 56. for this study.5 Growth Indicators (Compound Annual Growth Rate.0 32.5 Total Assets 18. are defined as the largest 100 companies in the top 1.6).8 percent of the total number of companies in the list (Table 3.1 25. indicating that they deployed resources more efficiently than large and small companies. 1988-1997 Indicators Large Medium 19. although they comprised only 8.2 29.1 No. Vol. However.5 128 10.3 Source: SEC-BusinessWorld Annual Survey of Top 1.5 73 6.6 Growth and Financial Performance of the Corporate Sector by Firm Size.0 156 16. sales of mediumsized companies grew faster than large companies.2 Other Indicators Share in Sales (%) 56.9 Retained Earnings 13. referring to the remaining companies in the list. various years. defined in this study as the next 200 largest companies in the top 1.4 28.000 Corporations in the Philippines.000 list.6 36.2 Stockholders’ Equity 18.164 Corporate Governance and Finance in East Asia.000 list. Medium-sized companies also performed better in terms of ROE.3 Turnover 65 Net Profit Margin 8.2 25.9 89 1. while small companies.0 730 0.4 Total Liabilities 18. II Philippine corporate sector are highly concentrated among the large companies.7 Net Income 1. .6 Small 19.9 Financial Ratios (%) Leverage 158 ROE 13.6 47.1 percent of the total sales of the corporate sector. averaging 16 percent. which.5 12.1 81 9.6 31.6 49.9 26.3 Fixed Assets 15.9 32. Sales per company in this group averaged P13.1 4.0 7. %) Net Sales 15. Medium-sized companies. averaged only P920 million in per company sales during the same year.

Sales revenue and net income declined from P76. The Asian financial crisis affected large companies most severely.7. net income.4 percent in 1997 from 11.8 billion in .2 percent for large ones. are shown in Table 3. manufacturing.7 percent in 1996 to 8. profits. and utilities and services sectors. Mediumsized companies’ leverage level was slightly lower.6 percent. For small companies. i. Leverage was the highest for large companies. utilities. at 158 percent on average during 1988-1997. Performance by Industry This study also looked at corporate performance by industry.Chapter 3: Philippines 165 Small companies. from 14. at 128 percent for the period.7 percent a year earlier.1 billion in 1996 to P4. and utilities and services sectors. unlike their counterparts in other Asian countries. and construction. especially during the period 1994-1996. of net income. Poor returns appear to have been caused by the low profit margin at 6. but lower than that of construction. net income. but suffered its largest decline in net profits in 1997. and the construction sectors than for the manufacturing.5 percent for medium-sized companies and 8.1 percent. and equity up to 1996. at -12. ROE dropped to 7. and profitability in 1997 when the crisis started. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. But small companies’ leverage was significantly lower.7 percent in 1997 for medium-sized companies. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. as indicated by the negative annual growth.8 percent in 1997.2 billion in 1997 for this sector. with their ROE dropping to 3. The growth and financial performance of selected industries.. showed the lowest ROE.e. compared with 9. 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. Growth of sales.7 billion and P35. and assets was much higher for the real estate and property. ROE dropped from 10.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. Large. at 156 percent. The sector showed consistent growth in sales. averaging 10. although the largest in number.8 percent. Net income declined from P54.8 the previous year. specifically those industries least and most affected by the financial crisis. reflecting to some extent a “bubble” phenomena in the former two sectors. real estate. assets. The real estate and property sector also suffered significantly in sales.

8 Stockholders’ Equity 21.7 19.8 48.2 12.0 21.4 3. respectively.8) 17.7 Net Income (12.3 20.4 Total Assets 19.2 45.7 83 2. %) Net Sales 16.7 Growth and Financial Performance of the Corporate Sector by Industry.7 ROA 5.1 2. and was also much more limited compared with the property sectors in other Asian countries.0 31 0. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.7 192 9. .6 Growth Indicators (Compound Annual Growth Rate.3 Fixed Assets 20.7 10.2 28 0.000 companies’ total sales on average during 19881997. 1996 to P56.1 10.9 5.5 Other Indicators Share in Sales (%) 82. II Table 3. As a result.0 Turnover 112 24 Net Profit Margin 5.8 41. the sector’s ROE dropped from 15.0 25.3 5.2 37. it does not appear to have been excessively exposed to foreign currency-denominated loans. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.9 23.6 Total Liabilities 18.6 69 16.7 billion in 1997.3 55.4 Source: SEC-BusinessWorld Annual Survey of Top 1.4 percent. 1988-1997 Utilities Real Estate and and Services Property 39.7 Indicators Manufacturing Construction 27.4 19.1 24 42.7 52.0 23.4 16.9 2.6 Financial Ratios (%) Leverage 142 181 ROE 13.2 8.9 billion and P24.7 percent to 10.000 Corporations in the Philippines.7 28.6 No. of Company 454 17 Sales per Company (P billion) 1. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.9 2.3 Retained Earnings 17. various years.166 Corporate Governance and Finance in East Asia.5 12. Vol.9 17.

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

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

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

10.2 percent of outstanding shares of publicly listed companies. controlling an average of 52.1 percent of publicly listed companies in the Philippines in 1997. Through these. the top five controlling shareholders were classified into eight groups. and 20 shareholders? In Table 3. Who are the top one. five. or 14 percent of the total. and share prices are sensitive to movements of foreign funds. With such high levels of ownership concentration. or 51 percent of the total. which are mostly privately owned and controlled by family-based shareholder blocs.9 shows that in 44 companies. In four companies. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. In 116 companies. 66 percent (signifying strategic control). In 21 companies. the top five shareholders owned more than 50 percent of the voting shares. a single shareholder held operating control of a company. or about 30 percent of the total. The shares of publicly listed companies are thinly traded and illiquid. holding only an average of 2. including pure holding companies. or 3 percent of the total. a single owner owned more than 80 percent of outstanding shares. The largest group is nonfinancial corporations. the top 20 shareholders collectively owned a majority of a company’s shares. nonfinancial corporations held majority control. the top five shareholders held more than two-thirds majority control of a company. In 76 companies. or almost 75 percent of the total. five. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. Individuals did not constitute a significant shareholder group among the top five shareholders. or 20 shareholders owned more than 50 percent (signifying operating control). II analysis of the number of companies in which the top one. or 80 percent (only nominally publicly listed) of outstanding shares. There are advantages to establishing pure holding companies.174 Corporate Governance and Finance in East Asia. or 78 percent of the total. minority shareholders are unlikely to be able to influence the strategic and operating decisions of a company without the support of one or more large shareholders. In four of 11 nonfinancial sectors. Vol. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. a single shareholder held two-thirds majority control. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. Table 3. In 111 companies. large and family-based shareholders pool the family’s ownership over many .

Distribution.Table 3. Source: PSE databank. a Data for top 20 shareholders were not available for five holding companies. 10 manufacturing companies.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. . 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. and two companies in the property sector. Beverage. and Trading Holding Power Transportation Property Total — = not available. and Tobacco Manufacturing.

2 5.7 0.6 0.5 13.8 0.6 1.5 53.0 2.0 0.0 0.3 1.9 6.0 0.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.1 5.0 0.0 0.8 66.0 0.0 0.7 3.2 3. and Other Services Property Mining Oil Average Shareholdinga 33.0 1.3 5.3 1.2 0.9 0.9 36.0 4.3 2.2 10.2 3.4 1.4 19.5 4.1 6.6 2.3 0.6 12.5 0.7 67.0 2.0 0.7 3.6 33.4 0.0 1.3 37.1 8.8 0.2 3. Distribution.0 10.3 0.0 5.5 4.5 2.0 1.2 0.0 0. and Trading Hotel.0 1.7 0.0 1. Beverage.4 29. and Tobacco Holding Companies Manufacturing.1 0.6 0.5 26.9 0.0 7.0 45.0 5.5 0.Table 3.3 12.7 1.3 0.6 0.1 9.4 8.1 a Weighted by market capitalization.3 0.0 0. Recreation.0 5.6 0.7 0.0 0.1 1.4 2.0 0.6 0.2 0.0 0.6 18.0 1. .6 5.3 26.2 59. Source: PSE Databank.5 12.4 5.2 1.2 0.2 0.6 0.3 5.3 0.6 2.8 21.0 1.9 52.0 5.0 0.0 1.0 0.6 0.7 0.1 0.8 11. 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.8 0.7 0.7 0.6 9.2 3.1 7.

The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.5 to 12. . and insurance companies (0.6 billion or 26. Petron and MERALCO in power and energy. Holding companies were themselves 66 percent owned by other nonfinancial corporations. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. 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. Because of limited ownership by institutional investors. financial institutions did not have a significant ownership in nonfinancial corporations.3 percent). while still allowing the public to own minority shares.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries.1 percent). securities brokers (1. and San Miguel Corporation (SMC) in food and beverages. Investment trust funds were the most important institutional investors. respectively. there was no real market for investment information. The 7. commercial banks (1. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. Privately-owned pure holding companies own a majority of shares and exercise control of publicly listed holding and operating companies through a multilayered pyramid structure.6 percent of market capitalization in 1997.7 percent of market capitalization of the nonfinancial publicly listed companies.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.2 percent in 1997. Holding companies as a sector had the largest market capitalization in PSE in 1997. with an average of only 7.1 percent). The investment funds’ presence in these sectors ranged from 8. As a group. accounting for P258.7 percent of shareholdings). Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. Such advantages have contributed to the popularity of holding companies among publicly listed companies. They can also better manage their income taxes because income from affiliated companies passes through a holding company.

and tracked the financial performance of each company from 1992 to 1997. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. of the financial resources in the country. Some 20 financial institutions were affiliated with these groups.000 corporations’ sales. A common feature of corporate ownership of a business group is the centrality of a commercial bank. using data on the Philippines’ top 1. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector.7 6 7 The study used publicly available shareholder information and published reports. Large shareholders and their families own these banks directly or through their controlled companies. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. including 16 commercial banks. The Central Bank deregulated interest rates and foreign exchange. However. but they comprised only 23. For this reason. identified the companies belonging to each of these groups. remain in force to control excessive lending of banks to insiders.4 percent of the top 1. suggesting that business groups are common in all major markets. . about three fourths.000 companies. the study put together a list of prominent business groups. Commercial banks hold the largest share. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. Vol. 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. Family-based groups have larger companies since their total sales were about 33. All major industries were represented.11).8 percent of total companies in number.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3.000 Corporations in the Philippines. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms.178 Corporate Governance and Finance in East Asia. Corporate financing depends on intermediation by banks. so far limiting their involvement to selected products. many companies in family-owned groups are not publicly listed. To understand the ownership and governance characteristics of family-owned business groups. Prudential regulations. 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. This is significant considering that there were only 31 local commercial banks in the country in 1997. including SBL and DOSRI rules. and increased the capital requirements for all types of banks. Still. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). suggesting that most publicly listed companies are parts of business groups.

and Henry Sy—as examples. ranged according to their sales (Table 3.Chapter 3: Philippines 179 Compared with other Asian countries. the principal owner of SMC. These corporate entities accounted for 53. Family-based business groups are most dominant in sectors such as manufacturing.000. with 27 affiliated companies in the top 1.000 corporations in 1997.000 companies. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. which was majority-owned by the Henry Sy group. for each of these groups. and Ayala. the study used the four largest business groups—Ayala. In the meantime.8 percent). Lopez. real estate. Together. Commercial banks are often affiliated to a particular business group. retail merchandising (69. the top 10 family-based business groups had only 119 companies in the top 1. the largest was the Eduardo Cojuangco group. construction. Also. 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. the biggest private company in the Philippines. 25 out of the 50 top corporate entities were familybased groups. broadcasting (49. To show this. it was manufacturing (36. For the Ayala group. an average group in the Philippines has fewer member companies. the two were closely related through their affiliations to business groups. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. the largest family-based business group was the Ayala Corporation Group. It is also noteworthy that. Cojuangco. or an average of about 12 per group.6 percent of the total sales of the top 1. Foreign-owned companies mainly serve the export markets. a substantial proportion of group profits came from its financial subsidiaries.1 percent). The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. and for the Henry Sy group. namely. In terms of sales. In terms of number of companies. the three largest entities were family-based groups. the nonfinancial sector was real estate (60. for the Lopez group. and banking. and more than 20 percent for the Lopez group and Henry Sy group. Gokongwei. for the Gokongwei Group. Lopez. including business groups and independent companies.2 percent). in most .4 percent of the group’s 1997 profits). Significantly. as discussed in previous sections. with the exception of Banco de Oro. In 1997.12). The main constraint may be the availability of family members that could be drawn for top management positions.

5 13.2 16. 13. and dairy products Investments.6 3.5 44.9 2.1 4. 6. and tourism Credit card 18.11 Total and Per Company Sales. Beverages. 5. power.0 17.4 48. 11.6 3. food. and food Food. real estate. agriculture. 2.0 5.5 26. 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. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. construction. telecom.8 84.0 26. Sector Orientation.0 Average Sales Per Company (P billion) 6. and packaging Power distribution and mass communications Real estate.5 47.1 4.1 2. 7. 15. 16. 8. 9.3 11. 10.4 .5 6.3 15. beverages.9 3. and personal care prods Shipping. beverages. 3.2 1.6 2. coconut oil.4 6.2 1. 4. 14.5 46. and Affiliated Bank of Selected Business Groups.3 3. Real estate.5 49. food. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. Consunji 4 3 Food and dairy products Construction and mining 10. Eduardo Cojuangco Lopez Family Group Ayala Corp.5 2. Flagship Company.3 2.4 10.6 7. of Affiliated Companies Total Sales (P billion) 123. 17.7 98.Table 3. and mining Management.0 13. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12.5 17.

7 4. 38. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. . 36.5 2. 26.6 0. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. 22.9 6.7 0. 25.7 3. SEC-BusinessWorld Annual Survey of Top 1. 23.0 2. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.19.0 0.000 Corporations (1997).0 1. 37.8 1. 4 238 1.7 0. 27.1 1.7 0.8 1. 28. 24.4 1. mining.3 2.2 4. 33.4 5.1 805.6 5. 34.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.9 7. 31. 30.6 2. distribution.4 3.9 0.1 2. 20. 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. 35.6 3. 29.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. 32.9 1. 21.7 1.9 1.4 3.1 1.1 0. P. Ramos Gaisano Family Group Felipe Yap Felipe F.5 8. and various company annual reports.3 2.2 1.3 7.2 6.8 6.9 0.9 1.8 1. 39.0 5.

2. Alaska Milk Corporation DM Consunji. 15. 4. Inc. 13. 16. 11. 1. 18. Eduardo Cojuangco Lopez Family Group Ayala Corp. 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. 9.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 W. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . Uytengsu/General Milling Group David M. Flagship Company. 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. 19. 12. 14. 6. 20. 10. Sector Orientation. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 5. 17. and Affiliated Bank of Selected Business Groups. 8.11 (continuation) Total and Per Company Sales. 3. 7. 21.

Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. Kepphil Shipyard Inc. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. medium = P1. and various company annual reports.65 billion to P4. a b Size class is measured in terms of sales: Large = greater than P4. . 22. 31. 37. SEC-BusinessWorld Annual Survey of Top 1. 36. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Refers to commercial banks. F. Inc. 30.. 28. 32.65 billion. 26. 34. Sources: PSE Databank. 27. 33. 35. 23. 24.48 billion. 25.48 billion.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp. 38. 29. Ramos Gaisano Family Group Felipe Yap Felipe F. P. small = less than P1. unless otherwise indicated. PT&T Corp.000 Corporations (1997). 39. Fil-Estate Development Inc. Cruz & Co.

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. food.5 77.12 Control Structure of the Top 50 Corporate Entities. and telecommunications Department store and banking Airlines.2 16. beverages. 23. construction. power.8 84. car manufacturing.5 44.7 98. 7. food. Inc. 24. and personal care products Shipping. and mining Gold and other precious metal refining .0 24. telecommunication. 22. 11. and real estate Banking.5 17. agriculture. 17.0 37.Table 3. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.5 26. 3. 6. First Pacific/Metro Pacific Group 21.4 19. 2.8 22. 18. and bank Real estate. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 13. coconut oil.4 48. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.0 38. mass communications.5 47. 16. Philippine National Bank Mercury Drug Corp.2 Business Group Business Group Business Group Government. 9. and car manufacturing Power Refined petroleum products Refined petroleum products Banking.3 15. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 12. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. 10. Inc. banking.1 60. 14.2 49.5 46. Fujitsu Computer Products Corp. bank. and dairy products Investments.6 18.5 15.1 17.). and food Food. 4. and packaging Power distribution. of the Phils. beverages. Texas Instruments (Phils.6 26. and tobacco Telecommunications and banking Refined petroleum products Radar equipment and radio remote control apparatus Cement and construction materials Pharmaceutical and distribution Electronic data processing equipment and accessories Electronic data processing equipment and accessories Bank Drugs and pharmaceuticals goods retailing Real estate. 8. 15. food.8 53. 5. Beverages. 19.). 20.

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.4 8.0 13. 27.6 12.9 14. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines.6 1.8 6.5 8. Corp.290 53. 30.. 29. Uytengsu/General Milling Group David M.2 7. Inc.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management. Inc.8 Privately-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned Government-Owned Government-Owned Government-Owned Foreign-Owned Business Group Business Group Foreign-Owned 38.0 11.9 7. W. corn (unmilled). 42. 26. 9. PSE Databank. 36. 44. Amusement and Gaming Corporation Mitsubishi Motors Phils. 37. Inc. 14. 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 1.8 9. real estate.0 5.9 7. 41. Consunji Uniden Philippines Laguna. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay.5 10. EAC Distributors Inc. 39. 47. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters.6 9.3 13. 35. 28.000 Corporations (1997). 40.9 6.25. 31.A.1 9. 43. and various company annual reports. 48. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. . National Steel Corporation National Food Authority Phil. 46.7 10. 34.7 13.4 10. Jollibee Foods Citibank N. 32. Philip Morris Philippines.5 8.3 8.7 10. 50. 33. Philips Semiconductors Phils. 45.0 12. 49.

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

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

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

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

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

2 69.4 No 0. An average of about 4. a company that is widely held but has a large shareholder.2 7.900 shareholders per company did not vote during the last annual general meeting. the successful hostile takeover by First Pacific Group of PLDT. Nevertheless. representing about 24 percent of outstanding shares.Chapter 3: Philippines 191 in a few controlling shareholders and families.0 48.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.0 36.8 56. Table 3.0 63. The ADB survey provides further evidence on shareholder rights. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.7 43. Nominees held about 45 percent of the outstanding shares.4 percent of shareholders but 58 percent of outstanding shares.6 30.8 92.13 summarizes rights that the shareholders of the responding companies enjoyed. representing 3.2 43. followed by management and banks.3 56. About 93 percent of the respondents contracted . About 333 shareholders per company voted by proxy. Yes 100. The brokers or securities companies were the most important proxy voters.0 51.13 ADB Survey Results on Shareholder Rights Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings Source: ADB Survey of Philippines Publicly Listed Companies. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. appointed either by the board or shareholders during the annual general meetings.522 shareholders each.4 70.8 30. and their activism in the corporate sector. protection. The responding companies had on average 43. 1999. Table 3.

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

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

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

04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. .1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42. (47.96%) Privately-Held Pure Holding Company Public Investors (41. Inc. (58.Figure 3..06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc. Inc.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.

see the World Bank research papers by Stijn Claessens. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights.5%] [39.3% x 1. Being in the public utilities sector. Vol. MERALCO. [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. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. Joseph P.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings.10 The Ayala family’s control rights over BPI was 1.44%] / [58. 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. Diversification and Efficiency of Investment by East Asian Corporations. Benpres Holdings. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Rockwell Land.98% x 42. Simeon Djankov. and Larry H. The situation offers large shareholders tremendous incentive to move resources 10 For details. a privately owned company. companies in the Lopez Group are large and minority-controlled.8%] 5. 1999b.12 These examples show that even when large shareholder groups are minority shareholders.64%) + (37. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. and Larry H.7 times Ibid.196 Corporate Governance and Finance in East Asia. 1998.64% +37. First Philippine Holdings Corporation. and 1999c. defined as control by large shareholders of an operating company through minority ownership by several companies.14%] / [1.11 The Lopez family’s control rights over MERALCO was 5.44%] = [42. and a minority-controlled holding company. The Separation of Ownership and Control in East Asian Corporations. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. is illustrated in the Lopez Group (Figure 3.44%] / [25%] = 1. See also Stijn Claessens.5% x 14. however. Lang: 1999a. Lang. Fan.7 times 12 .14%] / [6. Generally. Expropriation of Minority Shareholders: Evidence from East Asia. Simeon Djankov. P. P. The control of companies through indirect corporate shareholdings. Who Owns and Controls East Asian Corporations? 11 Ibid.3% x 5.76%)] [39.2).5%] / [(88.

Figure 3. Inc.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998. .5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.76% Operating Company MinorityControlled 24.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.64% MinorityControlled 14. Privately-Held Pure Holding Company 88.3% 11.7% 62.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.

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

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

. From the 1970s up to the early 1990s. Malaysia. As a result. this is because. compared with Malaysia ($186 billion). while interest rates were at high levels and volatile.000 companies. inflation. Table 3.200 Corporate Governance and Finance in East Asia. Philippine companies were less leveraged.4 billion (or $59 million using the average exchange rate). compared with other economies. Equity instruments include common stocks. and Indonesia ($61. most listed companies are controlled by their five largest shareholders. Interest rates. 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. Even in the real estate sector. Korea and Thailand). The stock market was depressed up to the early 1990s. and convertible securities. The Philippine stock market is not a liquid market. especially short-term debt. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. Korea) ($143 billion). 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. In part. They invested in only a few large companies whose shares were relatively liquid. the country experienced double-digit inflation. Vol. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Foreign portfolio investments also remained small. The market capitalization of the Philippine stock market in August 1997. the Republic of Korea (henceforth. Most publicly listed companies issue only up to 20 percent of total shares to the public.7 billion. companies expanded only at a moderate pace. Rising stock prices during the Ramos administration reflected to some extent the business optimism. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods.14 shows that the average volume of daily trading in 1997 stood at P2. was one of the smallest in the region at $47. However.g. is far ahead of the flock. the minimum required to qualify as a public corporation. The corporate sector raised a substantial amount of . but not to the same extent as it did in other Asian economies. about the size of Thailand’s. less exposed to foreign debt. only 84 had sales large enough to be placed in the top 1. however. preferred stocks. and less engaged in risky investments.5 billion). and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. The period 1993-1997 was one of lower inflation and declining lending rates. Of the 221 companies listed in the Philippine Stock Exchange in 1997. II sector. The crisis affected the Philippine corporate sector. Equity financing through IPOs was active.

2 59.5 1.7 1.2 3.9 114.2 0.2 57.8 1.0 2.5 571.7 0.7 391.2 297.8 1.5 26.906.0 161.0 1.421.445.1 5.0 0.9 12. 1983-1997 Daily Trading Volume (P million) — — — — 129.351.686.2 0. Source: PSE databank.2 925.8 1.077.7 41.3 4.545.1 524.3 2.3 0.3 0.515. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.251.3 Market Capitalization (year end.Table 3.6 1. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.7 207.088.7 2.248.3 — = not available.9 2.2 1.2 61.0 0.2 1.5 72.1 0.8 799.8 0.373. .8 102.14 Philippine Stock Market Performance.5 12.6 1.5 1. P billion) Gross Domestic Product (current prices.171.1 0.3 59.1 0.0 0.3 158.5 Year 369.1 88.4 9.3 314.4 Ratio of Market Capitalization to GDP 0.692.474.9 1.2 ($ million) — — — — 6.4 728.9 2.9 608.386.6 261.5 16.4 1.121.1 0.9 682.

and the dominance of large commercial banks. The measures used in the analysis are: .6 billion. From 1988 to 1997. tight regulations. Negotiated credits. The picture of the financial system that emerges is thus one of limited capital markets. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. of which 85 percent was raised from 1993 to the first half of 1997. new equity. Vol. The largest buyers have been commercial banks. However. However. asset-backed credits. sells these commercial papers through brokers. about 127 companies went public with a total value of offerings of about P134. Capital markets cannot provide the market discipline that corporate investors need. which buy commercial papers either for their own account or for their clients. The corporate bond market was stunted. leases. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. are in a position to provide such discipline.4. moreover. by volatile interest rates and the absence of a secondary market. a strong regulatory system for bank supervision is imperative. the rights issue was a popular way of raising equity capital. because business groups often own large commercial banks. lack of competition among financial institutions. Only the commercial banks. include bank credits. Under SEC regulations. which ultimately influences the pricing of commercial paper issues. and debt as sources of corporate financing by using flow of funds analysis. by virtue of their large stakes in the financial system. which were the principal source of corporate financing in the Philippines. Debt securities include commercial papers and corporate bonds. 3. Because existing shareholders wanted to retain their proportionate control over their companies. Corporate bonds are another type of debt securities. which in most cases is an affiliate of the issuing company. Debt instruments include negotiated credits and debt securities. The underwriter.. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. and inventory financing. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. and high transaction costs.2 Patterns of Corporate Financing The study looked at retained earnings. Only a few large companies floated commercial papers because of the limited market.202 Corporate Governance and Finance in East Asia. discounting of receivables. corporate bond issuing was even more limited.

7 0.5 0.6 0. the SFRT was low at Table 3.3 0. It measures a company’s reliance on borrowings in financing asset growth. It measures a company’s capacity to finance asset growth by equity capital. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.5 0.5 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.3 0.9 0. during this period.1 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.4 0.0 0.2 0.3 0. 1988-1997.2 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.9 0.000 Corporations in the Philippines from 1988 to 1997.15 Financing Patterns of the Corporate Sector.5 0.0 0.3 0.9 0.1 0.8 0.5 0.8 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.1 0. As shown in Table 3. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.5 0.4 0. It measures a company’s capacity to finance asset growth by internally generated funds.5 0.3 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. .15.1 0. On the other hand.3 0.5 2.6 0.2 0. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.4 0.5 0. the average SFRF was high at 109 percent.1 0.000 Corporations in the Philippines.2 0.4 1.1 Average 1.4 0.8 0.6 0.2 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.4 0.4 0.9 0.3 0.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets. it is one minus IDFR.5 0.4 0. By definition.

The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. 1988-1997. for all three types of companies—publicly listed. implying that internal funds were far from sufficient to finance growth in total assets. reflecting the capital flight caused by political instability in the early 1990s.16 Corporate Financing Patterns by Ownership Type. 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 1997.6 0.8 0.2 (0.3 0. On Table 3.and foreign-owned. debts were the most important source of financing. In all the years. Retained earnings were the least important. This was mainly caused by the declining contribution from retained earnings. Source: SEC-BusinessWorld Annual Survey of Top 1. There were significant year-to-year variations.0) 0.3 0.1 a Excludes negative balances. Total assets grew by 23 percent that year. and 1997. internal funds were not a significant source of financing growth in total assets.5 Privately-Owned 0. privately.5 Foreign-Owned 1.7 0. retained earnings declined and few new equity investments flowed into the corporate sector. Vol. except in 1991. II only 19 percent.000 Corporations in the Philippines.5 0.16. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1.2 0.204 Corporate Governance and Finance in East Asia. As a result. the level of corporate leverage increased. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.3 0. with debt providing 93 percent of the financing requirements. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. 1991. In 1997. except for foreignowned companies that had a negative new equity financing ratio.3 0. the SFRF was higher. In periods of an economic crunch such as in 1989.9 0. Companies financed fixed assets from internal sources in hard times. . Corporate Financing by Ownership Type As shown in Table 3. when it financed 45 percent of it.

3 10.3 11.7 13.17 Composition of Assets and Financing of the Publicly Listed Sector.5 27.0 10.6 37. 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 14.2 12.0 10.8 4.0 1995 1996 13.7 2.8 39.000 Corporations in the Philippines.5 12.Chapter 3: Philippines 205 average.4 3.9 0.3 48.4 100.8 38.0 9.0 53.8 16.5 16.4 2.4 12.4 41.7 23.9 4.7 4. significantly Table 3.4 10.2 100.7 13.7 7.3 10. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.4 100.8 0.5 9.1 9.0 9.3 4.9 16.4 43.6 0.17.6 48.0 9.4 100.0 13.3 12.9 12.8 0.2 51.6 26.2 100.4 2.0 8.8 26. Foreign-owned companies relied more heavily on debt financing.2 3.7 100.6 43.0 1993 14.9 24.1 7. The sector built up its short-term debts. contributing 90 percent of growth in total assets. publicly listed companies relied more on new equity financing than privately.and foreign-owned companies.0 12.8 17.9 3.3 13. especially bank loans.6 48.3 12.2 42.3 51.1 13.0 6.9 16.7 2.8 100.0 Source: SEC-BusinessWorld Annual Survey of Top 1.5 0.8 3.3 12.0 38.2 3. .0 9. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.9 38.8 51.1 10.1 49.1 15.0 1994 19.0 100.8 46. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.8 3.9 16.9 100. It presents a composition analysis of assets and financing sources for the period 1992-1996.1 50.5 41.4 100. 1988-1997.

Table 3.000 Corporations in the Philippines. the average SFRF of business groups was higher compared with that of independent companies. as opposed to 94 and 30 percent. For these two reasons. the current ratio.1 0. and economies of scale in fund raising. Group companies financed an average of 45 percent of growth in total assets by debt. On average. indicating that many publicly listed companies were likely to be in a tight liquidity position. As shown in Table 3.3 0.206 Corporate Governance and Finance in East Asia. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1.2 0. respectively.18.5 0.6 Independent Company 0. The traditional measure of liquidity.9 0. 1988-1997. retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups. their inherent ability to pool risks. Group companies were generally more profitable than independent companies.45 in 1996. the easier access to external credit.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. Vol. Further. for independent companies. . II in 1996 and became more vulnerable to the financial crisis in 1997.5 0. The normal standard liquid position is a current ratio of 2 or higher.13 was at 1. compared with an average of 54 percent for independent companies. group companies usually financed their investment in member companies by equity rather than debt.3 0.3 0.18 Financing Patterns by Control Structure. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.

Corporate Financing by Firm Size SFRF was highest for medium-sized companies. 1988-1997.5 Medium 3. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.50 (Table 3. compared with 55 percent for large companies and 47 percent for small ones. averaging 61 percent of growth in total assets.5 Excludes negative balances.2 0. On average. Table 3.19).55 was substantially higher than the small companies’ 0.20).1 0.2 0. Excluding . 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.9 0.76 for small companies and 0.6 0.08 and SFRT of 0. medium-sized companies used more debts.Chapter 3: Philippines 207 independent companies.2 0.3 0.3 0. with an average of 3. There was also increased reliance on debt financing.06. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. Large companies’ IDFR of 0.88 for large companies (Table 3.47. Source: SEC-BusinessWorld Annual Survey of Top 1. Large firms consistently increased their reliance on debts from 1994 to 1997. With assets growing at a fast pace during this period. equity financed 42 percent of incremental asset growth. and 1997 with 131 percent.5 0. These years were 1991 with 110 percent. The corresponding ratio was 0.6 0.3 0.19 Financing Patterns by Firm Size.4 Small 0. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.000 Corporations in the Philippines.8 0. 1993 with 96 percent.

Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.4 Construction 0. Table 3. the incremental equity ratios of the industry were high.27.000 Corporations in the Philippines.7 0.58 and SFRT of 0. many of the leading real estate companies successfully went public during that time. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.3 0. SFRF for the sector averaged 0. ranging from 41 to 118 percent. increasing to 0. In the eight years preceding the crisis.6 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year.32. The effects of the crisis of 1997 were adverse.29.47 two years later.20 Financing Patterns by Industry.6 0. Since the real estate boom coincided with that of the stock market. achieving an average SFRF of 3.3 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. with an SFRF as low as 0. Up to 1997. . 1988-1997. Vol. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.4 3.2) 0. The sector had the highest leverage among all industries that year. while SFRT averaged only 0.1 0.79 and in 1997 at 0.208 Corporate Governance and Finance in East Asia. Equity financed an average of 62 percent of total asset growth. the manufacturing industry financed 57 percent of its total asset growth by debt.3 0.6 0. Source: SEC-BusinessWorld Annual Survey of Top 1.4 0.5 (0.4 0. The situation improved beginning 1994. Incremental equity financing amounted to an average of 44 percent of total asset growth.04.5 0. debt financed about 78 percent of asset growth in real estate. During the crisis year.4 0.91. the total debt ratio was much higher in 1996 at 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994.6 a Excludes negative balances.5 0. The real estate industry financed its growth by substantial equity funds. The construction sector was a heavy user of debt financing. Excluding 1997 when fixed assets declined. II 1991.5 Utilities and Real Estate Services and Property 0. when debts declined.3 0. While this level is considered prudent. the industry generated internal funds.

creditors bear the consequences.4. was regressed against measures of profitability and of financial leverage.860 Leverage = the ratio of total assets to total equity. Using the PSE database. ROE. alternatively.00056 1. Profitability. .00125 2. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. measured by the percentage of shareholdings of the largest five shareholders.130 ROA 0.230 Leverage 0. as the dependent variable. more profitable. ROA.004 3. and the Failure of Internal Control Systems. Journal of Finance 48: 831-880. knowing that if an investment turns out to be successful they could capture most of the gain. and financial leverage are all positively and significantly related to the degree of ownership concentration. As shown in Table 3. while if it fails. the degree of ownership concentration. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.00036 2. Exit. ROE = return on equity. 1992-1996.009 5.21 Ownership Concentration.14 Large shareholders may borrow excessively to undertake risky projects. ownership concentration = the total shareholdings of the top five shareholders. Table 3. Source: Author’s estimates based on the PSE databank. The Modern Industrial Revolution.21.008 5. ROA = return on assets. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. 14 See for example Michael Jensen (1993). at the same time.Chapter 3: Philippines 209 3.421 0.3 Ownership Concentration. ROE. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Financial Leverage.769 0. and leverage.287 0. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies.

and agriculture at 21 percent. an overexpansion of capacities. II 3. Because of limited local capital. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis. the country was less dependent on foreign private capital. and intermediate goods. notably remittances of overseas workers. Although much lower than those of other Asian countries. their growth gathering momentum only beginning in 1992. Net investment inflows were $3. Compared to other East Asian crisis-affected countries.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. The largest contributors to GDP were services at 43 percent.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. with commodities accounting for the balance. Exports were growing at about 20 percent per year in the three years preceding the crisis. The country experienced balance of payments surpluses but these were due to transfers.5 3. with a narrow exporting industry base. Historically. In 1997. Net trades in goods and services averaged a deficit of 4. Commercial and industrial activities in the country were largely oriented to domestic markets.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. more than half (52 percent) of exports were semiconductors. the country’s GDP growth pace indicated that it did not have a “bubble economy.” that is. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion.210 Corporate Governance and Finance in East Asia.5 percent per year from 1992 to 1997. Garments was the second largest export sector at about 9 percent. Manufactures accounted for about 85 percent of exports.5. After a . foreign investments in the country have been low. the economy still showed vestiges of its import-dependent and substituting character. raw materials. industry at 34 percent. In sum. The export sector had a very narrow breadth. but its share had been declining by 4 percent per year since 1995.8 percent of GDP from 1995 to 1997. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. The costs of an economic correction brought about by the regional financial crisis were thought probably to be low due to the sound structure of the real economy and the strong position of the financial sector. which averaged 4. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). Vol.

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. Profitable operations since 1992 had allowed it to build equity. The corporate sector was in a relatively stable financial condition around the time of the crisis. a positive balance of payments from 1992 to 1996. assets grew at a compound annual rate of about 31 percent. . depended on the quality of the corporate sector’s investments. 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. which. in turn. an average Treasury bill rate of 13. the country and the corporate sector had no access to foreign currency debts from the international financial market. fueled also by successful IPOs during the stock market boom of 1993-1996. The lessons from debt restructuring became the basis for the Government’s economic policies. Financial institutions called on their shortterm loans and shortened the maturity of existing loans. resulting in stability in the short-term debt to reserves ratio.5 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.1 percent. while sales grew by only 20 percent per year. the Government restructured its debts into longer tenors with a maximum of 25 years. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. From 1993 to 1997. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. After hovering in the range of 100 to 127 percent. a government fiscal surplus from 1994 to 1997. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis.3 percent. adjustments were focused on the quantity and quality of the banking system’s corporate loans. In the Philippines. Eventually. unlike their counterparts in the region. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. From 1988 to 1996. and a relatively healthy banking system. Closer analysis. average ROE was 13. During this time.8 percent. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. Total debts were only 52 percent of assets or 108 percent of equity.6 billion as of March 1997. however. the Government sought stability and achieved this in 19921997.

1997 = 29.22. In 1997. or 114 percent of net foreign direct investment (FDI).073 (406) 121. growing by about 34 percent per year from 1994 to 1997.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. Net foreign portfolio investment amounted to $1.303 23.5. Most of this leverage happened during the boom years in the region.5 billion in 1995.517 1.4 1997 762 1. Vol. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.650 32.074 2.0 1998 739 555 328 69.718 30. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. 1996 = 26. In sum. . Data for 1998 cover only January-August. mitigated the effects of the pullout and liquidation of investments in the aftermath.22). Debts financed a large part of this expansion. It rose to $2.749 26. precisely.0 1996 3.485 145. It financed 26 percent of corporate capital growth.7 Note: Peso-dollar exchange rates used are: 1995 = 25.” 3. These patterns in investment and financing are similar to those of other countries in the region. 1995-1998 Item Net Foreign Investments ($ million) Foreign Direct Investment (FDI) Foreign Portfolio Investment Net Capital Increase by Corporations (P million) Net FDI as a Percentage of Corporate Net Capital Increase (%) 1995 1. but to a lesser degree. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this. Sources: Bangko Sentral ng Pilipinas and SEC.71. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. But portfolio investment amounting to $406 million flew out of the Philippines.06.212 Corporate Governance and Finance in East Asia.101 92. Table 3.300 1. 1998 = 41.609 1.22 Foreign Investment Flows. the other immediate impact of the crisis was that on foreign investment flows. net FDI remained stable at more than $1 billion.47. 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.101 billion or 196 percent of net FDI in 1996.

they were willing to restructure and renegotiate existing loans by corporate borrowers. the sectors with the highest outstanding loans had reduced their credit exposures. Companies deferred investments in new fixed assets.7 percent in January 1998.513 billion. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. By March 1988. and the wholesale and . meanwhile. The real problem of the corporate sector during the crisis was the rise in interest rates. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. sparking a rise in interest rates on corporate loans.2 to 28. in turn. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. Lending rates were well above the 20 percent level from July 1997 to March 1998. albeit at current market interest rates. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. Because commercial banks were strongly capitalized. which held about 75 percent of the assets of the financial system in 1997.2 percent in November 1997. lending rates also came down. The interest rates on Treasury bills. new borrowings financed asset growth. Average bank lending rates climbed to their peak of 25. ranged from 11 to 13 percent from 1993 to July 1997. When the Treasury bill rates eased in March 1998. the corporate sector became vulnerable to loan calls and high interest rates. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation.369 billion. The resources of the financial system that year totaled P3. depended on the liquidity and capital position of commercial banks. By October 1998. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. Net profit margins were at a 10-year low at 4.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997. with commercial banks holding P2. the commercial banking sector’s capital remained strong at 17. ROE at 6. Because of weak internal fund generation.9 percent. Loans outstanding of commercial banks declined by the first quarter of 1998. The banking system was able to absorb the impact of the crisis primarily because of its strong capital position.2 percent was barely above inflation rate. Although corporate borrowers were not highly leveraged. Loan calls.3 percent of assets. and leverage increased to 149 percent compared with 109 percent in 1996. in varying degrees for each sector. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. With the increase in borrowings and reduced liquidity. then rose to a high of 22.

thereby reducing overall intermediation costs. and subsequently went down to 13. In March 1997. II retail trade sector. The Central Bank adopted other measures to strengthen the financial system. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. But the Philippine banking system had gone through worse crises in the past. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. was a problem sector. This allowed the Central Bank to convince the banks.5-6 percent. However.214 Corporate Governance and Finance in East Asia. and set up a hedging facility for borrowers with foreign currency-denominated loans. 3. As for nonperforming loans (NPLs). This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. Vol. single-digit NPL ratios began only since 1989.3 percent in December 1997. through the Bankers’ Association of the Philippines. the ratio increased to a high of 11. These peaked at 14.5. These figures show that adjustment problems were industry-specific and that the real estate industry. and the financial system. as with its counterparts in other Asian countries. real estate loans averaged 11. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. set limits on overbought/oversold foreign exchange positions of banks. 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 move retained the liquidity position of banks but lowered their cost of reserves.5 percent by September 1998. by 12 percent. the fiscal position. Still.9 percent of bank loan portfolios. and its experience of low. including (i) a regulatory limit of 20 percent on banks’ loans to the . The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. the aggregate effect of the crisis on NPLs was of a magnitude comparable only to the country’s last major banking crisis in 1984-1986.6 percent in June 1998.

PAL. (v) improving disclosure requirements on the financial position of banks. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. the Asian crisis opened a unique opportunity for foreign investors. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. its accessibility to foreign capital. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors.6 percent growth in 1999. changing technologies. The policy directions and actions taken by the Government appear to have ushered in recovery. Average Treasury bill rates have cooled since mid-1998. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management. With prudent monetary management. took more action. The economy avoided a recession in 1998 and achieved 3. First Pacific Corporation. With its weakened financial position. Financially strong companies were able to survive the crisis by effecting such internal restructuring. the largest telecommunications setup in the Philippines. In response to calls for lower bank intermediation costs. (PAL).Chapter 3: Philippines 215 real estate sector. the country’s flag carrier. In the case of PLDT. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. bank loan rates have also come down. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. subcontracting and outsourcing. Responses of the Corporate Sector The corporate sector’s financial position. The acquiring company. was known to have a policy . consolidating business units. the corporate sector dealt with the crisis as any company facing a recession and drying up of credit would—companies cut costs by reducing staff. and the legal framework for reorganization and liquidation conditioned its response to the crisis. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. the Government kept inflation below 10 percent. Large companies with heavy loan exposures such as Philippine Airlines Inc. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. and giving up noncore businesses. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks.

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

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

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

the government budget in surplus. including suspension of payments. strong capital position built on IPOs in a buoyant stock market. Specific actions recommended are described below. SEC’s quasijudicial functions. adversely affecting companies’ operations and financial position. there were sharp rises in the number of bankruptcies and petitions for debt relief. a strong international reserves position. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans. decisions by large sharehold- . 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. and a market-oriented policy environment. A number of large debtors petitioned SEC for rehabilitation under procedures set by PD 902-A. The corporate sector accessed the foreign debt market only in the mid-1990s because of the country’s long-drawn debt moratorium. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. low inflation. decide on the financial future of a troubled debtor. There are systemic risks involved in highly concentrated ownership. and sound overall creditworthiness. rather than the banks that lent millions of pesos.2 Policy Recommendations The Government should address weaknesses in corporate governance identified in this study by introducing reforms in the policy and regulatory framework and promoting the development of markets. resulting in the banks’ accelerated restructuring of troubled debts in this sector. are to be removed and transferred to courts. with recently restructured public debt. mostly by highly leveraged companies and speculative investors in real estate. The Central Bank imposed strict limits on real estate lending. Still.6. As the crisis wore on in 1998. For example. Promoting a Broader Ownership of the Corporate Sector The highly concentrated ownership of the publicly listed corporate sector should be a concern of SEC and PSE. SEC officials. This law is flawed in concept because it supplants a market-based credit agreement with a political process. 3. Under the new Securities Regulation Code enacted in 2000. That is.

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

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

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

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

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

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

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

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

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

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

1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. . its growth and financial performance. Section 4. The country initiated national economic development planning in 1961 when the economy was growing rapidly. Section 4. while new industries were encouraged to reduce the need for imports. 4. This study examines these and other factors that might have weakened corporate sector governance in Thailand. Vol.2.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. The First and Second Plans (1961-1971) Under the first two plans. The National Economic and Social Development Board was created to plan the country’s economic and social development. To protect domestic industries.230 Corporate Governance and Finance in East Asia. the Government increased tariffs on products that could be produced locally. lack of transparency and adequate disclosure.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).2 4. with government policy providing support but avoiding direct interference. and a family-based corporate ownership structure. Section 4. The study then considers policy recommendations with emphasis on corporate governance improvement. as well as its legal and regulatory framework. Import tariffs on machinery and heavy equipment were removed.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. Section 4.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.

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

while exports expanded considerably.6 percent target of the Seventh Plan. Vol. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due. China—went to export-oriented manufacturing industries. The exchange rate was steady at around B25 to the dollar. The country’s high ratings in the international capital market. Most of the FDIs—originating mainly from Japan.4 percent targets. averaging 10. compounded by a slump in property sales. Growth rates during 1987-1991 ranged from 9. United States. Average annual growth in real GDP was 8 percent. combined with its liberal financial policies. Thailand became a debtor’s market. reaching an annual inflow of $2 billion in 1991. The country also attracted a large amount of foreign direct investments (FDIs). the bulk of domestic investments went to speculative ventures such as real estate. and Hong Kong. better than the 5. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates.6 percent. rather than to productive activities. the property sector began to collapse in 1996. an oversupply of housing emerged. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. compared with the 8. Inflation was 4. increasing its share in total export value from 42 to 76 percent.7 and 11. From 1989. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. and the stock market. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. lower than the target of 8. By 1995.5 to 13.232 Corporate Governance and Finance in East Asia. On top of its predominantly “borrowed” nature.2 and 13. respectively.2 percent per year. invited a deluge of capital seeking profitable investments. .8 percent. with private foreign debt reaching $92 billion by the end of 1996. from only $31 billion in 1992. Europe. Growth of exports and imports averaged 14. compared with the 14.2 percent target. The manufacturing sector became a dominant force in the economy. property development.5 percent. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. Singapore. Private sector investment grew at an average annual rate of 7 percent.8 percent.

Foreign banks were barred from competing directly with domestic banks. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. Under the 1962 Commercial Banking Act. a policy that held throughout the first six economic development plans. In 1978. its policy had always been to protect domestic banks. the Bank of Thailand and . Before the capital market emerged. placing all publicly listed companies under regulation. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996. the capital markets didn’t play a significant role until 1975. The deficits caused the Government to rely on even more external borrowing. In 1972. the Government amended the “Announcement of the Executive Council No. 4.8 percent in 1995 to 1.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. In his report.2. many companies considered the Act too restrictive and a hindrance to growth. And because the Government considered the banking system vital to the development of the economy. which raised the debt service ratio. a former Chief Economist from the US Securities and Exchange Commission. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. the Government passed the Public Limited Company Act. which was amended in 1979 and 1985.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. Robbins. In May 1974. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. the corporate sector’s main source of funding was the banks.3 percent in 1996.Chapter 4: Thailand 233 Toward the end of the Plan period. Exports went into a tailspin. on account of an overvalued baht that weakened export competitiveness. However. 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. Sidney M. prepared a comprehensive report entitled “A Capital Market in Thailand. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. the signs of an economy about to falter were there.” which later became the master plan for the development of the Thai capital market. In 1969. SET officially became “the Stock Exchange of Thailand” in 1991. with growth shrinking from 23. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development.

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

394. In terms of capital.1 Public Companies Registered. Forestry.9 1.6 1. The majority of the companies are in manufacturing. Ministry of Commerce.9 34.2 Type of Business Agriculture. and Fishing Mining and Quarrying Manufacturing Electricity. Gas.0 21.5 111.0 110.6 350.9 16. the country became recognized as an economic development model for other emerging economies. in that order. and Water Construction Wholesale and Retail Trade. Storage.1). with B1. finance.5 791. about 661 companies with total registered capital of B2. 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. Thailand. Real Estate.Chapter 4: Thailand 235 fast-growing neighbors. Financial deregulation and liberalization were key to realizing that vision. 4.0 19. Hunting. Worldwide. 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.3 trillion have been registered with the authority (Table 4.1 30.101.6 23. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.1 78.291.5 50.2 11.1 trillion and paid-up capital of B1.3 83. Source: Department of Commercial Registration. however. and Communication Financing. the financial sector is the largest. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. Insurance.2. Social and Personal Service Total Note: The data for 2000 is as of October 2000. and Restaurants and Hotel Transport. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1. .6 2.4 trillion in registered capital and B791 billion in paid-up capital.0 Paid-up Capital (B billion) 1. and Business Service Community. and wholesale/ retail trade and restaurant/hotel sectors.9 261.

While a rebound was apparent beginning in 1998.3 194. reducing the value of offerings to a little more than a quarter of the previous year’s level. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.2 Public Offerings of Securities. Securities and Exchange Commission of Thailand.6 8.7 136. the value of public offerings rose steadily.6 7.6 — = not available.8 1995 64.2 40.2 25.1 2. Vol.1 599. These peaked at B89.5 1. from only B20. respectively.8 151.2).9 31.4 51.4 96. The number of listed companies and securities steadily increased until 1996 (Table 4. The signing of Article VIII with the IMF.1 54. meanwhile.1 — — — 6. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.7 billion in 1996.5 — — 56.8 billion.4 34.3).6 174.3 22. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.6 39. The stock market also became an invaluable source of funds for corporations. reaching a precrisis peak in 1996 (Table 4.0 20.9 1998 1999 15.3 6.236 Corporate Governance and Finance in East Asia. reached . The preeminence of the financial sector is a direct result of financial deregulation and liberalization.2 12. moreover.1 286.7 billion and B27.3 31. Market capitalization. II B261 billion.7 5. Source: Key Capital Market Statistics.3 1996 1997 65. After the passage of the SEA of 1992. The development of the corporate sector closely followed the development of capital markets.8 — 26. allowed Thai financial institutions and corporations to obtain funds overseas.4 277.0 1994 82. the year before the crisis struck.9 37. Table 4.7 9.5 39.2 5.7 7. Domestic and offshore debt issues reached B54.7 27.5 1.0 0. The 1997 crisis battered the primary market for securities. the capital market became instrumental in the rapid growth and development of the corporate sector.8 201.5 billion and B1 billion the previous year. 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.

The trend reversed in 1995.4).301 3. resulting in their inability to fulfill debt obligations. its high point in 1995 at B3. The financial leverage of all companies declined until 1994. then stalled in 1990. The key financial ratios of all companies listed on SET bear this out (Table 4.8 percent. From 10. and gross profit margin. however. return on equity (ROE). Throughout the 1990s.610 1.4 percent to 5. The upward trends for ROE and ROA continued through 1989. pulled down by active public offering activities. had been on the rise throughout the 1980s.193 2. Meanwhile. the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. was the ominous deterioration in the key financial ratios of publicly listed companies.114 1. Corporate profitability.3 Statistical Highlights of the Stock Exchange of Thailand. Foreigners accounted for an increasing proportion of SET’s turnover value. gross profit margin rose until 1991 before falling in 1992. in the end. their share rising from 17 percent in 1993 to 43 percent in 1997.325 3. when long-term debt grew as Thai corporations began to borrow heavily to finance growth.565 2.560 1.683 1.4 percent in 1996. as measured by return on assets (ROA). By the early 1990s.201 2. While the decline in gross profit margin was not as sharp. the averages for all three profitability ratios took a downswing all the way until 1996.3 percent in 1989 to 3. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the .268 2.303 930 855 1.360 1. not all public companies are listed on the SET.1 by 1996.281 832 373 356 482 Due to listing requirements and other reasons. corporate profitability had been declining.6 trillion. But instead of shifting to a low gear. the average times interest earned (TIE) was down to 5. the companies could not generate enough net returns from their assets and equity.5 at its peak in 1987.Chapter 4: Thailand 237 Table 4. ROA dipped from 10. ROE similarly fell from 21. 1993-1999 Item Number of Listed Companies Number of Listed Securities Market Capitalization (B billion) Turnover Value (B billion) SET Index a 1993 1994 1995 1996 1997 1998 1999 a 347 408 389 494 416 538 454 579 431 529 418 494 392 450 3. however.133 1. Source: Securities and Exchange Commission of Thailand. Side by side with this surge of financing for corporate growth.535 1.

7 27.2 215.7 59. was also distinct in the region.9 14.7 12.9 7. the textiles.9 27.2 10.5 52. Vol.1 52.2 10.5 50.6 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.4 139.1 242.4 119.7 5. which fell from 16 percent in 1991 to just under 6 percent in 1996.4 7. which was particularly significant in the two years preceding the crisis.1 16.2 27.1 60.3 12.5 63.8 11. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations. and footwear had the lowest at 11 percent. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market.0 7. 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 (%) (%) (%) 3.1 120.7 20.4 28.8 88.3 10.0 29. practice of heavy borrowing. these companies opted for debt.0 63.6 41.5 15.2 64.1 9.6 27.4 9.2 6.4 Key Financial Ratios of Publicly Listed Companies. A major reason for this was the rapid rise in asset prices. clothing.2 49.6 168.7 21.8 151.6 138.238 Corporate Governance and Finance in East Asia. Among the crisis-hit countries.1 16. Severely affected by global competition throughout the decade.9 39.0 3.4 24. US.7 27.7 12.8 5.5 38.9 77.9 140.8 14.7 5.3 8.6 12.5 9.7 4.6 36.1 114. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.4 34.2 27.6 125.8 25.0 117.7 54.5).7 15.8 54.9 51.2 161.4 47.4 12.4 7.9 7. Hotels and travel showed the highest ROE of 15 percent while textiles.3 4.1 44. Korea and Thailand had the highest debt-to-equity ratios.9 144.5 30.4 5.4 12.9 66. was felt across industries. They were generally more efficient in managing their assets and .7 5.8 51. Thailand’s ROE.7 34.4 18.7 35.4 3.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.9 8.8 8.4 26.7 80. II Table 4.6 7.8 5. Overall.7 12.0 139.2 10. clothing.4 51.4 4. and footwear industries also experienced losses.0 145. Despite the availability of the equity market.5 51.3 91.0 125.4 44. The downtrend in corporate profitability.7 12.2 35. resulting in higher collateral values for borrowers.

some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.6 5. .5 87.4 8.6 30.8 6. it was thought. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness. US. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies. total asset turnover declined after 1989.5 Average Key Financial Ratios by Company Size.6 12.6 31.1 5. They also tended to use more financial leverage than small companies as their total DERs show.4 52.3 15.0 83.7 6.4 116.3 135.6 30.0 48. also deteriorated.5 7.8 62.1 29. the law disallowed cumulative voting. During the 1990s.6 61. Cumulative voting.5 6.3 25.1 13.3 23.9 20.2 10. For instance. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.2.2 18.0 20.3 88.6 6. 4.8 142.3 49. could lead to a high turnover in the board.9 13. by the 1990s.3 49.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.5 94. measured by total asset turnover.7 10. although the performance of listed companies in the late 1980s was strong.8 26.6 10.6 7. the overall activities of listed companies.8 6. Although stable in the 1980s. However.3 43.3 52.1 25.8 10.Chapter 4: Thailand 239 Table 4.1 Small Medium Large 5.3 176. capital despite the higher gross margins of small companies. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. In sum. weaknesses became evident.8 47.4 Legal and Regulatory Framework Before 1992.1 6. which would be disruptive to company management. 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 6.2 121.7 14.2 134.3 164.2 12.

The legal and regulatory framework for the corporate sector also includes provisions related to insolvency.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. As it turned out. .240 Corporate Governance and Finance in East Asia. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. Fortysix companies responded. that creditors had generally little influence on the management of corporations. adopted to promote the development of publicly listed companies. The law prohibited the largest shareholders. but not all questions were answered. played an important role in bringing about the financial crisis. and external monitoring and control of corporations were also weak. However. The protection of minority shareholders was inadequate under the Public Company Act of 1992. coupled with weak corporate governance. and the punishment for management misconduct was also lightened considerably. II Another issue was the proportion of shareholding by top shareholders. The provision discouraged original family owners from registering their companies. the exit of these provisions appears to have contributed to the 1997 financial crisis. the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually.5. 4. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. Cumulative voting was made optional. An Asian Development Bank (ADB) survey conducted for this study shows. concentrated ownership. As the succeeding sections point out. as a group. The Public Company Act of 1992. This will be discussed in Section 4.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. relaxed the contentious provisions of the 1978 Public Limited Company Act. Vol. for instance.

Ownership Concentration Between 1990 and 1998. Ownership was most concentrated in the packaging. Source: Comprehensive Listed Company Information Database.Chapter 4: Thailand 241 4.6 28.9 52.5 28.8 11.7 percent. respectively.3 16.5 Average for 1990-1998 period.1 11. and 28.2 11.3. Unfortunately.4 percent of outstanding shares.4 10. Table 4.8 5.9 26.6 57.8 32.7 11.6 68. one would expect the public. Thai.4 26.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.9 4. creditors.4 5. with the top three shareholders accounting for almost 50 percent (Table 4. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.1 4. 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. In the past.2 4.6 27. In contrast.6).5 9.1 12. But with their increased reliance on new varieties of equity and debt instruments. 33.0 3.3 percent and 18. and minority shareholders to stake their claim in the control and regulation of these companies.7 12. this was not the case.9 52.9 55. Indonesian.1 percent of control rights.4 4. there were only slight variations in the pattern.3 28.9 6. the top five shareholders of each of publicly listed Thai companies held.1 5.7 7.1 5. on average.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. Across industries.4 6.3 11.3 percent. China firms have the highest single shareholder ownership concentration at 35.2 56.6 4. Stock Exchange of Thailand.4 26.0 5. with the largest shareholder on average controlling 10. and Hong Kong.4 6.9 11. Most large Thai corporations listed on SET started out as family businesses.9 3.0 53.9 54.1 3.7 6.2 4.4 26.9 52.3 7.3 7. 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.1 5. 56.0 7.0 7.China have the least concentrated ownership.0 3.9 percent of shares of a company. these companies obtained funding solely from banks or from their own retained earnings.1 7. .3 5.0 56.2 4.9 3.

** at the 5 percent level. Company size is significantly related to ROE and leverage. Vol.080 6. On the other hand.005** 0.034*** 0. US. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries.7). 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.7 Statistical Relationships between Corporate Profitability.003 0.242 Corporate Governance and Finance in East Asia.001) 0. Table 4.8). Other industries had their top five shareholders controlling at least 55 percent of outstanding shares. year. as measured by debt-to-equity and debt-to-asset ratios.029 3.7 percent of outstanding shares on average (Table 4.800 0.031 3. Based on a regression analysis. owning 26.022*** 0.115 9.116) Debt-to-Equity (1.058* ROE (0. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.037 0.533)*** Debt-to-Assets (0.072) (0. and ownership types. founding families maintain effective control of entire groups. Through these holding companies. Leverage.001 0. II agribusiness. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.001*** 0. including those that are publicly listed .647 Note: The regression included dummy variables for industry. 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. * Denotes significance at the 10 percent level.090 0. results show a significant positive relationship between ownership concentration and financial leverage. *** at the 1 percent level. with a top-five ownership concentration of at least 60 percent. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.169*** 0. and building and furnishing industries. Ownership Concentration.

0 18. Source: Comprehensive Listed Company Information Database.3 1.8 28. . 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.8 1.1 1.5 0.1 0.3 1. operates five of the most successful shopping malls in Thailand.6 1. individual members of the Chirathivat family aggregately hold 25.7 0.2 18.5 Individuals 13. a joint venture among three families.6 1. in SET.5 2.5 0. the company increased its registered capital and became a public company listed in SET.0 3. Established in 1980 with a registered capital of B300 million. These individuals usually hold important management positions in concerned companies. the affiliate firms rarely hold shares of their parent companies. Although holding companies set up affiliate firms.7 1. In 1994.2 7. Typically.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.6 1. a company listed in the real estate sector of SET. owned by the Chirathivat family. averaging about 18.5 1. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.2 5.3 0.9 6.9 7.3 27.2 1. This practice is illustrated by Central Pattana. In addition.9 0. Stock Exchange of Thailand.5 Government Other 0.5 5.8 0.3 27. including finance and investment companies.4 20. The top 10 shareholders include a holding company owned by the Tejapaibul family.9 18. Individual family members also hold a significant amount of outstanding shares. a NBFIs denotes nonbank financial institutions.0 19. The ADB survey indicated that listed companies held shares in an average of 11 companies.2 1. one of the founding members.7 Bank 2.8 23.3 20.3 27.3 percent of outstanding shares.1 4.6 28.0 17.7 — 1. The largest shareholder is Central Holdings Company. the company. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand.6 25.5 percent. with 29.6 percent of outstanding shares. unlike in Japan where crossshareholding is common.1 1.5 26.4 1.9 15.3 — = not available.Chapter 4: Thailand 243 Table 4.7 5.4 22.4 1.5 NBFIsa 6.5 0.4 1.5 1.6 5.3 1.9 19.

the top 10 shareholders consist predominantly of members of founding families and their holding companies. they account for 80 percent of total outstanding shares. There was a trend of rising government shareholdings throughout the period 1990 to 1998.244 Corporate Governance and Finance in East Asia. duties. the Government’s role in public companies is expected to decline.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process.9 percent of outstanding shares. where the top three shareholders are the Ministry of Finance. qualification. Vol. Moreover. Across industries. In such cases.1 percent of total outstanding shares of listed companies. the Government owns the majority of the shares. with the envisioned privatization master plan. 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. on average. the predominance of individual family members and holding companies in the top shareholder list remains valid. On average.5 percent of total outstanding shares of listed companies. By owning 62 percent of voting shares. 4. the Petroleum Authority of Thailand. Together. Thai Airways International Plc.3. However. Another example is Bangchak Petroleum Plc. and responsibilities of directors of public companies. . Although the list of top shareholders of publicly listed companies includes financial institutions. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. The Government holds. II another of the company’s founding members. 1. they exercise limited influence in operations because of the restricted size of their shareholdings. and a state bank.5 percent of total outstanding shares. roles. Nonbank financial institutions hold an aggregate 5.. 3 Discussions in this section are based on results of company surveys by SET and ADB. has the Ministry of Finance as its only large shareholder with 92. these shareholders are able to control the company. commercial banks account for only 1. For example. both conducted in 1999. Except in the hotel and travel service sector. In effect. only one tenth of listed companies have commercial banks on their top-five shareholder list.

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

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

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

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

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

II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. In 1996. The first category is the acquisition of shares in the open market. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. with a significantly lower total tender offer value of B8. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. There are detailed requirements regarding such notification. however. of shareholders: (i) all shareholders must receive tender offers. with a total tender offer value of B42. The second category is the tender offer.250 Corporate Governance and Finance in East Asia. It will take years. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. Such efforts would serve to strengthen external discipline on controlling owners. and failed to provide managers with strong incentives to perform efficiently. there are two categories of merger and acquisition activities with associated regulatory measures. its main role is to ensure transparency and fairness. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. Recently. In 1994 and 1995.3 billion (Table 4. In this case. The market for corporate control has not been active in Thailand. before the extent to which the bankruptcy framework has been strengthened becomes clear. and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. According to the SEA of 1992. Although merger and acquisi- . the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. Vol. 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.9). SEC has no authority to either approve or reject tender offers. SEC was later made responsible for regulating corporate takeovers.3 billion. there were 41 cases of tender offers. if the purchase of shares implies a change in the directors or business activities. only a limited number of successful mergers of public companies have taken place. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. there were only six tender offers. Since the introduction of the Public Limited Company Act of 1978. whether directly or indirectly.

if any.7 Purchase Value Number of % of Tender Offer Value Companies 84.0 55.2 8.8 81.7 11. but employees have never been represented in the board of directors since their shareholdings are minimal. trading by mutual funds in SET represented less than 10 percent of total trading. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.0 B billion 4. employee participation in corporate governance in Thailand.2 6. employees are even less willing to accept common shares as a form of compensation or benefit. .9 Merger and Acquisition Activities. Provident funds for government workers and workers in public enterprises have been established only recently. tion activities increased after 1997. While the Thai mutual fund industry compares well to those in other developing countries in the region. Few companies offer employee stock option plans (ESOPs).2 6. Since 1994. they have mostly been concerned with short-term gains. employees regard the plans as monetary incentives.1 75.3 60.6 17. Even when companies offer ESOPs.1 84. But instead of opting for an active role in the market for corporate control.Chapter 4: Thailand 251 Table 4. Eleven of the 46 responding companies in the ADB survey offer ESOPs. Employee Participation in Corporate Governance There has been little. Twenty-nine firms indicated that employees held shares of their companies. The number of domestic institutional investors rose after the mutual fund industry was established in 1991.4 23.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.3 6. Source: Securities and Exchange Commission of Thailand.2 7. Because of the current crisis. most of these were forced mergers or related to rescue packages. but the average shareholding is smaller than 1 percent of total outstanding shares.5 6. it remains small. Pension funds are perhaps even weaker in Thailand.1 19.1 58. not with a view to becoming involved in actual management.9 3.3 11.

5 trillion.8 3.6 6.0 3.0 SET Market Capitalization 1.2 2.1 Domestic Debt Securities Outstanding 215.4 4.3 1.1 5.10) shows that Thailand is a highly bank-dependent economy. the banking sector was highly concentrated.906. 15 of which were domestic banks.669.1 3.1 3. The country’s largest bank. The bond market played only a marginal role in corporate financing.564. Table 4.0 424.912. Bangkok Bank Ltd.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.485.5 5.1 6.663. Thai Bond Dealing Centre.979. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.559.4 1.252 Corporate Governance and Finance in East Asia.3 5.5 Outstanding Loans from Commercial Banks 2..4 4.3 546.325.230.9 2.193.0 339.1 7.4 3. total assets of commercial banks amounted to B5.5 4. Vol.6 2.477. although its role increased in the wake of the crisis.372.825.0 8. The Banking System Until recently.430. the next four largest banks accounted for 63 percent.4 519. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.775.119.300.2 262.390.268.5 4. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.133. there were 29 commercial banks. II Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4. accounted for 28 percent of the banking sector’s total assets.8 941. .6 1. and Bank of Thailand. The share of domestic banks in the banking system’s total assets was 80 percent. In 1996.360.10 Size and Composition of the Thai Financial Sector.5 6.4.

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

The listing application should be submitted concurrently to SEC and SET. approved by SET. II jurisdiction of SEC. and pro forma balance sheet and income statements. Company applicants must have an established history of operating under substantially the same management. Before 1993. SET established new requirements for initial public offerings. turnover value was negligible and the BSDC Index remained flat throughout 19961998. If the issue is oversubscribed. Listed companies were those that had (i) paid-up capital of at least B20 million. Its main role is to serve as a secondary market for unlisted companies trying to raise capital. the two classifications were merged. so now only listed companies are traded in SET. The allocation procedure is nondiscretionary. among other functions approved by SEC. there were two kinds of companies in SET—“listed” and “authorized” companies. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. also acts as a clearinghouse. with each facing different listing requirements. but dropped the following year to B122 million. In 1996. and securities registrar. If approved by SEC and the SET Board of Governors. and (ii) a minimum of 300 shareholders.254 Corporate Governance and Finance in East Asia. It separated the primary and secondary markets to promote more flexible and effective supervision of both.5 percent and collectively owning at least 30 percent of paidup capital. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. . In 1998. the BSDC was dissolved in 1999. According to the SEA of 1992.8 billion in 1996. SET’s primary functions are to serve as a center for the trading of listed securities and to provide the essential systems needed to facilitate securities trading. securities deposit center. securities can be traded in the secondary markets. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. SET. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. however. After initial public offerings. Turnover value was B1. stock trading can commence within five days. which consist of SET and BSDC. Only one security was listed in BSDC in 1995 and two more in 1996. financial projections. to assist in the public offering process. Consequently. each holding no more than 0. Vol. In July 1990. lottery drawing must be used to ensure fairness. The primary market is supervised by SEC. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. The company should then appoint a financial adviser.

the first bond rating agency in Thailand. it represented only 9 percent of GDP. 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. To gain some perspective of the size of the bond market in Thailand. while secured debt instruments accounted for just above 10 percent. The Thai Rating Information Services. was also instrumental to the growth of the corporate debt market. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. it accounted for a small share of the entire financial sector. Investors had limited knowledge of debt instruments. however. The budget surpluses of the 1990s eliminated the need for new bond issuance.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. in 1994. Four years after the passage of the SEA. . The proportion of domestic convertible debt instruments increased until 1995. which encouraged limited companies and public companies to issue debt instruments. the size of the corporate debt market rose to B132. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. In 1996. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. The recent financial crisis. and the Government did not issue new bonds during 1990-1997. the Bank of Thailand assumed responsibility for regulating the bond market. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization.11). A turning point of the corporate debt market was the enactment of the SEA of 1992. However. the Government issued more bonds to finance industrial development projects and perennial deficits. compared to 110 percent in the US and 74 percent in Japan in the same year. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. Upon its founding in 1942. Beginning 1961. 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 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 bond market in Thailand started in 1933.9 billion.

7 — — — — — — — 77.6 — — 0.3 3.8 47.0 26.3 50.7 538.8 167.1 41.7 5. a surge attributed to capital inflows encouraged by high returns on Thai bonds.9 0.2 39.5 — 39.3 46.1 6.0 60. the year the crisis unraveled and the baht was floated.0 333.0 17.3 — — 3.4 7.2 43.7 95.0 86.1 141.3 6.0 — 5. by the end of 1997.4 57.4 billion.0 5.7 28. this had climbed to B200. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.6 billion.5 — 0. Vol.0 27.2 45.3 29.7 90.4 — 26.5 billion.1 107.9 5.0 33.0 7.1 21.6 19.7 132. then declined substantially in 1996 and 1997. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.5 55.2 — — 50.0 281.4 — — — 1.2 57. turnover value had reached B51.7 0.7 — — — — — 4. II Table 4. However.4 — 9.7 821.1 121.8 2.1 — — 6.7 0.1 — — — 29. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.9 37.8 191.7 5.9 30.9 329.1 61. total offshore debt offerings had plunged by 68 percent to a mere B28.5 — — — 3.7 — — 40.2 2.11 Offerings of Debt Securities.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.8 31.4 110.1 59.1 315.2 28.5 — — — — 1.0 0. Total offshore debt offerings peaked in the run-up to the financial crisis.1 55. The following year.3 22.4 49.9 40.5 10.5 37.5 43. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.5 5.0 — 5.0 — 26.3 13. By 1995.5 138.3 140.3 — 14.3 46.3 8. 1992-1999 (B billion) Item Government Bonds Treasury Bills State Enterprise Bonds Guaranteed Nonguaranteed Other Government Bonds Corporate Bonds Domestic Secured Unsecured With Warrant Convertible Short-Term Offshore Secured Unsecured With Warrant Convertible Total 1992 1993 1994 1995 1996 1997 1998 1999 — — — — — — 400.1 289.1 10.2 89.256 Corporate Governance and Finance in East Asia.1 12. .9 37.9 20.6 — 0.1 8.5 — — 32.7 7. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.8 55.

The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. short-term loans accounted for more than 40 percent of total liabilities. For the construction industry. these comprised 31 percent. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. and marketable securities holdings. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. Construction and property development industries tended to have high proportions of long-term loans and debentures.4. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. 4.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. From 1990 to 1996. turnover value plummeted to B106. these accounted for 33 percent of total liabilities. The average for all industries was only 22 percent.12). steadily easing up between 1990 and 1996. a trend most apparent in the leap between 1991 and 1992. while for the property development industry. In 1997. At lower than 5 percent of total liabilities. Equity financing remains an important part of listed companies’ long-term financing. Longterm loans accounted for about 20 percent of total liabilities.1 billion in 1998. There was also little change in the trend in retained earnings within the seven-year period.Chapter 4: Thailand 257 compared with investment in equities. with equity levels remaining high despite an increase in debt. they also had a relatively small proportion of equity and . The proportion of accounts receivable also declined steadily. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. Companies in construction and property development seemed unable to generate internal funds. Retained earnings accounted for about 30 percent of total equity financing.2 billion as a result of the default of debentures due to the Asian crisis. Across industries. cash balances. judging by their relatively low levels of retained earnings. In any case. Turnover fell further to B72. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. significant variations can be noted. In the same year. In addition. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis.

3 14.6 12.3 18.9 17.1 36.0 15. II Table 4.8 46.9 6.6 36.9 14.0 100.8 14.1 17.4 49.0 13.2 16.8 10.0 100.3 2.0 1.4 6.7 16.5 9.2 15.8 7.3 17.5 1.9 40.2 1. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.6 0.3 12.258 Corporate Governance and Finance in East Asia.2 16. were highly leveraged.0 100.0 10.2 1.4 49.2 2.9 50.8 19.0 12.0 100.1 7.0 100.3 1.1 50.5 1.8 35.5 0.2 43.7 7.5 1.0 100.0 100.8 20.3 48.1 18.6 38.4 7.9 16.9 38.6 2.6 50.4 21.5 9.2 1.8 21.1 13.2 22.7 9. medium.5 37.9 14.3 34.0 100.9 15.3 49.6 21.8 8.2 2.8 34.3 50.3 14.8 17.4 14.6 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.6 0. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.6 10.2 12.7 50.9 17.9 3.6 0.7 14.8 37.2 42.9 14.2 3.6 0. Printing and publishing companies had lower financial leverage than companies in other industries.7 18.0 6.2 17.3 34.8 9.7 52.6 6.6 8.7 17. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.6 51.9 0.9 6.9 2.0 100.0 100.9 43.7 36.0 100.4 8.8 3.2 17.5 43.6 100. Vol.0 100.0 48.4 17.6 22.9 49.8 25.2 43.13).3 18.4 2.2 45.2 2.12 Common-Size Statements for Companies Listed in SET.2 2.9 12.6 11.3 38.7 15.0 51.7 1.8 1.0 7.3 25.5 11.0 10.1 2.3 1.2 34. The level of total liabilities for the group characterized by high ownership concentration .9 10.3 6.2 17. US.9 18.8 9.5 14.7 16.8 37.0 100.0 100.0 14.4 48.6 13. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.4 43.4 17.6 14.3 21.8 6.1 49.6 15.9 14.1 5.6 100. compared with the 44 percent general average.7 0.2 35.0 2.9 20.2 17.9 14.

common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.6 2.0 41.8 13.1 53.7 19.3 35.2 11.8 13.9 50.5 11. .8 12.9 0.7 17.9 36.4 35.5 13. was 53 percent of total assets compared with 49.1 18.3 100.0 6. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.6 0.3 8.0 100.6 100.5 percent for low ownership concentration companies.5 100.2 14.6 22.6 9.6 47.3 1.4 7.5 18.4 3.9 100.0 19.2 0. For the high ownership concentration group.Chapter 4: Thailand 259 Table 4.2 22.3 1.0 Medium 2.4 13.0 6.4 49.4 18.3 16.0 16.0 Low 1.4 1.5 21. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.1 49.7 percent for medium ownership concentration companies and 49. 1990-1996 Degree of Ownership Concentration Item Assets Cash Marketable Securities Accounts Receivable Inventories Other Current Assets Total Current Assets Net Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Loans Debentures Other Liabilities Total Liabilities Capital Stock Paid-In Capital Retained Earnings Total Equity Total Liabilities and Equity High 2.4 50.6 15.9 21.13 Common-Size Statements of Public Companies by Ownership Concentration.0 100.1 36.7 12.2 8.9 16.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. US.4 37.8 37.0 14.1 44.9 7.9 2.6 14.2 45.0 7.

6 138. As a result. US. Such deterioration of financial positions during the period was a common feature of listed companies.4 12. bond issues.7 5.4 7.4 5.9 7.7 12. The ratio of total debt to total assets increased from 50. Table 4. While further detailed investigations are necessary.14 Financial Ratios of All Listed Firms.8 65. however. and rights issues. followed by bank loans.1 16.4 51.3 31.1 in 1996. and maintenance of the existing ownership structure. Vol.6 41. minimization of transaction and interest costs.7 34.260 Corporate Governance and Finance in East Asia. especially from 1994 to 1996.1 52.8 151. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing. however.4 44. The TIE ratio declined from its peak of 7.8 percent in 1990 to 52.0 50.9 14. bond issues overtook loans from commercial banks as the second preference.7 12.0 28.0 145. these firms more easily increased their leverage.1 144. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.7 66.0 25. Public companies relied more on short-term debt financing in the period before the financial crisis.15.8 51.5 52.2 49.1 31. thus rendering them more vulnerable. . was the headlong deterioration of firms’ ability to meet their interest payment obligations.6 125. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration. the choice of financing is determined by the company’s liquidity considerations.1 16. After the crisis.6 7.2 68.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.3 61.1 44.7 34.8 65.7 11. 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 4.5 38.1 64.7 percent in 1996.2 35.7 in 1994 to 5. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4.7 28. Generally.9 63. Short-term debt accounted for most of the increase.9 51.9 140. 1990-1996 Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) 1990 1991 1992 1993 1994 1995 1996 8.1 23.1 31.14). More important.8 5.4 139.

on the other hand.15 Financial Ratios of Listed Companies by Ownership Concentration. The proportion of external debt as a percentage of GDP consequently increased from 42. 4. The proportion of nondebt-creating capital flows.5 percent between 1985 and 1990 to 8.4 13. continued to slide from 1985 to 1997.Chapter 4: Thailand 261 Table 4. unhedged foreign exchange liabilities.4 27. 1990-1996 Degree of Ownership Concentration Ratio Times Interest Earned Total Debt to Equity (%) Long-Term Debt to Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Net Working Capital-to-Assets (%) Operating Capital-to-Assets (%) Low 6. the proportion of short-term debt increased from 15. From only 34 percent in 1986.2 124.3 42. Additionally. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. debt-creating capital inflows rose to 65 percent in 1990. is even more telling. however.5 148.1 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.5.2 percent in 1986 to 251. such as direct equity and portfolio investment.1 High 6.2 49.9 percent in 1997.5 126.16). Their average annual growth rate declined from 28.4 63.8 29.0 64.8 28.8 66.8 Medium 7.8 percent in 1986 to 52 percent in 1995.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 percent to 46 percent during the same period. private debt accounted for 84.8 14.8 49. The composition and term-structure of this debt.6 11. . peaking in 1994 at 84 percent.6 30. From 45 percent of total net capital movements in 1985. Nonbank private debt increased from 27.5 4.5 34. 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. US. and a preponderance of short-term debt liabilities.5 percent of external debt in 1996 (Table 4.7 percent from 1991 to 1996.4 52. This decline was accompanied.

1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.4 5.5 12.5 12.2 0.9 0.1 22.8 0.1 Source: Bank of Thailand.1 34.1 0.9 11.9 4.5 14.2 15.4 18.8 3.6 Total 18.0 11.3 0.3 10.0 13.9 5.8 10.3 0.5 4.0 8.7 10.0 11.1 0.9 3.4 2.7 23.3 20.6 18.1 30.1 5.0 0.4 15.2 2.3 2.3 0.3 7.6 52.9 10.2 14.3 12.9 7.9 1.1 12.1 95.8 12.7 24.3 37.5 16.1 0.4 3. .3 16.7 13.7 109.6 7.9 31.4 10.8 108.3 0.7 1.9 13.9 6.9 100.9 1.0 21.2 0.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.7 0.3 0.7 20.2 2.2 2.5 19.1 64.9 3.6 1.1 23.1 2.Table 4.9 29.9 10.4 — — — — — — — 1.2 0.3 0.16 External Debt.3 0.2 32.0 6.9 43.0 4.2 10.1 0.3 3.8 13.3 — — — — — — — 6.9 35.3 3.8 31.3 105.3 0.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.7 2.0 3.5 1.6 — 0.8 3.9 6.5 4.

the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. Foreign investors retreated from the market.281 in December 1995 and to 831. Due in part to liquidity problems on the one hand. Even before the crisis. On average. Aside from the problem of NPLs.6 billion from the 1996 level of B201 billion.360. the SET Index stood at 1. At the end of 1994. If lending rates remained high. 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. With easy access to foreign funds. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. It hit a 10-year low in the second quarter of 1998. and poor business confidence on the other.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. based on the three-month past due definition. . SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. Similarly. After that. outstanding credit also declined throughout the second half of 1998. according to the Bank of Thailand. the liquidity problems faced by the corporate sector are likely to continue for some time.17). nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. closures. and drastic decline in the number and capital of newly registered companies.6 in December 1996. the index declined to 1. The effects of the crisis were felt across all industry sectors. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. banks would be recording more of such NPLs. the number of newly registered companies dropped to a 10-year low in 1998. Meanwhile. leaving domestic investors with large capital losses. and (iii) bankruptcies. reaching 45 percent of total outstanding credit in December. exposing the companies to disaster when the baht started tumbling on 2 July 1997. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. suggesting that serious investors have not returned to the market. Trading volume has since been thin. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. Most of these foreign debts were not properly hedged. The value of public offerings sank in 1997 to B56. from its peak in 1995. trading activity at SET had been on the downturn.

201 24.409 6.096 22.112 9. Thailand.264 Corporate Governance and Finance in East Asia. the Government was left with no choice.095 14.334 4. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. As part of the assistance package. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.2 billion for balance of payments support and buildup of the country’s reserves.695 3.977 Source: Department of Commercial Registration.933 25. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.307 4.797 4.904 20.925 12.777 11.5 at the end of 1994 to 12 in 1996 and further to 6.066 19. A steady price decline over the past few years has dragged down the ratio of market price to book value.2 Responses to the Crisis Initially. It also explains the higher dividend yield ratio.080 9.6 in 1997. 4. II Table 4. The price-to-earnings (P/E) ratio deteriorated from 19. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. .410 37.218 3.134 31.410 5. Ministry of Commerce. But when assistance from other sources did not materialize. Vol.5.915 37. The IMF financial package was a credit facility of $17.312 25.105 4.052 36.677 Bankrupted/Closed 2.288 35.17 Number of Newly Registered and Bankrupted/Closed Companies. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.224 4.902 3.792 7.407 28.

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

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

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

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

accounting for B1. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. As of November 2000. methods. with the majority of the debtors coming from the commerce. Another 77. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. The first bankruptcy court in Thailand opened on 18 June 1999. By October 2000.767 cases involving outstanding credit of B2.147 cases (B1.1 trillion of outstanding credit. accounting for B1. 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.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. Commercial banks initiated 74 percent of these cases. Some 82 percent of these cases have been successfully restructured. Cases for which negotiations were unsuccessful. only 7. and manufacturing sectors. Considerable progress has been achieved on this front. In particular. will be settled by the courts. This point is crucial because compared with . In addition. 322. the number of cases has abated.1 trillion in outstanding credit.764 debt restructuring cases involving B1. However. Within three months. contributing to the unprecedented rise in the corporate sector’s bad debt. although since then.8 trillion had been completed. as well as those that did not cooperate with CDRAC’s restructuring process. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. where bankruptcy procedures are swift and effective. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. and procedures for debt restructuring. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. CDRAC’s target debtors comprised 10. In response.6 trillion. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance.068 cases involving B475 billion are undergoing restructuring.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. personal consumption. the Government introduced debt restructuring-related measures to help resolve bad debts. the court had more than 80 cases for disposition.

the Government protected certain corporate sectors through tariffs and regulation. Philippines. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. 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. Vol. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. and promoted key industries through incentives. and even Indonesia. The . to push companies to harmonize their accounting with international standards. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations.6 4.270 Corporate Governance and Finance in East Asia. For this reason. It required listed companies to establish their own audit committees by the end of 1999. and performance during this period helps understand the causes of the crisis. despite the weakness of their disciplinary powers. II Malaysia. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. Financial information from listed companies will also soon be required to conform to International Accounting Standards. Such improvements in disclosure standards are part of the efforts of SET and SEC. behavior. 4. 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. 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. In the next three decades. The study covers the period 1985 to 1996.1 Summary. Conclusions.6. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. Examination of corporate ownership.

Thai companies were vulnerable to exchange rate risks. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999.000 from the previous year’s level. at a time when most of them were already experiencing declining profits and high leverage. the increase in long-term debt more than compensated for the drop. the overall pattern of ownership concentration seems to have been stable for the past 10 years. The study examined the impact of ownership structure on corporate governance and financing patterns. there was a marked increase in the number of public corporations. In 1995 and 1996. The SEA of 1992 also marked the beginning of an active bond market in Thailand. . One of the major findings is the high ownership concentration among Thai companies listed on SET.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. foreign debt in the Thai corporate sector increased continuously. Because most of these debts were not hedged. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. The number of newly registered companies in 1997 dropped by almost 10. the top five largest shareholders hold about 56 percent of total outstanding shares. the overall corporate sector was seriously affected. During 1992-1997. One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. Minority shareholders. Nonbank private corporations accounted for most of the increase. After 1992. Although there are some variations across industries. even after the development of capital markets. the corporate sector entered a new era with the enactment of two major pieces of legislation. At the onset of the 1997 financial crisis. Although there was a decline in short-term foreign debt. the number and value of public offerings of securities accelerated. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. This implies that the control of an average Thai company is typically in the hands of a few persons (founders or their associates) who own a majority of total outstanding shares. the Public Company Act of 1992 and the SEA of 1992. The impact of the crisis was felt across all industries. On average. Consequently. At the same time. Subsequently. the numbers of bankruptcy cases and company closures reached alltime highs. Meanwhile. the profitability of publicly listed companies abruptly declined and their financial leverage increased. In 1992. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. reaching its peak in 1996.

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

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

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

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

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

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

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