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A Study of Indonesia, Republic of Korea, Malaysia,Philippines,andThailand
Edited by: Juzhong Zhuang SeniorEconomist RegionalEconomicMonitoringUnit AsianDevelopmentBank David Edwards AssistantChiefEconomist ProjectEconomicEvaluationDivision AsianDevelopmentBank Ma. Virginita A. Capulong SeniorSectorAnalyst AgricultureandSocialSectorsDepartment(West) AsianDevelopmentBank
© Asian Development Bank 2001 Allrightsreserved. ThispublicationwaspreparedundertheAsianDevelopmentBanksregionalTechnical Assistance 5802: A Study on Corporate Governance and Financing in Selected DMCs. The views expressed in this book are those of the authors and do notnecessarilyreflecttheviewsandpoliciesoftheAsianDevelopmentBank,or itsBoardofDirectorsorthegovernmentstheyrepresent. The Asian Development Bank does not guarantee the accuracy of the data includedinthispublicationandacceptsnoresponsibilityforanyconsequencesfor theiruse. Use of the term country does not imply any judgment by the authors or the AsianDevelopmentBankastothelegalorotherstatusofanyterritorialentity . ISBN 971-561-323-3 Publication Stock No. 100800 Published and printed by theAsian Development Bank P.O. Box 789, 0980 Manila, Philippines
List of Tables List of Figures Foreword Preface Abbreviations 1 Indonesia 1.1 Introduction 1.2 OverviewoftheCorporateSector 1.2.1 HistoricalDevelopment 1.2.2 TheCapitalMarket 1.2.3 The Banking Sector 1.2.4 ForeignCapital 1.2.5 GrowthandFinancialPerformance 1.2.6 LegalandRegulatoryFramework 1.3 CorporateOwnershipandControl 1.3.1 CorporateOwnershipStructure 1.3.2 ManagementandInternalControl 1.3.3 ExternalControl 1.4 CorporateFinancing 1.4.1 FinancialMarketInstruments 1.4.2 PatternsofCorporateFinancing 1.4.3 CorporateFinancingandOwnershipConcentration 1.5 TheCorporateSectorintheFinancialCrisis 1.5.1 CausesoftheFinancialCrisis 1.5.2 ImpactoftheFinancialCrisisontheCorporateand BankingSectors 1.5.3 Responses to the Crisis 1.6 Summary, Conclusions, and Recommendations 1.6.1 SummaryandConclusions 1.6.2 Policy Recommendations References vi ix x xi xii 1 1 3 3 4 5 7 8 15 17 17 25 30 32 32 34 35 36 36 39 42 45 45 48 51
2 Republic of Korea 2.1 Introduction 2.2 OverviewoftheCorporateSector 2.2.1 HistoricalDevelopment 2.2.2 Rise of the Large Business Groups (Chaebols) 2.2.3 RoleoftheCapitalMarketandForeignCapital 2.2.4 GrowthandFinancialPerformance
53 53 55 55 60 62 65
iv 2.3 CorporateOwnershipandControl 2.3.1 PatternsofCorporateOwnership 2.3.2 InternalManagementandControl 2.3.3 ShareholderRights 2.3.4 ControlbyCreditors 2.3.5 TheMarketforCorporateControl 2.3.6 ControlbytheGovernment 2.3.7 EmployeeParticipationinCorporateGovernance 2.4 CorporateFinancing 2.4.1 Overview of the Financial System 2.4.2 PatternsofCorporateFinancing 2.4.3 FinancialStructure,Diversification,andCorporate Performance 2.5 TheCorporateSectorintheFinancialCrisis 2.5.1 WeaknessesinCorporateGovernance 2.5.2 TheRoleofGovernmentIntervention 2.5.3 ManifestationsofWeakCorporateGovernanceand GovernmentIntervention 2.5.4 ShortcomingsinMacroeconomicPolicy 2.6 Responses to the Crisis and Policy Recommendations 2.6.1 CorporateRestructuringActivities 2.6.2 PolicyMeasuresforCorporateReform 2.6.3 Policy Recommendations References 3 The Philippines 3.1 Introduction 3.2 OverviewoftheCorporateSector 3.2.1 HistoricalDevelopment 3.2.2 GrowthandFinancialPerformance 3.2.3 LegalandRegulatoryFramework 3.3 CorporateOwnershipandControl 3.3.1 PatternsofCorporateOwnership 3.3.2 CorporateManagementandShareholderControl 3.3.3 TheRoleofCreditorsinCorporateControl 3.4 CorporateFinancing 3.4.1 TheFinancialMarketandInstruments 3.4.2 PatternsofCorporateFinancing 3.4.3 OwnershipConcentration,FinancialLeverage,and Performance 3.5 TheCorporateSectorintheFinancialCrisis 3.5.1 TheFinancialCrisis:CausesandManifestations 3.5.2 ImpactoftheCrisisontheCorporateSector 3.5.3 Responses to the Crisis 74 74 94 103 105 108 110 111 113 113 118 128 130 132 134 134 137 139 139 143 148 153 155 155 156 156 158 167 171 171 186 198 199 199 202 209 210 210 212 214
v 3.6 Summary, Conclusions, and Recommendations 3.6.1 SummaryandConclusions 3.6.2 Policy Recommendations References 216 216 219 226
4 Thailand 4.1 Introduction 4.2 OverviewoftheCorporateSector 4.2.1 HistoricalDevelopment 4.2.2 DevelopmentofCapitalMarkets 4.2.3 GrowthandFinancialPerformance 4.2.4 LegalandRegulatoryFramework 4.3 CorporateOwnershipandControl 4.3.1 PatternsofCorporateOwnership 4.3.2 CorporateManagementandControl 4.3.3 ExternalControl 4.4 CorporateFinancing 4.4.1 OverviewoftheFinancialSector 4.4.2 PatternsofCorporateFinancing 4.5 TheCorporateSectorduringtheFinancialCrisis 4.5.1 ImpactoftheFinancialCrisisontheCorporateSector 4.5.2 Responses to the Crisis 4.6 Summary, Conclusions, and Recommendations 4.6.1 SummaryandConclusions 4.6.2 Policy Recommendations References
229 229 230 230 233 235 239 240 241 244 248 252 252 257 261 261 264 270 270 273 277
5 Financial Performance of Publicly Listed Companies by Sector. 1992-1995 Table 1.13 Presence of Board Committees in Listed Companies Table 1. 1992-1997 Table 1. 1993-1997 Table 1.vi List of Tables 1. 1992-1999 Table 1.21 Nonperforming Loans by Type of Bank.20 ROE of the Banking Sector.6 GrowthandFinancialPerformanceofState-Owned Companies. 1992-1999 Table 1.14 Banking Sector Outstanding Loans.17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1986-1996 Table 1.10 Anatomy of the Top 300 Indonesian Conglomerates.11 CharacteristicsoftheBoardofCommissioners Table 1.4 Growth Performance of Publicly Listed Companies by Sector.18 GDP Growth by Sector. 1990-1997 Table 1. 1992-1997 Table 1.8 OwnershipConcentrationofPubliclyListedCompanies. 1992-1997 Table 1. Indonesia Table 1. 1996-1998 Table 1. 1996-1998 2.3 Subsidiaries of the 30 Largest Chaebols Table 2. 1992-1997 Table 1. 1988-1996 Table 1.3 GrowthandFinancialPerformanceofPubliclyListed Companies.2 KeyMacroeconomicIndicators Table 2. 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 .16 FinancingPatternsofPubliclyListedNonfinancial Companies.12 CharacteristicsoftheBoardofDirectors Table 1.2 Foreign Capital Flows.19 DER and ROE of Publicly Listed Companies by Sector.4 Development of the Stock Market. 1996-1999 Table 1.1 Listed Firms with Positive Economic V alueAdded. 1993-1999 Table 1.9 OwnershipConcentrationofPubliclyListedCompanies by Sector. 1997 Table 1. 1992-1998 Table 2.15 V alue of Stocks Issued and Stock Market Capitalization.7 Growth Performance of the Top 300 Conglomerates.1 Growth of the Banking Sector. 1990-1998 Table 1. Republic of Korea Table 2.
17 Table 2.20 Table 2.26 Table 2. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry. 1993-1997 The Top 30 Chaebols Debt-to-Equity Ratio. 1997 Ownership Concentration ofAll Listed Firms.22 Table 2.16 Table 2. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.24 Table 2. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector.6 Table 2. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.19 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size.10 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries.vii Table 2.23 Table 2.14 Table 2.11 Table 2. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.21 Table 2. 1995-1997 Ownership Composition of Listed Companies.15 Table 2.12 Table 2.27 Table 2.8 Table 2.9 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols. 1994-1998 Financing Patterns of the Top 30 Chaebols. 1999 InternalShareholdingsofthe30Largest Chaebols.25 Table 2.13 Table 2.18 Table 2.30 Private Capital Flows to Korea. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type.7 Table 2. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.28 Table 2.5 Table 2. 1993-1997 64 66 66 68 70 71 72 73 75 78 80 82 82 83 84 85 86 87 90 91 120 121 122 126 126 127 . 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies.29 Table 2.
1992-1999 . 1988-1997 Table 3. 1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct. The Philippines Table 3.11 TotalandPerCompanySales.2 Growth and Financial Performance of the Top 1. 1997 Table 3.viii Table 2. Thailand Table 4. 1997 Table 3.22 Foreign Investment Flows. 1985-1997 Number of Firms with Dishonored Checks.Profitability andFinancial .7 GrowthandFinancialPerformanceoftheCorporateSector by Industry. 1989-1997 Table 3.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure. 1995-1998 4.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.1989-1997 Table 3. 1990-1999 Table 3.14 Philippine Stock Market Performance.17 Composition ofAssets and Financing of the Publicly Listed Sector. Leverage Table 3. 1988-1997 Table 3.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1989-1997 Table 3. 1989-1997 Table 3. 1986-1998 Nonperforming Loans of General Banks.31 Table 2.33 Net Profit Margins of Chaebols.12 Control Structure of the Top 50 Corporate Entities. Flagship Company. 1988-1997 Table 3. 1988-1997 Table 3.SectorOrientation.18 Financing Patterns by Control Structure. 1988-1997 Table 3.1 GDP Growth of SoutheastAsian Countries. 1988-1997 Table 3. 1978-2000 Table 4.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size. 1997 Table 3. 1997 Table 3. 1989-1997 Table 3. 1990-1998 131 137 138 158 159 160 161 163 164 166 173 175 176 180 184 191 201 203 204 205 206 207 208 209 212 235 236 3.21 OwnershipConcentration.16 CorporateFinancing PatternsbyOwnershipType.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies.15 Financing Patterns of the Corporate Sector. andAffiliated Banks of Selected Business Groups.13 ADB Survey Results on Shareholder Rights Table 3.32 Table 2.19 Financing Patterns by Firm Size.000 Companies.2 Public Offerings of Securities. 1992-1996 Table 3.20 Financing Patterns by Industry.1 Public Companies Registered. 1983-1997 Table 3.
1985-1996 Average Key Financial Ratios by Company Size. 1992-1999 Common-Size Statements for Companies Listed in SET.4 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.12 Table 4.7 Table 4. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.3 Table 4.9 Table 4. 1990-1996 Financial Ratios of All Listed Firms.14 Table 4.6 Table 4. 1990-1998 Merger and Acquisition Activities.2 Figure 3.1 Figure 3. 1990-1996 External Debt.1 Figure 1.2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.8 Table 4.13 Table 4.ix Table 4. 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.5 Table 4.10 Table 4. Leverage. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1993-1999 Key Financial Ratios of Publicly Listed Companies.16 Table 4. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1993-1999 Size and Composition of the Thai Financial Sector.15 Table 4. 1992-1999 Offerings of Debt Securities.11 Table 4.17 StatisticalHighlightsoftheStockExchangeofThailand. Ownership Concentration.
Corporate governance has become a major policy concern in the wake of the Asian financial crisis. Weak governance structure, poor investment, and risky financingpracticesofthecorporatesectorintheaffectedcountriescontributedto their sharp economic recession in 1997-1998. The weaknesses in corporate governanceandfinanceunderminedthecapacityofthesecountriestowithstandthe combined shocks of depreciated currencies, massive capital outflows, increased interestrates,andlargecontractionindomesticdemand. Tohelpunderstandcorporategovernanceissuesandtheirimpact,aswell astoidentifyneedsforinterventionsinaddressingpolicyandinstitutionalweaknesses, the Economics and Development Resource Center of theAsian Development Bank (ADB) undertook a regional study on corporate governance and finance in selected developing member countries. The countries covered are Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. This book presents the major findings of the study. The policy recommendations will supportADBs financialsectorworkinitsdevelopingmembercountries.
Arvind Panagariya ChiefEconomist
Corporate Governance and Finance in EastAsia presents the findings of a regionalstudyofcorporategovernanceandfinanceinselecteddevelopingmember countries of theAsian Development Bank (ADB). The study attempts to identify theweaknessesincorporategovernanceandfinanceincountriesmostaffected by the 1997Asian financial crisis, and recommends policy and reform measures to address the weaknesses. The study covers Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. The findings of the study are presented in two volumes. Volume One,A ConsolidatedReport,presentsaframeworkforanalyzingcorporategovernance and finance, summarizes the major findings of the five country studies, and provideskeypolicyrecommendationsforstrengtheningcorporategovernanceand improving the efficiency of corporate finance inADB member countries. Volume Two,CountryStudies,collectsfourcountryreports.Wewouldliketothankcountry experts Saud Husnan of Gadsab Mada University, Indonesia; Kwang S. Chung andYen Kyun Wang of Chung-Ang University, Republic of Korea; FazilahAbdul Samad of University of Malaya, Malaysia; Cesar G. Saldaña of PSR Consulting, Inc., the Philippines; and Piman Limpaphayom of Asian University of Science and Technology, Thailand, for their efforts and cooperation in conducting the countrystudies.CesarG.Saldañaalsoprovidedusefulinputstothepreparation oftheconsolidatedreport. The volumes benefited extensively from constructive comments from ADBstaffandofficialsoftheministriesoffinance,centralbanks,securitiesand exchangecommissions,stockexchanges,andcorporaterestructuringagenciesof theeightADBmembercountriesthatparticipatedinthestudysfinalizationworkshop in Manila, on 18-19 November 1999. Our deep appreciation goes to Jungsoo Lee, former Chief Economist, and S. Ghon Rhee, former Resident Scholar, for their strong support at various stages of the study; Manabu Fujimura, for his efforts in organizing the finalizationworkshop;MarceliaGarcia,MarinieBaguisa,Ma.ReginaSibal,andRosanna Benavidez, for their administrative support and assistance; and JosefYap, Leah Sumulong, Graham James Dwyer, Judith Banning,andLynetteMallery, for their editorialassistanceandadvice.
ADB AGM AGSM AMU APEC B BDC BIBF BIS BOC BOD BSDC BSP BUN CB CDRAC CEO CP CRA DER ESOP EVA FDI FSC GAAP GATT GDP GNP HCI IBRA IDFR IEFR IFS IMF IPO IPP JSX NBFI NEFR NPL OECD OTC Asian Development Bank annualgeneralmeeting annualgeneralshareholdersmeeting assetmanagementunit Asia-Pacific Economic Cooperation baht Bond Dealers Club BangkokInternationalBankingFacility BankforInternationalSettlements board of commissioners boardofdirectors BangkokStockDealingCenter BangkoSentralngPilipinas(CentralBank) Bank Umum Nasional convertiblebond CorporateDebtRestructuringAdvisoryCommittee chiefexecutiveofficer commercialpaper CorporateRestructuringAgreement debt-to-equityratio employee stock ownership plan economicvalueadded foreigndirectinvestment Financial Supervisory Commission generallyacceptedaccountingprinciples GeneralAgreementonTariffsandTrade grossdomesticproduct grossnationalproduct heavyandchemicalindustries IndonesianBankRestructuringAgency incrementaldebtfinancingratio incrementalequityfinancingratio InternationalFinancialStatistics InternationalMonetaryFund initialpublicoffering investmentprioritiesplan JakartaStockExchange nonbankfinancialinstitution newequityfinancingratio nonperformingloan OrganisationforEconomicCo-operationandDevelopment over-the-counter
xiii P PCO PD PICPA PLDT PSE PTB ROA ROE Rp RSA SBL SCS SEA SEC SET SFR SMC SSS SOC TIE TQ W US peso planningandcoordinationoffice PresidentialDecree PhilippineInstituteofCertifiedPublicAccountants Philippine Long Distance Telephone Co. Philippine Stock Exchange principaltransactionsbank returnonassets returnonequity rupiah Revised SecuritiesAct singleborrowerlimit shareofacontrollingshareholder Securities and ExchangeAct Securities and Exchange Commission StockExchangeofThailand self-financingratio SanMiguelCorporation Social Security System State-ownedcompany timesinterestearned Tobins Q won UnitedStates
Note: In this volume, $ refers to US dollars, unless otherwise stated.
The currency crisis that began in mid-1997 in Thailand spread quickly to Indonesia and the rest of Southeast Asia. Initially, Indonesia’s monetary authority tried to defend the domestic currency, the rupiah, by widening the intervention band, while maintaining its managed floating system. From 5 to 8 percent in June 1997, when the currency crisis hit Thailand, the band was widened to 12 percent on 11 July 1997 when the crisis started spilling over to Indonesia. After resisting pressure for a short period, the rupiah fell by 6 percent against the dollar on 21 July 1997, the biggest one-day fall in five years. Finally, the Indonesian monetary authority realized that the system could not cope with the continuing pressure on the currency, as the risk of losing all foreign exchange reserves to prop up the rupiah was too high. On 14 August 1997, the monetary authority decided to adopt a free floating exchange rate system. The currency fell further because of strong demand for dollars. As the rupiah weakened, nervous lenders refused to refinance maturing loans, investors cut down and then reversed the flow of funds, borrowers tried to obtain dollars before the rupiah fell further, and individuals joined the chase for dollars. At that time, several banks ran out of dollar notes. From Rp4,950 to the dollar at the end of December 1997, the exchange rate fell to more than Rp15,000 at the height of the crisis in June 1998, although it later stabilized at about Rp9,000. At that exchange rate, it is estimated that half of Indonesian corporations became technically insolvent. The crisis also exacerbated an already deepening political turmoil. The financial crisis devastated the Indonesian economy. In 1998, gross domestic product (GDP) contracted by 13 percent and the inflation
Associate Professor, Faculty of Economics, Gadsab Mada University, Yogyakarta, Indonesia. The author wishes to thank Juzhong Zhuang, David Edwards, both of ADB, and David Webb of the London School of Economics for their guidance and supervision in conducting the study, the Jarkata Stock Exchange for its help and support in conducting company surveys, and Lea Sumulong and Graham Dwyer for their editorial assistance.
5 percent. Foreign creditors. patterns of financing. When the crisis hit the country. regulatory framework. and responses to the financial crisis. this left the Indonesian economy extremely vulnerable. prior to the financial crisis. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. Section 1. In many instances. However. It analyzes the weaknesses of corporate governance in Indonesia. All sectors. The study also identifies family-based companies and corporate groups. On the other hand. 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. This study reviews the Indonesian corporate sector’s historical development. these controlling families had political connections that allowed their companies to enjoy special privileges. To facilitate even easier access to credit. contracting by 36. placed a high premium on these political connections in assessing the chances of being repaid. Malaysia. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. how it has affected corporate financial performance and financing. short-term loans were used to finance long-term investments. posted negative growth. Lending activities of affiliate banks that were not sufficiently backed by owners’ equity and the reliance by foreign lenders on the strength of political connections paved the way for risky investments. The highly concentrated and family-based ownership structure of corporate groups and companies resulted in a governance structure where corporate decisions lie in the hands of controlling families. Foreign debt reached more than $100 billion. and . In this setup. II rate reached 58. the currency composition and term structure of corporate foreign indebtedness were causes for concern.2 Corporate Governance and Finance in East Asia. the controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. and how it contributed to the crisis.5 percent. and analyzes their importance to the corporate sector in Indonesia. or Thailand.2 presents an overview of the Indonesian corporate sector.6 percent) and trade (-18 percent). the Indonesian economy seemed to be in generally good shape. Vol. except utilities. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. were the ones most affected. These banks were allowed to operate even if they violated minimum capital adequacy requirements. highly leveraged companies. Section 1. particularly those with large foreign loans. followed by finance (-26. patterns of ownership and control. no doubt. The construction sector was the worst hit.3 looks at patterns of corporate ownership and control.
The industries that emerged were highly import-dependent and reliant on tariff protection. substantial volumes of private investment entered the scene. how it was affected by the crisis. Despite the oil revenues. and tobacco industries. . in the course of the fight for nationhood from 1942 to 1950.5 examines the corporate sector during the financial crisis in terms of its role. Not all items in the questionnaires were answered by the respondents.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. It also examines the statistical relationship between corporate performance and corporate governance characteristics. Subsequently. However. and its response.2. 1. medium.2 Section 1. a gradual shift in public investment away from manufacturing took place.2 1.and large-scale companies were dominated by state-run industrial concerns. In the early 1970s. Section 1. Section 1.4 analyzes corporate financing patterns. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange. the windfall from oil and gas revenues was an important factor that allowed the Government to promote industrial development via import substitution. only 40 companies replied—39 are private companies and one state-owned company (Bank BNI). Up until the mid-1960s. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. textiles. while Chinese and indigenous entrepreneurs ran some large businesses in trading.
the Capital Market Executive Agency and National Investment Trust tried to attract small investors to the stock market by setting prices and preferring small orders in initial public offerings (IPOs). the value of manufactured exports overtook the value of oil and gas exports for the first time. the Indonesian industrial sector was quite diverse. the stock exchange was also unattractive to companies trying to raise capital as they could borrow from state banks at very low interest rates. During this period. and employed the bulk of the industrial labor force. But until the end of 1988. Last.4 Corporate Governance and Finance in East Asia. Third. wood. there were also many rapidly growing large-scale companies and business groups or conglomerates. the number of firms quoted in the stock market was only 24. Export credits with low interest rates were granted to industries that were intensive in the use of local labor and raw materials. II the currency needed to be devalued periodically under a managed floating exchange rate system to avoid large current account deficits. Second. A number of underwriters emerged. Generally speaking. mostly nonbank financial institutions and stockbrokers. and related products) had shares in total exports that were rapidly increasing. the Government shifted its industrial policy toward the promotion of labor-intensive exports. By 1987.2. which dominated their respective sectoral outputs and markets. In the 1980s. produced consumer goods. potentially subjects companies to greater regulatory scrutiny. Partly as a result of various government policies. But these proved counterproductive because they limited the potential for capital gains to prospective investors. These were families with strong links to the political elite of the New Order. the dilution of corporate ownership. a distinct industrial elite started to emerge. First. The equity market remained largely unappealing due to a number of factors.2 The Capital Market The Government reactivated the stock exchange in 1977. even when new shareholders do not threaten the control exercised by the original owners. Vol. many founding owners of companies were reluctant to go public and dilute their corporate ownership. Regulations in the banking sector led to equities having higher risk but lower returns than bank deposits. . In 1992. exports of nonoil products (particularly textiles and footwear. 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. While most of the companies were small. 1.
During this period. which were previously constrained to 4 percent per day. private domestic banks dominated the sector in terms of number and total assets. the capital market played an increasing role in raising long-term funds needed by the corporate sector. Partly as a result of these reforms. However. reduced restrictions on foreign exchange transactions. However. the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. the banking sector has been and still is the major source of credit for the corporate sector. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. The banking sector. six SOCs had issued equities in the market. with a total value of Rp16.3 The Banking Sector Despite the development of the stock market. the number of private domestic banks increased. more significant reforms were introduced. The initial banking sector reform was introduced in 1983. Since 1977. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). companies could no longer enjoy low-interest credit from state banks. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market.1 shows that from 1994 to 1998. . Interest rate regulations on state banks and credit ceilings in general were removed. However. Through the years. Table 1. The dominance of state banks started to erode. the number of listed companies in the stock exchange increased substantially. and increased access of domestic banks to international financial markets. Conglomerates carried out 210 out of 257 IPOs. state-owned banks were still among the biggest.Chapter 1: Indonesia 5 At the end of 1988. Consequently. These included the opening of the banking industry to new entrants. Further reforms along the same direction and affecting state-controlled banks came in the 1990s.2. to date. the banking sector has undergone many reforms.5 trillion. which up to then was channeling oil revenues to priority sectors. The Government also allowed foreign investors to buy up to 49 percent of listed shares. But in terms of assets per bank. In 1988. from 24 in 1988 to more than 300 in 1997. Thus. with a total value of more than Rp8 trillion. began to face competition. the controlling shareholder of these SOCs is still the State. 1.
Because regulation was weak. The other banks among the top 10 were state banks.7 27 37.3 201.0 234 1994 104.6 Corporate Governance and Finance in East Asia. 1993 100.9 304.8 31 10.2 161 214.8 27 147.4 34 12. and Bank International Indonesia (ranked 9th).4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.3 27 51.8 29 6.7 351.9 39 18. II Table 1. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).8 391.6 7 7.8 27 200.6 7 12.9 27 113. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).5 528.5 27 66.8 10 19. BCA.5 7 7 7 5 15. Bank Danamon. .1 Growth of the Banking Sector.9 31 9. In terms of assets. Among private domestic banks.2 10 14.1 240 1995 122. Both BCA and BUN have shareholders linked to the former President Suharto.9 10 11.6 34 14. the 10 largest were all affiliated with major business groups.4 789.9 762.6 164 144 130 92 387. Bank Danamon (ranked 7th). Vol. banks could earn profits even when they did not gather and process information about risk.5 7 9.3 10 17. The deregulation of the banking industry and the liberalization of the capital account created a variety of new sources of financing for the corporate sector.4 10 35. while BUN has been closed down by the Government.6 240 1996 1997 1998 1999 141.5 165 308.9 291. Of these.1 10 47.8 10 37.3 30 7. But the banking system proved incapable of performing its intermediation function.8 166 248. 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.9 248.5 27 88.
87 7. Indonesia received capital inflows averaging about 4 percent of GDP. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1.00 2. except in certain strategic sectors. Net FDI flows increased to $5. FDI flows were strong.01) (0.81 3. such as metal goods. Table 1. Most FDIs came in through joint ventures with business groups having strong political connections. Between 1990 and 1996. Increasingly.59 billion in 1996.Chapter 1: Indonesia 7 Foreign and domestic banks defaulted on their responsibility of deciding where capital should go and ensuring that it was used in the most effective way. Source: IFS CD-ROM. 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. In 1994.2 Foreign Capital Flows.88 4. foreign creditors were eager to provide financing to Indonesia. November 2000.88) — — — — — — 8.40) (0. foreign investment also had a strong presence in the services and infrastructure sectors. Successive policy deregulation facilitated FDIs in various light manufacturing industries. IMF.74 5.09) 1. initially from Japan and the Republic of Korea.4 Foreign Capital The years of rapid industrial growth attracted a large amount of foreign direct investments (FDIs).01 (2. In the 1990s.2. especially through bank loans.09) (0. as shown in Table 1.2.15) — = not available. and footwear. In effect.50 (0.10 5.48 1. From the mid-1980s until July 1997. But FDIs were only one form of foreign capital inflows to Indonesia.11 3. the Government allowed foreign investors to own 100 percent of an Indonesian company.78 2. Until the onset of the crisis.33 (13.59 4. textiles. they still amounted to a large sum for the economy to absorb.63) (1.09 1. September 2000. . Joint BIS-IMF-OECD-World Bank Statistics on External Debt. when the financial crisis hit Indonesia. there was a phenomenal growth in direct borrowings by Indonesian corporations. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP). 1.
The following section looks at the growth and financial performance of the corporate sector. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country.4 trillion in 1997. foreign investors began to dominate daily trading. The external corporate debt owed to foreign commercial banks was $67 billion. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. but declined to an average of 25 percent during 19951997. 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. Domestic corporate debt was about $50 billion equivalent. participation in the Indonesian stock market was exclusive to domestic investors. II Up until the late 1980s. Consequently. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations. This increased to 30 percent by the end of 1993. with the onset of the Asian crisis.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. Due to data constraints. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. state-owned companies (SOCs). especially the short-term ones. the analysis focuses only on publicly listed companies.2. From 1987 to 1996. . an interesting question is whether standard measures of corporate profitability and performance also indicated the same. Between 1989 and 1992. the average borrowing rate for dollar loans was 9 percent. Private borrowers preferred foreign loans since these were relatively cheaper. the average foreign ownership of listed companies was 21 percent. The Government relaxed this restriction in 1988. total corporate debt reached nearly $118 billion. foreign banks became a significant source of financing for the corporate sector. increasing the total trading value from Rp8 trillion in 1992 to Rp120. In November 1998. 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.8 Corporate Governance and Finance in East Asia. plus 4 percent for the depreciation of the rupiah. of which two thirds were rupiah-denominated. In the 1990s. In September 1997. 1. and conglomerates. By the end of 1997. Vol. The private sector left foreign loans unhedged because the depreciation of the rupiah had never reached more than 4 percent annually since the 1986 devaluation under the managed floating system.
the average DER increased to 310 percent from 230 percent the . 250 firms. ranging from 220 to 250 percent between 1992 and 1996. Source: JSX Monthly (several publications).7 — 250.2 7.0 11. Return on assets (ROA) was also relatively stable during 1992-1996.7 percent in 1997. and 1992. 248 firms. but dropped to 1. 226 firms. Note: The number of firms is not identical for each year. b Asset turnover is defined as sales over assets. 246 firms. a Value added was assumed to be 30 percent of total sales. there were 204 firms.0 10. averaging 3.0 64. publicly listed companies as a group contributed less than 10 percent to GDP.4 1996 18.4 31. but turned negative in 1997.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1. Table 1. Average return on equity (ROE) of listed firms was 11. while total assets grew at 43 percent.5 240. Asset turnover was above 30 percent until 1996.3 Growth and Financial Performance of Publicly Listed Companies. but declined to 0.7 3. 174 firms.4 percent.2 1995 37.0 6.1 percent in 1997 when the crisis began to buffet Indonesia.5 34.6 3.8 6.4 1993 45.0 33.3 shows the growth and financial performance of Indonesian publicly listed companies. When the crisis battered Indonesia in 1997. The growth of listed companies was sustained by continuing investments.6 24.4 38.6 1994 50.0 1.7 — = not available. 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. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.5 34.6 48.9 37. In 1997.2 30.5 3.3 3.1 4.3 6.0 12. but fell to 24.1 0.6 percent in 1997.9 310.1 220. 1993. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996. total sales of listed companies grew at an annual average rate of 31 percent. During 1992-1997. 1994.0 12.5 37.0 12.0 3. Despite such rapid growth. 1995.8 230. although the contribution increased over time.4 1997 7. 1996.8 percent between 1992 and 1996.8 220.
with ROE falling to -11. although asset turnover was slow. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. infrastructure.73 percent in 1992 to 1. and building construction. in terms of growth of sales and assets. Vol. But the sector’s ROE fluctuated a lot. finance. II previous year. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. the property sector was severely affected by the crisis. the mining sector had the lowest DER. During those years. the companies in the sector did not operate with a high leverage. real estate. investment. The same applied to the trade sector. the mining sector ranked first. and services. When interest rates increased. still posting a positive but lower ROE. In terms of share of value added to GDP. The finance. and property. mining. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. Meanwhile. and services.3 percent between 1992 and 1996. ROA of all sectors dropped in 1997.10 Corporate Governance and Finance in East Asia. This sector was less affected by the crisis.4).2 in 1997. Table 1. The consumer goods sector ranked second in terms of ROE. property. trade. miscellaneous industry. the mining sector had the highest ROE.64 percent in 1997. averaging 21. For instance. and trade) even posted . consumer goods. increased from 0. Also. indicating its reliance on equity to support growth. However. From 1995. Overall.5 presents the financial performance of listed companies by sector. Four sectors (basic industry and chemicals.7 percent during 1992-1996. followed by agriculture (Table 1. real estate. the banks eagerly provided credit to property development companies. property. helped in part by the relatively strong demand for consumer goods. which operated in nickel and copper mining in 1992 and 1993. meanwhile. and trade. miscellaneous industry. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. when the property sector was booming during 1993-1997. averaging 17. The finance sector’s contribution to GDP. investment. Before the crisis. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. due mainly to the domination of the International Nickel Company of Canada. In terms of sales and asset levels in 1997. ROE fell drastically because the sector had one of the highest DERs. basic industry and chemicals. the dominant sector was the finance sector. only two sectors (mining and finance) showed a consistently increasing trend from 1992.
6 0.4 170.1 0. Real Estate.5 53.3 0.5 1.5 1.4 21.8 51.4 103. and Bldg.3 31.3 17.9 0. Infrastructure Finance Trade. Real Estate.9 53.5 0. Constn.3) 53.7) 17. Industry Consumer Goods Industry Prop.7 21.6) 25.8) 0.0 0.7 0.8) (12.1 1.2 41.6 1.6 28.0 31. Investment.7 54. Infrastructure Finance Trade.3 92.6 (41.6 0..4 1.9 0.8 29. Constn.5) 6.3 0.7 112. Constn.5 23.6 1994 (75.2 0.7 90.7 43.8 27.5 45.1 16.9 123.6 135.0 64. Investment.7) (27.8 1.1 0.6 26.0 0. Constn.3 0. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.0 1996 1997 58.1 1.8 0.8 62.6 22.6 83.7 40.5 (11.4 1993 155.7 — 36. Real Estate.0 1.9 8.1 0.6 15. Industry Consumer Goods Industry Prop.1 1.9 14.Table 1. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.1 0..2) 0.3 31.1 35.1 42.4 30.5 61.1 71.1 23.8 32.7 62.5 13.9 59.4 (149.7 0.6) 119.2 0.9 54. and Bldg.8 1.7 24.4 30.9 54.3 1.7) (113.6 0.8 50. and Bldg.1 1.8 28.8 (76.4) 6. and Services — = not available.5) 13.1 32.2 35.8 24.3 340.3) 39.0 0.2 41.1 0. Industry Consumer Goods Industry Prop.4 0.4 1.2 11.1 28.9 31.7 133.4 31.9 64.4 44.5 68.9 25.9 1.7 17.2 14.0 (28.6 24.1 (11.5 95..1 0.1 — 39. Source: JSX Monthly (several publications).1 (41.7) 26.9 36.1 0.2 5. Infrastructure Finance Trade.1 1.7 (82.8 66.4 1.4 64. Industry Consumer Goods Industry Prop. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc.6) 19.4 Growth Performance of Publicly Listed Companies by Sector.0 (192.1 0.0 0.3 51.5 1.5) 49.5 28.4 43.7 34.3 (203.1 0.6 (0.9 . Real Estate.0 24.2 13. Infrastructure Finance Trade.6 85.. Investment. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.6 51.5 9.1 0.9 (7.0 (20.5 (8.0 22.4 38.0 0.0 68.0 43.5 0.3 0.7 28.1 67.0 18.0) 46.4) 8. Investment.5 92.0 0.6 0.4 77.0 16. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.3 0.6 133.7 — — 11. and Bldg.2 59.7 1995 51.
6 14.1 11.6 (11.9 10.8 382.0 130.0 630.6 18.0 9.8 168.9 42.9 29. Investment.3) 5.4 6.0 150.7 8. 1992 20.0 110.1 65.1 4.3 1.4 6.5 4.1 10.6 23.7 61.0 39.9 4.2 3.0 160.2 1993 130.. and Bldg.8 67. Infrastructure Finance Trade.0 180.0 650.7 (3.0 11.0 680.5 1995 80.0 15.7 5.5 19..2 111.6 13.2 (4.7 4.1 9.6) 36. Real Estate. Investment.2 7.3 18.0 70.6 13. Investment.4 1.5 17. Infrastructure Finance Trade.6 19.2 3.7 4.4 .1 9.0 3.4 35.8 479.0 80.0) 7.3 73.2 7.1 1996 100.7 71.2) 7.5 43.4 71.9 40.0 80.7 12.4 79.3 17.1 89.7 10.4 17.8 5.5 13.1 1994 80.7 10.0 110.3 33.7 8.1 4.7 1. Industry Consumer Goods Industry Prop.0 110.7 13. Constn. and Bldg. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.0 1997 230.6 8.5 56.1 63.7 4.1 2.7 1.5 4.0 180. Real Estate.6 74. Real Estate. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc. and Bldg.0 180.6) 18.0 100.0 8.8 20.4 5.0 3.0 170.2 30.0 380.3 0.4 46.1 10.0 560.3 38.4 13.7 26.2) 15.9 38.0 220. Industry Consumer Goods Industry Prop.6 8.9 17.0 120.5 7.8 16. Investment.0 19. Industry Consumer Goods Industry Prop.7 9.1 10.0 160. Constn.0 120.0 110.2 15.0 150.1 3. and Services Source: JSX Monthly (several publications).1 (3.3 17.7 12.0 160.1 7..0 50. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.2 53.1 8.3 7.0 66.0 210.5 11.4 35.0 120.0 150.0 12.9 41.0 8.2 11.0 90..1 13.0 14.0 100.3 5.2 39.0 190.9 87. Real Estate.9 14.2 13.0 140.0 650.3 13.7 5.2 8.8 11.8 9.2 6.0 69.0 100.0 140.5 5.0 110. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.8 81.1 (5.8 8.7 10.4) (1.0 110.0 190. Constn.8 11.Table 1.1 1.1 6.6 1. Constn.4 13. and Bldg.0 110.0 60.7 46.1 4.4 4.0 70.0 86. Industry Consumer Goods Industry Prop.5 14.4 46.8 25.3 64. Infrastructure Finance Trade.7 12.3 7.0 100.4 20.0 70.8 44.8 3.0 17.8) 8.2 23.0 700.6 (2.0 80.0 46.9 7.5 Financial Performance of Publicly Listed Companies by Sector.0 (0.9 38.0 190.0 120. Infrastructure Finance Trade.
These growth rates were low compared to those for listed companies during the same period.6 to 8. The DER was slightly higher than for listed companies.Chapter 1: Indonesia 13 negative ROA.4 percent the following year. This was relatively high compared to the 3. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. ROA had been at high levels from 1992 to 1995. growth of net profits and assets was erratic. which collectively had the largest assets. and finance company (four companies). Taken together. By 1995. However. SOCs actively operated in various sectors4 under the supervision of “technical” departments.6). there were 165 state-owned companies (SOCs)3 in Indonesia.1 percent in 1993. between 1993 and 1995. but it continuously declined from 370 percent in 1992 to 250 percent in 1995.7 percent. there were 58 SOCs with subsidiaries and affiliates. State-Owned Companies At the end of 1995. Assuming a fixed ratio of value added to sales. averaging 24 and 31 percent. insurance (11 companies). SOCs’ ROE ranged from 6. but dropped dramatically to 4.3 percent in 1995.7 to 7 percent for publicly listed companies. respectively. indicating SOCs’ declining contribution to GDP. the subsidiaries and affiliates number 459 with total assets of Rp343.8 percent between 1992 and 1995 (Table 1. Trade had the highest ROA of 39. Similarly. the ratio decreased from 8.1 percent in 1992 to 28. . SOCs’ sales growth fluctuated during 1990-1996. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest. This was due to large sales by the National Oil Company (Pertamina).7 percent in 1990 to 6 percent in 1996. and basic industry and chemicals sectors had relatively stable ROA before the crisis. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). much lower than that of companies listed in the stock exchange. Just like private companies. increasing from 21. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. Asset turnover rates were lower relative to those of publicly listed companies. the Department of Finance supervised 30 SOCs. For instance. The finance and miscellaneous industry. registering an average annual rate of 10 percent. SOCs diversified into many businesses. banks (seven companies). Six SOCs were listed in the Jakarta Stock Exchange. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.3 trillion.
4 7. Their total sales increased from Rp90.766 business units.5 percent in 1995.14 Corporate Governance and Finance in East Asia.7 (2.1 30.4 13.0 8.0 24.6 Growth and Financial Performance of State-Owned Companies.6 28. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17. In 1997.8 12.8 percent in 1990 to 13.1 trillion in 1990 to Rp234 trillion in 1997.0 12.1 6.4 percent in 1992 to 28.2 — = not available. the contribution of conglomerates to GDP increased from 12.7 16.0 6. SOCs’ asset turnover rates showed a downward trend from 32.3 12. II companies consistently declined over time. Assuming a constant ratio of value added to sales. Vol.7 13. these conglomerates owned 9.6) 260. Source: Indonesian Data Business Center. but dropped to 11.4 13. mostly private companies.1 310.6 28.2 18.7).1) 5.1 19.4 1993 16. 1992 — 7.5 3.4 16. Table 1. but climbed to 30.8 11.0 7.7 Growth Performance of the Top 300 Conglomerates.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.3 250.1 12.4 percent in 1994.1 32.2 percent in 1997 (Table 1.3 30. a Value added was assumed to be 30 percent of total sales. Table 1.2 23.4 13.2 — 370.6 1995 25. Source: Indonesian Data Business Center.7 1994 (9.0 17.0 8. b Asset turnover is defined as sales over assets. 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.6 percent in 1994. .0 28.8 21. a Value added was assumed to be 30 percent of total sales.
such as the appointment (or replacement) of directors. and the accountant. For example. commissioners. is the only shareholder mechanism for monitoring and controlling the BOD. and the attendance should at least be two thirds of total shareholders. In general. and consolidations. The BOD undertakes operating decisions while the BOC participates in strategic decisions and operations review. the legal and regulatory framework of the corporate sector was far from adequate. The BOC. For instance. If the BOC does not perform well.Chapter 1: Indonesia 15 1. the Government promulgated a number of laws and regulations to protect investors. The law mandates the BOC and BOD to work for the best interests of the company and not just of the shareholders. The meeting decides on important issues. the decision to use certain company assets as collateral for bank credit might need BOC approval. The law also specifies that the highest “institution” in the limited company is the shareholders’ meeting. an approval needs the majority (50 percent plus one) vote. A chairman heads the BOC while a chief executive officer (CEO) heads the BOD. The Corporate Law The Corporate Law of 1995 governs the establishment and operation of limited liability companies in Indonesia. The actual responsibilities of BOCs vary by company and are stipulated in the company’s charter. a member company might sign a disadvantageous contract with another company where the same controlling shareholder has a higher stake. 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. mergers. tasked with supervising the firm. By international standards.2. The law also holds the directors and commissioners jointly responsible for decisions made by the company. tasked to provide direction to the company. The law replaced an earlier statute that was based on the Dutch system. The law explicitly requires approval during the meeting of decisions on strategic issues such as amendment of the company charter (articles of incorporation). shareholders lose control. This guards against shady intercompany dealings within a group of companies. acquisitions. and declaration of bankruptcy. For mergers. The company charter details the issues that need shareholder meeting approval. as representative of shareholders.6 Legal and Regulatory Framework During the 1990s. The 1995 law requires limited liability companies to set up two boards: the board of commissioners (BOC). except in strategic issues stated in the law. For instance. however.
(x) mandatory shareholders’ approval of major transactions. (v) preemptive rights on new share issues. investment managers. An important rule is the requirement for independent shareholders’ approval for arrangements that might lead to conflicts of interest. (xv) mechanisms to resolve disputes between the company and shareholders. decrees of the finance minister. such as custodian banks and the securities registration bureau.16 Corporate Governance and Finance in East Asia. and guidelines promulgated by the head of capital market supervision. consolidations. insider trading (including market rigging and manipulation) investigation. (xi) mandatory disclosure of transactions by significant shareholders. the decision should be approved by three fourths of the shareholders present. . It regulates the requirements of investment companies. brokers. and the attendance should at least be three fourths of total shareholders. Vol. The Capital Market Law The Capital Market Law (1995) regulates companies listed in the stock exchange. (vi) one share one vote. 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. The law is supplemented by Government regulations. (ix) mandatory shareholders’ approval of interested transactions. A tender offer is also required for acquisitions of up to 20 percent of listed shares. The law provides the following rights to or protection of shareholders: (i) access to regular and reliable information free of charge. transparency requirements. underwriters. Because of such requirements. (iii) proxy voting by mail. (ii) proxy voting. (xvi) independence of auditing. and other supporting agencies. and bankruptcy. and administrative and legal punishment. delineating the tasks and responsibilities of the Capital Market Supervisory Agency. 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. (iv) cumulative voting for directors. II acquisitions. investment advisors. (xiii) mandatory disclosure of nonfinancial information. (xii) mandatory disclosure of connected interests. securities companies. It also regulates reporting and auditing procedures. (viii) the right to make proposals at the shareholders’ meeting. and (xviii) severe penalties for insider trading. Controlling shareholders have no vote on the matter. (vii) the right to call an emergency shareholders’ meeting. (xiv) mandatory disclosure of intercompany affiliation such as affiliated lending or guarantees. (xvii) mandatory independent board committee.
g. The old bankruptcy law based on the Dutch system was biased in favor of debtors and made it almost impossible for creditors to seek court resolution when debtors defaulted. 1.1 Corporate Ownership Structure Quality of corporate governance is closely related to corporate ownership structure (see discussions in the Consolidated Report of this study). The two most important elements of ownership structure are concentration and composition. Banking regulations also set lending limits. the Banking Law (1992). 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. whether they are individuals. for instance. . or 20 shareholders. A new bankruptcy law was passed in August 1998. etc. the viability of a project). 1. capital adequacy. Banking Laws Affecting the Corporate Sector Some elements of the banking law also affect the corporate sector.Chapter 1: Indonesia 17 Bankruptcy Law Despite loan covenants. or financial institutions. creditors of unsecured loans are unprotected when borrowers fail to meet their obligations. For instance. net open positions. families. It aimed to protect creditors by providing easier and faster access to legal redress. Ownership concentration is usually measured by the proportion of shares owned by the top one. A Commercial Court was also set up to deal with bankruptcy cases. Discussions on corporate ownership cover listed companies and conglomerates. five.. It reveals characteristics of controlling shareholders. The court can declare the debtor bankrupt upon the request of at least two creditors and default on one loan. the collateral could take the form of nonphysical assets (e. However. states that a bank is not allowed to provide credit without collateral. holding companies.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.3. amended in October 1998.
On average. This preserves the pro rata share of existing shareholders.8 1. 3. The percentage owned by each of the five largest shareholders was 48.1 4. II Publicly Listed Companies Table 1.9 0. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families. Meanwhile.1 13.0 0.8 68.8.4 percent.6 4.8 Ownership Concentration of Publicly Listed Companies.4 2. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.6 13. for instance.0 4.9 14.6.0 2.6 3.9 2.9. and basic industry and chemicals sectors than in others. Zebra Nusantara (taxi services).1 1.5 1997 48.2 67.5 percent.6 percent. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.2 1.7 3.6 68.6 3. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). the founder usually continues to own the majority of shares through a .7 1994 48. The pattern of ownership concentration changed little over this period.0 1. When a company makes a rights issue.18 Corporate Governance and Finance in East Asia. issued 93.9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.0 0. When a company goes public. the controlling shareholders usually act as standby buyers. Vol.9 2. the five largest shareholders owned 68.5 12. 13.9 Source: The Indonesian Capital Market Directory.3 1995 47. This is because a few companies in the transportation sector issued high proportions of shares to the public. Table 1. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.5 16. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997.8 68. and 0.2 11. consumer goods.7 1996 48.5 Average 48. Table 1. mining.9 percent of total outstanding shares. 2.1 0.5 72.6. Rig Tenders Indonesia (shipping services) issued 51.0 67. respectively.
1 1.8 14. Table 1.6 9.1 0. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm.7 4.5 58.3 0.2 46.6 1.3 36. and Services Average Source: The Indonesian Capital Market Directory. Real Estate.1 1. and Bldg.9 1.5 1.1 1. and Transportation Finance Trade.4 1. Industry Consumer Goods Industry Prop. in a cross-country study.3 0.2 10.9 3. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.. Infrastructure.1 percent) of Indonesian publicly listed companies were in family hands. two thirds (67. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals. 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.6 percent were widely held.4 6.1 2.2 15.1 13.2 This is confirmed in Claessens et al. Util. In terms of capitalization. (1999).6 2.6 0. as well as the existence of corruption. Claessens et al.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).0 5.1 1.4 4. and the efficiency of the judicial system. that the correlation between the share of the largest 15 families in total market capitalization.1 2.6 8. on the one hand.9 44. the rule of law.2 2. is strong. which shows that in 1996.1 0. (1999) also found.7 6.7 1.3 14. on the other.. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.7 percent of the market.1 11.1 2. and only 0. Constn. In fact.3 48.5 4.2 0.7 13.9 0.7 9. the top family controls 16.9 44.4 44.4 54.4 11.6 percent of total market capitalization while the top 15 families control 61. and corruption.3 2. Indonesia has the largest number of companies controlled by a single family. Investment.9 50. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.9 Ownership Concentration of Publicly Listed Companies by Sector. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .
or other ethnic groups.20 Corporate Governance and Finance in East Asia.5 Conglomerates Table 1. Vol.42 percent in December. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. was able to create a favorable environment for business development. Indian. and Padang. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. foreign ownership increased to 21 percent. II the small number of families and the tight links between companies and the Government. accounting for 64 percent of total conglomerate sales in 1988-1996. Sundanese. political affiliation. Among the top 300 conglomerates. and family origin. the legal system is less likely to evolve in a manner that protects minority shareholders. with all its regulations. conglomerates established before 1969 dominated in terms of sales. Batak. it rose to 30 percent. resulting instead in a decline in the proportion of foreign investor ownership. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker. their number increased to 5 In 1997. The nonindigenous businesspeople are usually Chinese. 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. the Government allowed foreign investors to buy up to 100 percent of listed shares. However. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. The corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. In Indonesia. most were established during the New Order Government. Indigenous businesspeople include the Javanese. ethnicity. but later declined and steadied at around 25 percent.55 percent in August to 25.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. But these benefits are few and often dubious compared to the high costs of concentration. From 193 in 1988. During 1988-1996. the onset of the crisis negated this development. the proportion of foreign ownership declined from 27. This may indicate that the New Order Government. . In September 1997. In 1993. However. Coordination is easier because informal communication channels exist. numbering 162 in 1988 and 170 in 1996.
4 86. more than five times its 1988 level.10 Anatomy of the Top 300 Indonesian Conglomerates. sales of the Bakrie group before it went public in 1990 were only Rp369.0 28.0 18.8 25. In 1996.8 12.5 22.1 42.6 12. due to their “go public” activities.0 31.4 52. the number of mixed groups declined from 86 in 1988 to 68 in 1996. While they supplied 20.9 13.Chapter 1: Indonesia 21 Table 1.5 106.2 33.0 44.3 20.1 25.8 36.1 87.4 31.9 42.6 17.1 52.4 68.2 30. 204 in 1996.4 19.7 40.4 16.1 103.4 59.7 24.1 33.0 116. Meanwhile.1 21.3 134.4 22.7 106.0 58.7 64.1 46.6 trillion in 1988 to Rp137.8 Source: Indonesian Business Data Centre.2 29.1 41.3 36.5 120. its sales reached Rp1.9 47.9 73.9 billion. For instance.3 101.0 58.5 21.6 95.6 54.2 76.6 114.2 159.3 80.7 49.4 37.4 31.8 57.4 18.2 48.9 35.4 59.1 percent of total .4 57.4 69.3 43.8 30.9 137.9 14.6 77.6 34.1 179.1 58.8 49.8 28.1 46.4 32.8 38.4 15. Conglomeration Indonesia 1997.4 trillion in 1996.4 81.2 12. Their total sales also increased from Rp38.7 89.9 trillion.8 68.2 23.7 28.0 15.7 95. 1988-1996 Item Number of Groups Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily Sales (Rp trillion) Year of Establishment Before 1946 1946-1968 1969 Forward Ethnicity Mixed Nonindigenous Indigenous Political Affiliation Nonofficial Official-Related Origin Family Nonfamily 1988 1989 1990 1991 1992 1993 1994 1995 1996 13 125 162 86 193 21 260 40 176 124 13 125 162 83 196 21 259 41 175 125 13 123 164 80 196 24 260 41 171 129 13 120 167 76 199 25 260 40 174 126 13 118 169 76 198 26 262 38 172 128 12 122 166 71 201 28 263 37 171 129 12 122 166 69 205 26 262 38 172 128 11 120 169 71 204 25 260 40 177 123 10 120 170 68 204 28 259 41 175 125 9.4 48.3 120.9 77.
Conglomerates were also classified into nonofficial. Prudential credit analysis tends to be ignored. The Suharto family is the largest stockholder in Indonesia. and Fast Food (restaurants). In 1997 and 1998.and officialrelated groups. The Salim group. In 1996.2 trillion. or have resulted from alliances between entrepreneurs and officials. average sales of official-related conglomerates reached Rp1.22 Corporate Governance and Finance in East Asia. which is the largest conglomerate in Indonesia. their contribution declined to 13. The contraction in the number and economic contribution of mixed groups may be an indication of increasing social polarization along ethnic lines. Official-related groups have owners (or founders) who are or are allied with former or current government officials (or their families). II sales in 1988. Out of 174 companies. 117 are jointly owned by the family and 57 are owned by individual family members. and Ibrahim Risyad of the Salim group. Some of them later became public companies by listing in the stock market. and Wisnu Suhardhono of Apac-Bhakti Karya. Bank Indonesia.7 percent in 1996. But listed companies within conglomerates were few. But only a handful of these companies are listed in the market. compared with the less than Rp700 billion of a nonofficial-related conglomerate. Vol. Indocement Tunggal Prakarsa (cement industry). owns four groups with many subsidiaries and affiliate companies. More recent alliances were between Bambang Trihatmodjo (former President Suharto’s son) and Johannes Kotjo. Most of the top 300 conglomerates were established by ordinary citizens. Average sales of official-related conglomerates were substantially greater than nonoffficial-related ones during 1988-1996. there were 175 groups that originated from a family business. including Indofood Sukses Makmur (food industry). Bambang Rijadi Soegomo. most of the 16 liquidated banks had violated the legal lending limit set by the central bank. Djuhar Soetanto. Political alliances between entrepreneurs and officials have often led to the violation of regulations meant to promote prudent business practices in the banking industry. collectively controlling . In November 1997. Banks owned by groups or conglomerates typically act as a “cashier” that provides credit to companies within the group. Only about 13 percent were formed by official or ex-official families. for instance. The well-known official-business alliances are those between Sudwikatmono (former President Suharto’s cousin) and Soedono Salim. In 1996. banks that had to be closed down included Bank Surya (owned by Sudwikatmono) and Bank Andromeda (owned by Bambang Trihatmodjo). The high NPLs accumulated by banks within official-related groups could be partly attributed to this practice.
besides Suharto himself. continue receiving some kind of protection and special treatment. families mostly manage the groups and make strategic decisions themselves. Cases in point are the Bank Papan Sejahtera and Bank Niaga. In 1996. If the family members cannot actively manage the companies as directors. The Salim Group is also in part controlled by the Suharto family. This is because cross-owned banks had to consider not only their own interests.Chapter 1: Indonesia 23 assets worth $24 billion (Claessens et al. The BOC chairperson often represents the controlling party of the company. or both. The families retain control of the companies through ownership. for instance. and hence. Cross-Shareholdings Cross-shareholding is one way to enhance corporate control and occurs when a company down the chain of control has some shares in another company within the same chain. management. 1999). many of whom. Indofood Sukses Makmur (food industry) was owned by Indocement Tunggal Prakarsa (cement industry).1). It is generally believed that there are cross-holdings between financial and nonfinancial companies and among nonfinancial firms. Both are listed companies and members of the Salim group. Although some groups employ professional managers. But it is difficult to obtain data on cross-shareholding among firms. In so doing. Although they are not actively involved in the daily operations of the companies. the controlling shareholders are able to maintain their special relationship with officials. Semen Cibinong. He or she could either be the biggest shareholder. While the source of the . Indonesian law allows cross-shareholdings. as well as other relatives and business partners. The family controls 417 listed and unlisted companies through a number of business groups led by the Suharto children. with no restrictions. The officials (or their family members) often own a small portion of shares given to them freely by controlling shareholders. which were liquidated or recapitalized after being acquired by the Tirtamas group that owns a listed cement company. they maintain their position as commissioners. but those of the entire group. they still control the work of the directors. Some of the groups related to officials have a unique share ownership structure. Cross-holdings between financial and nonfinancial firms potentially create more serious problems.. or someone very close to and trusted by the controlling shareholders. served in some government function (see Figure 1.
Figure 1. . (Feb.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. Financial Sector Practice Department. 1999). Lang. Simeon Djankov. and Larry H. Who Controls East Asian Corporations? Financial Economics Unit. World Bank. P.
The discussions are based on the ADB survey of 40 companies listed in the Jakarta Stock Exchange. This is based on the Dutch system. both controlling and minority. The managers execute the BOD’s decisions and lead employees in their departments. 1. The typical structure of a publicly listed company in Indonesia is shown in Figure 1. Therefore. management and managerial compensation. the BOC supervises the work of directors.2 Typical Internal Organizational Structure of a Publicly Listed Company in Indonesia Shareholders Board of Directors Board of Commissioners M a n a g e r s Employees The succeeding discussions examine some aspects of the internal management and control system in practice in Indonesian listed companies. the directors. role and protection of minority shareholders. and. and accounting and auditing procedures. if necessary. request a shareholders’ meeting. including the boards. Figure 1.3. seek an audience with directors.2 Management and Internal Control A company’s internal organizational structure determines how shareholders control management. Shareholders are at the top of the organization. The BOD leads the company and makes strategic and operational decisions. the BOC has the right to obtain any information concerning the firm.2. . As the owners’ representatives.Chapter 1: Indonesia 25 problem is inconclusive. one possibility is that legal lending limits had been violated.
Corporate Governance and Finance in East Asia, Vol. II
Board of Commissioners and Board of Directors Table 1.11 presents a summary of some characteristics of the BOC. The table reveals that 29 out of 40 companies surveyed did not have independent commissioners. Although 23 companies reported that commissioners were elected based on professional expertise, nine companies reported that selection was based on relationships with controlling shareholders, and another nine reported that commissioners were the company’s founders. Table 1.11 Characteristics of the Board of Commissioners
Number of Firms Responded 11 29 23 9 9 10 22 7 27 7 8 8 30 6 4
Questions Presence of Independent Commissioners a. Yes b. No Basis for Electing the Board of Commissioners a. Professional expertise b. Relationship with controlling shareholders c. As founders of the company Procedure in Electing the Board of Commissioners a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis for Electing the Chairman of BOC a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders Relationship between the Chairman and CEO a. Not related by blood or marriage b. Related by blood or marriage c. No answer
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
In most companies (22 out of 40), members of the BOC were nominated by significant shareholders and confirmed at the annual general meetings (AGMs). A nominee that was not supported by significant shareholders
Chapter 1: Indonesia
was unlikely to be chosen as a commissioner. Most companies (27 out of 40) elected their BOC chairman based on professional expertise. The majority of firms (30 out of 40) also reported no relationship between the chairman and CEO either by blood or marriage. A similar picture is obtained for the BOD (Table 1.12). Most companies (30 out of 40) reported not having independent directors. Professional expertise was an important basis in electing directors for 29 companies. Relationships with controlling shareholders and founders of the company were the basis for selecting directors in 11 companies. Table 1.12 Characteristics of the Board of Directors
Number of Firms Responded 10 30 29 7 4 13 22 6 29 3 7 8
Questions Presence of Independent Directors a. Yes b. No Basis in Electing Board of Directors a. Professional expertise b. Relationship with controlling shareholders c. As founders Procedure in Electing Board of Directors a. Nominated by the management and confirmed by the AGM b. Nominated by significant shareholders and confirmed by the AGM c. Nominated and elected by shareholders during the AGM Basis in Electing the Chief Executive Officer a. Professional expertise b. Shareholdings c. As founders of the company d. Relationship with controlling shareholders
Note: Since companies could answer more than one alternative, the total does not necessarily add up to 40 for each question. Source: ADB Survey.
Twenty-two out of the 40 respondents elected their directors through nomination by significant shareholders and confirmation by the AGM. Most companies (29 out of 40) selected the CEO based on professional expertise, although some companies based it on relationships with controlling shareholders.
Corporate Governance and Finance in East Asia, Vol. II
Management and Managerial Compensation The Corporate Law mandates the BOD to lead the company and make strategic and operational decisions, and the BOC to supervise the work of the directors. The BOC also reviews the results of operations and participates in strategic decision making. This indicates some overlapping functions for the BOC and the BOD, which is confirmed in the ADB survey. This overlapping of responsibilities, particularly in making strategic decisions, may result in conflicts. However, since the BOC appoints members of the BOD and determines their remuneration, the BOC is in a strong position to dominate the BOD. Twenty-five out of 40 firms indicated that the CEO makes important decisions after consulting the chairman of the BOC. In carrying out their tasks, the majority of firms reported not having committees to assist the BOD and BOC, as shown in Table 1.13. Only a few companies have nomination, remuneration, and auditing committees, most of which were set up between 1995 and 1997. In 1995, Bank Indonesia required commercial banks to have an auditing committee. Table 1.13 Presence of Board Committees in Listed Companies
Type of Committee Nomination Committee Remuneration Committee Auditing Committee None Total
Source: ADB Survey.
BOD 5 5 5 23 38
BOC 1 1 3 35 40
Most firms reported terms of appointment of three to five years for the BOD and BOC. In some companies, the term differs for commissioners and directors. Although the term is for three to five years, in 13 out of 40 companies, the directors and commissioners have been in service for more than five years. Results of the ADB survey show that in 18 companies, the CEO is given fixed compensation plus a profit-related bonus. In 14 companies, only fixed compensation is given. For the BOC chairman, 10 companies
Chapter 1: Indonesia
provide fixed compensation plus profit related bonus, while 14 companies provide fixed compensation only. Role and Protection of Minority Shareholders Indonesian law requires publicly listed companies to have at least 300 shareholders to help ensure share liquidity and dispersed ownership. The highest number of shareholders is found in Bank BNI (a state-owned bank), reportedly having 27,568 shareholders. Small companies simply comply with the minimum shareholder number requirement. Most companies reported that their shareholders enjoy all mandated rights and protection, except those on proxy voting by mail, cumulative voting for directors, and the independent board committee. A company charter (articles of incorporation) stipulates the quorum requirement during annual meetings, which is usually two thirds of total shareholders. The ADB survey showed that more than 67 percent of shareholders attended the last annual meeting in most companies. While proxy voting is allowed, proxy votes accounted for less than 10 percent of shareholders on average. Brokerage companies and management were the usual proxies. A change in the company charter requires a two-thirds majority vote by shareholders. The ADB survey revealed that in the last three years, only one management proposal (i.e., director’s fee) was rejected during the AGM. This is not surprising because management usually seeks prior approval of proposals from controlling shareholders. Accounting and Auditing Procedures Thirty-five out of 40 respondents in the ADB survey claimed to have substantially followed international accounting standards even prior to the financial crisis. Accounting authorities, however, can easily change acceptable accounting methods. After the crisis, for instance, the Indonesian Accountants Association recommended that potential foreign exchange losses be reported as losses at the end of the accounting year. Later, the association allowed companies to choose between declaring it in the profit and loss statement at the end of the accounting year or in the balance sheet. All companies in the survey reported the presence of an independent auditor, which is usually an international audit company. Most companies have been associated with their independent auditors for more than five years. Shareholders appoint the external auditor during the AGM.
Corporate Governance and Finance in East Asia, Vol. II
Control by Creditors The control of creditors over a debtor company rests on assets used as collateral for loans. Unsecured creditors resort to the legal process when problems arise. Based on the ADB survey, each company was associated with an average of five creditors, the majority of which were banks. Some companies were associated with an excessively large number of creditors, reaching up to 30. Most of the companies have been dealing with their institutional creditors for less than three years. Although the banking law requires collateral for bank loans, some creditors did not enforce the requirement. Only 10 companies reported that they were required to provide collateral by all creditors. Twelve companies claimed having creditors that did not ask for collateral. Twenty-five out of 32 companies reported having renegotiated loans with creditors in the last five years, mostly after the Asian crisis. This indicates that many companies experienced serious difficulties in repaying debts as a result of the crisis. But most of these companies stated they would possibly borrow from the same creditors, indicating their relatively strong bargaining position. The majority of firms (22 out of 29) also said that creditors had no influence in management decision making. In 1998, the Bankruptcy Law was passed to protect creditors and the Commercial Court was set up to deal with bankruptcies. This paved the way for unsecured creditors to proceed against a debtor in default based on loan covenants and through the legal process of collection against the debtor’s assets. However, enforcement of the law was a disappointment to those who hoped that it would put corporate restructuring and the settlement of corporate debts on a running start. Only 17 cases had been filed with the court by late November 1998. Just two companies had been declared bankrupt, and three suits were dismissed by the Commercial Court. The Government’s political will and support are still very much needed in order to set up a well functioning Commercial Court. Long and hard work is required to restore creditors’ confidence in Indonesia’s legal system. The Market for Corporate Control Between 1992 and 1997, there were 40 cases of acquisition and takeover of Indonesian companies. Most of these, however, were internal acquisitions (i.e., acquisition of a company in the same group). Only five cases were
The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. appointment of management.6 In this case. They then replaced the BOD and later sold the bank. 6 7 Later in March 1999. Bank Niaga was under a recapitalization program. restrictions on market entry. the Government took over NPLs and put them under IBRA management. the bank was liquidated. the acquiring interest was apparently seeking economic profits. . Since the NPLs reached up to Rp300 trillion. which was acquired by Yopie Wijaya in 1995. the owner of Tirtamas group. In these two latter cases. This used to be a common practice in companies associated with the Suharto regime.Chapter 1: Indonesia 31 external acquisitions. However. with the minister’s approval. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. it was common for the Government to invest in certain private companies. In April 1999. a state-owned insurance company may invest its funds in a private firm. Most Indonesian state companies are 100 percent owned by the Government. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. Wijaya and his friends bought shares of the bank on several occasions until they gained control. to Hashim Djojohadikusumo. One famous takeover was Bank Papan Sejahtera. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. In the massive restructuring of the banking sector that commenced after the crisis. 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. Before the financial crisis. at a large profit. State ownership for listed SOCs ranges from 25 to 35 percent. The Government appoints the BOD and BOC of these firms. IBRA found itself tasked with managing large amounts of assets in the private sector. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. For instance. except for publicly listed SOCs. who was acquiring his second commercial bank. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. The bank was reported to have high NPLs and had broken the legal lending limit. or direct subsidies. Control by the Government Government control could be in the form of state ownership.
5 80.9 153.4 trillion in 1998.9 234.2 27.3 188. this market was not well developed.2 71. II 1.32 Corporate Governance and Finance in East Asia.6 6.5 42. stocks. new instruments have been introduced to the corporate sector. bank credit surged from Rp122. Bank loans. and others offered by nonbank financial institutions or finance companies. 1992 1993 1994 1995 1996 1997 1998 1999 68.6 150.8 193. Bank Credit As shown in Table 1.5 108.4 86. Vol.5 7. Since then.4 225.1 Equities In 1977.3 60.9 378.4 percent in 1992. private national banks overtook state banks as the dominant credit source.4 56. equities became available to the corporate sector.7 50.6 percent in 1997.4 1.9 150. remain the major financing instrument for the corporate sector. From 34.4 24.7 122.1 220. Table 1.9 trillion in 1992 to Rp487. companies considered alternatives to bank loans. the share of private national banks in outstanding total loans increased to 44. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.2 5.3 111. jointly providing almost 90 percent of loans until 1997. However.6 292. when the Government reactivated the stock exchange.2 6.14 Banking Sector Outstanding Loans. Data from Bank Indonesia show that from 1994 to 1997.0 487. . including bonds.3 9.7 18. however.6 3.0 93.1 Corporate Financing Financial Market Instruments Prior to 1977.0 6. bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.3 66.7 112.6 4. Private national banks and state-owned banks were the biggest domestic creditors. because of the restrictions discussed below.4.0 168. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).14.6 48.3 14.0 3.
The ratio reached 8. factoring.2 16.6 859.Chapter 1: Indonesia 33 Some companies went public. when foreign investors were not yet allowed to purchase listed shares.15 Value of Stocks Issued and Stock Market Capitalization. Table 1. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector. Most banks therefore set up subsidiary finance companies to circumvent banking regulations.5 1995 35.9 1999 76. i. and consumer credit. however. In 1995. They were not.5 333. finance companies were increasingly used as channels for the inflow of foreign loans.6 310. In 1988. thus increasing the role of the capital market in raising long-term funds. allowed to accept deposit accounts from the public. the Government issued regulations to supervise and promote prudential practices in finance companies.7 percent in 1997.7 14.0 206.e.7 9. capital adequacy ratio.8 48.1 18. Overall.1 17.6 301. legal lending limit.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. It gradually increased again starting in 1991.0 15.1 10.4 1996 1997 1998 50.7 15. shooting up to 18.1 1994 26. 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 1996.0 70.g. During the 1990s. credit cards. limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. the stock market has gained a bigger role in corporate sector financing (Table 1. . the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.6 123. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. 1992 1993 11.6 91..5 Financing by Finance Companies Finance companies first emerged at the end of 1980. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy..4 207.15). Prior to 1995. offering services such as leasing. and net open position).9 406.
they were not rated by a rating agency. Vol. PACAP Research Center.1) 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). 1.5 (0.6 8.8 percent.0 — = not available. Thus in November 1995. 1996.16 Financing Patterns of Publicly Listed Nonfinancial Companies.6 100.5 21.4 23.5 11. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.7 22.4.3 (0.1) 23. While banks had some exposure to these instruments.0 39. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36. respectively.3 14.5 — 26.0 100.2 Patterns of Corporate Financing Table 1. . short-term borrowings were greater than long-term debts.34 Corporate Governance and Finance in East Asia.0 1991-1996 16.0 3. averaging 26. have been popular in Indonesia since 1990.3 37.4 8.6 100. otherwise it would be classified as a loss in the banks’ books.8 7.6 23.2 26. This is in contrast to the lower share of borrowings during the same period.3 16. In the second half of the 1980s. In terms of composition.8 17. II Commercial Papers Commercial papers.6 12. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. at 81 percent of total borrowings.0 1986-1996 17.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.4 13.9 16. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).5 percent and 36. Table 1.
6 trillion and Rp1.3 Corporate Financing and Ownership Concentration It has been suggested.1 trillion. Hence. also suffered from foreign exchange losses but managed to post profits of Rp0. corporate debts accounted for 39. This amount doubled in 1997. Most corporate charters require commissioners to approve debt issues or sign debt agreements. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. the pattern changed. with longterm debts increasing rapidly.2 trillion (mostly foreign exchange losses). The analysis of ownership patterns in Section 3 indicated that founders (the controlling party) or the five biggest owners held at least 50 percent of total shares. Large shareholders are inclined to undertake risky projects intended to generate high returns using borrowed funds. reaching Rp229. Indosat and Telekom. respectively. They also do not want to dilute corporate control and are more likely to finance growth with debt.4 trillion in 1993 to Rp112. The high share of equity financing was due to the surge in capital market activity following the 1988 reforms. was due largely to a rapid rise in long-term debts. The results indicate that firms with higher ownership concentration tend to have a higher DER. which managed to post significant profits due to low exposure to dollar-denominated loans. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997.3 percent during 1991-1996. Table 1. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. For instance. rising from Rp54. . in the context of Indonesia and some other countries. Of the various financing sources. 1. These liabilities grew significantly because corporate expansion was largely financed by debt. Bank loans also surged when the banking sector was liberalized in 1988.2 trillion. Corporate debts grew over time.9 trillion. Two telecommunications companies.17 compares the DER of listed firms by degree of ownership concentration. while Semen Cibinong’s losses reached Rp2. Many companies suffered big losses in 1997 due to their high exposure to dollar loans.4. that ownership concentration may be associated with heightened risk-taking by companies. the corporate sector’s high leverage. which was masked by the rapid growth in investments.9 trillion in 1996. All companies in the cement industry suffered from foreign exchange losses. Indofood registered losses of almost Rp1.Chapter 1: Indonesia 35 In the 1990s. except Semen Gresik (an SOC).
ultimately.56 significant at the 10 percent level. to maintain control of the company.358. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. Vol.0 386. heavy reliance of companies on bank credits to finance investments.5. As a result. 1. aided . The test of the difference between the two means found the t-value of 1.17 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. 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. the private sector borrowed heavily in unhedged dollars. since commissioners represent the controlling party.0 351. Source: Author’s estimates. the free capital flow system allowed private companies to borrow dollars offshore without any restriction.1 The Corporate Sector in the Financial Crisis Causes of the Financial Crisis Many intertwined factors led to the crisis. Controlling parties rely on external financing to maintain their equity share and. and high ownership concentration among families with political affiliation.0 1. In addition.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. decisions on debt are made with the implicit endorsement of owners. the borrowings swelled.5 1.36 Corporate Governance and Finance in East Asia. 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. Table 1. Between 1987 and 1996. II However.
Conglomerates that had difficulty in getting loans (i.. It was doubly difficult to exercise supervision when groups with political clout owned the banks. This often led to the violation of prudential credit management practices. In the process. The large supply of foreign funds. and the negative net open position (short position in dollars) continuously rose to precarious levels. 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. large amounts of credit were directed to the companies within the group. only created to serve the companies to which they lent. Decisions to borrow in dollars made sense to many borrowers because dollar loans were cheaper than rupiah loans. substantial amounts were also funneled into projects that guaranteed repayment mainly on the strength of borrowers’ close political connections. did finance many viable ventures. They were. The banks served as a “cashier” that provided easy credit to nonfinancial companies within the group. after all. However.e. 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. A director at Bank Indonesia revealed that in 1995. The removal of entry barriers in the banking sector caused the number of private national banks to soar from only 65 in 1988 to 144 in 1997. A lot of short-term foreign funds were used to finance long-term investment projects. The supervising agency was caught unprepared.Chapter 1: Indonesia 37 by the lack of an existing mechanism to supervise and monitor foreign transactions. The Government later specified the legal lending limit and the net open position that banks had to follow. It is not known if these regulations had an effect on nonbank intermediaries. conglomerates set up finance companies and used these as channels for the unfettered inflow of foreign loans in lieu of banks. to circumvent these banking regulations. the level of corporations’ foreign debt could not even be ascertained. It was only in 1995 that some regulations on the activities of finance companies were contemplated. many firms became highly leveraged. As a result. It also meant that the cashier bank had neither the independence nor the incentive to exercise ex ante and ad interim monitoring of borrowers. averaging about 4 percent of GDP. This left them vulnerable to interest rate surges as well as sudden currency fluctuations in the case of dollar loans. those with high DERs) established their own banks. . However.
In many cases. Families retain control by keeping the majority percentage of outstanding shares. but on the basis of who the borrower was. In early 1998. Since the Government could not afford to undertake these projects. There were cases where banks and borrowing companies were controlled by the same groups or families with strong political connections. there was also almost universal confidence that the economic growth would continue indefinitely. or both. They enhance their control over companies through cross-shareholdings. contracts were granted to the private sector. banks did not lend on the basis of the soundness of the project. Collusion between big businesses and the political elite was widespread in Indonesia.5 billion. Corporations were certain that they could roll over short-term loans when these fell due. II By mid-1997. most often to people who were close to the ruling regime. . and investing shares among nonfinancial companies within the group and in other groups’ companies. Controlling shareholders also prefer to use debts to finance expansion so as not to dilute their ownership. total private sector foreign debt stood at $72. and in the process maintain control of the company. and power generation) require huge capital. politicians. This fact was usually not disclosed in financial statements. toll roads. The ultimate control of the corporate sector rests in the hands of a small number of families who own groups of companies. $35 billion of Indonesia’s foreign debt owed to private foreign banks was about to mature in less than one year. partly because they used nominee accounts to register ownership rather than set up a holding company.5 billion was owed directly by corporations. by setting up their own banks. High Ownership Concentration High concentration of corporate ownership (particularly by families) led to poor financing and investment practices. as they had done so in the years before the crisis. Projects involving massive capital investments and long-term operating deals (in telecommunications. This was often the case in the banking industry. Aside from the fact that many of these loans were channeled through banks and corporations of politically connected families. of which $64. Family-controlled corporations were generally structured as a complicated web of affiliates and associated companies. Vol.38 Corporate Governance and Finance in East Asia. where private banks are usually in the hands of big businesses. They ensure that commissioners represent their interests and maintain close relationships with the chairperson.
This continued in 1998. Sectors with lower ROE generally had higher DER.19.8) (13. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.3 11.1) (26.4 7.1 5. much higher than the 307 percent registered in December 1997.Chapter 1: Indonesia 39 1.3 12. and Business Services Other Services GDP 1996 3.6 8.0 3.6) (3.0) (15. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. and 128 companies reported a total loss of Rp46. posted negative growth rates.7) (2.370 percent.6 (36.0 2. The average DER was found to be 1.18 shows that growth in most sectors significantly fell in 1997.1 (1. followed by the finance and trade sectors. DER and ROE were calculated per sector.0) 1999 2.1 6.7) 2. Table 1.6 12.4 7. Gas.2 (1. Livestock.8 8. as shown in Table 1. Most sectors showed significant increases in leverage.4) 2.7) (8.24 trillion for the first six months of 1998. Forestry.0 5.2 8. The construction sector was the worst hit. and building construction. 53 companies reported negative equity of Rp6.5. The consumer goods industry reported the lowest ROE.4 5.6) (0.7 6. indicating a rapid rise in . real estate. Hotels. Real Estate. and Restaurants Transport and Communications Financial.58 trillion (meaning their losses were greater than the paid-up capital). BPS).8 0.1) 1.18 GDP Growth by Sector. followed by property.8) (11. and Fisheries Mining and Quarrying Manufacturing Electricity.4) (0. and Water Supply Construction Trade.6 13. 1996-1999 (percent) Sector Agriculture. when all sectors.6 4. except utilities.5) (18.3 Source: Central Bureau of Statistics (Biro Pusat Statistik.7 1998 (0.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.8 7.52 trillion.9 3. Only 86 companies reported profits.8 1997 1.
Financial and banking analysts estimate that by September 1998.0 72.625.2 (4.1 (5.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 158.0 191.0 697. the NPL ratio had reached more than 60 percent.1 (92.0 65.6 (11.0 2.0 631. Second.8) 36.271.0 a ROE 1996 1997 1998a 14.0 1.1 (3.0) 10.0 177.097.0 108.0 1997 234. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999. and would have kept on increasing if interest rates had not declined.0 1998 186.0) (78.20 reveals that the banking sector’s ROE decreased significantly in 1997.0 105. losses in operation were due to declines in sales and increases in the cost of imported inputs. The huge losses suffered by most companies were caused by three factors. This figure further increased to 47.8 percent in 1996.0 229. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses. foreign exchange losses came about with the use of unhedged foreign debt.0 219. a Actual data for 1st semester only.4) 18.19 DER and ROE of Publicly Listed Companies by Sector. private banks posted negative ROEs in the same year. but annualized to approximate full year values.6) (115. several publications. small foreign banks enjoyed the highest profits.395.3 7.0 12.0 2. as shown in Table 1. Impact on the Banking Sector Table 1.0 97.8 (373.0 193.0 108.2 13.0 1. As the rupiah weakened and interest rates increased.7 percent in July 1998.9 12.8 17.1 1.0 635.0 177.21. .7) 6.0 864.40 Corporate Governance and Finance in East Asia.0 205.0 1.2) (264.0 163.4 5.6) 15. First.0 111.5 8.370. Vol. Source: JSX Monthly. Third. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits. II Table 1.0 307. from only 8. the NPL ratio rose to 25.1) 7. Mostly suffering from a liquidity squeeze.1 (124.7 1.1 30.2 23.4) 8.4 (6.0 92.5 percent in April 1998.
20) Table 1.5 31.7 106.8 3.6 — 4.38) 11.68 1996 1997 8.37 19.0 — 4.1 1.67 8.20 ROE of the Banking Sector.2 48.81 13.7 — 1.2 8.3 445. In July 1998.1 30.2 47. coupled with negative spreads (deposit rate was higher than the credit rate).86 11.28 5.9 — 11.09 11.2 37.72 16.30 5.6 — 1.2 — 19.1 13.8 8.91 21. Source: The National Banking Association.70 1995 7. 227/1998 and October No.4 7.3 22.89 27.2 8.Chapter 1: Indonesia 41 Table 1.7 4.7 29.34 16.8 11. put pressure on the banking sector.8 187. 1996-1998 (Rp trillion) State-Owned Banks — 140.50 9.43 10.44 15.8 14.2 — 8.2 1.09 (11.45 — 1993 15.47 20.9 297. however.9 percent.21 Nonperforming Loans by Type of Bank.2 10.5 222.6 — 13.73 30.0 — 32.25 22.12 15.7 Item Total Loans Dec 1996 July 1997 Dec 1997 July 1998 NPLs Dec 1996 July 1997 Dec 1997 July 1998 NPL Ratio (%) Dec 1996 July 1997 Dec 1997 July 1998 Total 331.5 2.9 11.5 128.3 361.0 129.45 21. private national banks overtook State-owned banks when their NPL ratio jumped to 57. .1 47. State-owned banks initially had the highest NPL ratio.3 Private National Banks — 179.84 27.7 — = not available.07 13.9 Regional Foreign and Development Joint Venture Banks Banks — 9.07 1994 14.15 20.0 622.6 6.5 57.24 15. The high and increasing NPLs.39 13. July No. 230/1998.5 34.1 198. Source: Infobank. 1992 7.1 274.06 20. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.24 (4.69 14.
none of the 2.000 eligible firms had signed up for the scheme.5. On 9 September 1998.7 percent ($64. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. Unfortunately. 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. 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. Corporate debt accounted for 46. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. a number of prominent companies. In June 1998. by mid-September 1998. However. assembling the legal and policy framework to facilitate corporate restructuring. few companies were in a position to resume interest payments. The scheme encourages negotiation between creditors and debtors.4 trillion of domestic debt and $6. 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. Vol. a more comprehensive scheme to tackle domestic and foreign corporate debt. the committee launched the Jakarta Initiative. Since September 1998. In addition. Aside from being described as overly complicated. and Ciputra (property business). the scheme failed. about 80 percent of which was private. such as Garuda (a national flag carrier). the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. II 1.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997. the corporate sector had more than Rp600 trillion ($75 billion at Rp8.2 billion debt. have been subject to restructuring deals under the initiative.42 Corporate Governance and Finance in East Asia. companies were not servicing their debts.6 billion) of Indonesia’s total external debt in March 1998. particularly in terms of debt resolution. Astra International (automotive). Thus. In November. While the process of restructuring was in progress. the Government and private sector formed a committee to help corporates deal with the crisis.000/$1) in debt from domestic commercial banks.7 billion of foreign exchange debt. By end-November. only a .
especially in preventing unjustifiable delays in the adjudication of bankruptcy. as well as general commercial disputes. The Commercial Court can be asked to hold off creditors and impose strict guidelines on the negotiating process .e. Astra International. and mining equipment. with the requirement that adequate compensation and protection will be provided to such creditors during that period. for equity infusion. lay off workers. Rabobank and Citibank. forcing them to cut costs. focused on its core business of car and motorcycle manufacturing and sold off its subsidiaries in semiconductors. plantations. aiming to modernize the bankruptcy system and promote the fair and expeditious resolution of commercial disputes. some companies attempted to restructure their businesses on their own. Bank Niaga also negotiated with some of its creditors. When credit from the banking sector became unavailable and interest rates increased significantly. Debtors. Procedural rules are also being introduced to ensure certainty and transparency in the proceedings. 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). In the banking industry. Bank Bali agreed on a debt-to-equity swap with its creditor. Qualified professionals from the private sector will act as receivers and administrators in the management of estates of companies in bankruptcy or reorganization. Astra International (automotive industry) and Bakrie Brothers (a holding company in several sectors) explored this option. Standard Chartered. 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. consolidate business units. For instance. i. mining. and sell noncore businesses or nonoperating assets.. A Commercial Court was set up to handle corporate restructuring and debt settlements. under which the latter would become one of the bank’s shareholders. Moreover.Chapter 1: Indonesia 43 few companies reached agreement with their creditors on this. Meanwhile. Some listed companies with relatively “rich” shareholders decided to replace their loans with additional equity through rights issues and privileged subscription (limited offering). Bankruptcy Reform The Bankruptcy Law was passed in August 1998. Protection against insider and fraudulent transactions taken by a debtor prior to the adjudication of bankruptcy will be enhanced. the companies’ financial performance deteriorated. a publicly listed company operating in the automotive industry.
The Government has also been concerned with the issue of capital controls. and recapitalization of state banks. However. Some companies simply decided not to pay their loans knowing that it would be difficult for creditors to take the case to court. 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. (iii) the merger. the monitoring system for foreign exchange transactions will be strengthened to improve transparency and better assess the credit exposure of the corporate and banking sectors. and (v) a strengthened banking supervision system. The bias in favor of debtors has retarded the pace of corporate restructuring. since the market reflects the condition of the economy. In the longer term. II to achieve liquidation of the company. collusion. The Court has also declared only two companies bankrupt. including procedures for handling operational issues and processing bankruptcy cases. the measure had only a minimal impact. (iv) measures to recover liquidity support previously extended to troubled banks by Bank Indonesia. and nepotism (anti-KNN) was signed in 1999. The Government. Banking Sector Reforms The Government’s banking sector reform strategy is focused on (i) government-assisted recapitalization programs for potentially viable private banks. legislation against corruption. Realizing that they undermine investors’ confidence. To push bankruptcy reforms. However. with only 17 cases filed as of November 1998. Previously. reform. Vol. the Capital Market Supervisory Agency allows companies to offer additional shares directly to the public. The Agency also allowed companies to buy back up to 10 percent of outstanding shares to improve the condition of the stock market. Capital Market Reform In the capital market. . is also reviewing the Bankruptcy Law.44 Corporate Governance and Finance in East Asia. There will be changes in the implementation of the bankruptcy law. the Government did not impose restrictions nor did it attempt to regulate capital flows. the Court’s early record has been a disappointment. companies were allowed to sell shares only by issuing stock rights. in consultation with IMF and the World Bank. (ii) the resolution of nonviable private banks. Rather. it is envisaged that the Commercial Court will play a central role in modernizing the commercial legal system.
Banks deemed ineligible for recapitalization will be closed. The importance of this legislation may need to be emphasized. providing Bank Indonesia with substantially enhanced autonomy. To overcome these problems. the Government established IBRA to supervise problem banks. The Bank Indonesia 21st package includes recapitalization. was enacted in 1999. In October 1998. and follow-up action on bank restructuring. The Company Law at present can be interpreted as severely limiting the scope for debt-equity swaps.1 Summary.6. 1. it is doubtful whether pure holding companies are able to enter into swaps. A new central banking law.6 1. To obtain a clearer picture of the banking sector. BEII. Some 175 groups that originated from family businesses controlled . the Government has drafted a regulation providing tax neutrality for mergers and removing other tax disincentives for restructuring. and Bapindo) will be merged into one bank named Bank Mandiri. Bank Indonesia has announced a recapitalization program for potentially viable private banks. It has also drafted regulations to remove obstacles for converting debt to equity. the Government required banks to be audited by international external auditors. The merger process will be finished within two years.Chapter 1: Indonesia 45 In 1997. Other Regulatory Reforms To push corporate restructuring further. Parliament approved amendments to the banking law that were geared toward strengthening the legal powers of IBRA and its AMU. and Recommendations Summary and Conclusions Corporate Ownership and Structure Most of Indonesia’s top conglomerates were established as family businesses. improvement of rules and prudential regulations. or sold (after transferring NPLs to the AMU). The agency set up an Asset Management Unit (AMU) to directly manage problem loans of banks under its supervision. However. merged. In particular. The four state banks (BDN. BBD. regulations will need to be issued to permit debt-toequity swaps in the context of corporate restructuring plans. Conclusions. depositors will be fully protected by the Government. Liquidity support given to troubled banks should be repaid in four years.
conglomerates set up finance companies to bring in cheap foreign loans as these companies were not adequately regulated. put a significant amount of corporate assets of conglomerates in the hands of creditors or the Government. These banks also obtained cheap offshore funds. As a result. Foreign creditors. The free capital flow system permitted the inflow of foreign capital to fuel the credit boom in the economy. However. conglomerates set up their own banks to serve as “cashiers” providing credit to companies within groups. meanwhile. The restructuring and resolution of financial distress may. 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. thus. families control 67. This study reveals that Indonesian listed companies with higher ownership concentration had higher levels of leverage. On average. However. Vol. Indonesian companies borrowed short term. When the Government regulated the legal lending limit and the net open position of banks. Among those listed in the Jakarta Stock Exchange. retain ownership control of companies. But because foreign creditors were reluctant to lend long term. while a single family controlled 16.46 Corporate Governance and Finance in East Asia. the majority remains family-controlled. Companies relied heavily on bank credit. Therefore. These figures show the extent of power wielded over the corporate sector by a small number of families.6 percent of the total stock market capitalization in 1996 and the top 15 families controlled 61. this financing pattern supports the claim that family-based controlling shareholders relied on excessive borrowing to finance corporate expansion .7 percent. lacked the information necessary to allow them to assess projects’ risks and chances for success. The financial crisis created opportunities for addressing the inefficiencies in the legal and judicial system that supported corruption. however. On the one hand. allowing them to maintain their equity shares and. banks were unwilling to provide credit to highly leveraged companies. II 53 percent of total assets of the top 300 Indonesian conglomerates. corporate debts grew over time. when barriers to entry in the banking sector were lifted.1 percent of publicly listed companies in Indonesia. not all of the conglomerate-affiliated companies are publicly listed. Rapid growth in investments masked the corporate sector’s increasing leverage. Financing Patterns Controlling shareholders opted to use debts to finance expansion.
The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. followed by the property sector. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. NPLs rose and capital adequacy ratios fell. although at a declining rate. Total profits of publicly listed companies dropped to Rp3. facilitate debt restructuring. The significant increases in leverage indicate a rapid rise in the rupiah value of debts due to the revaluation of dollar-denominated debts. At the height of the crisis. DER increased to 307 percent in 1997 and further surged to 1. and the rapid decline in equity due to losses.370 percent in 1998.24 trillion in the first half of 1998.21 trillion in 1996. On the other hand. As the rupiah weakened and interest rates increased. Meanwhile. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative).1 percent in 1998. the corporate sector was in quite good shape in terms of growth and profitability. The Government and the private sector responded with measures to mitigate the negative effects. particularly those with large short-term foreign loans. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious.Chapter 1: Indonesia 47 without diluting their control. The financial crisis led to the closure of several dozen banks. and registered a net loss of Rp39. the high domestic interest rates that prevailed from 1998. and strengthen prudential regulations and supervision of the financial sector. The Government introduced reforms to improve bankruptcy procedures. ROE dropped from 1. corporate-initiated debt restructuring . were the most adversely affected.1 trillion in 1997 from Rp13. financed by issuing nearly $80 billion worth of bank restructuring bonds. the consumer goods industry was the worst hit.1 percent in 1997 to -124. When the crisis hit Indonesia. Bank Indonesia extended emergency loans to many banks. the highly leveraged companies. To restructure the corporate sector. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. Impact of the Financial Crisis Prior to the crisis. Sales of conglomerates as well as those of publicly listed companies were increasing.
Amendments should include (i) empowering minority shareholders by raising the majority percentage of votes required on critical corporate decisions and mandating minimum representation of minority shareholders on the board. improving the legal and regulatory framework for bank supervision. The Government should ensure that all laws and regulations are effectively enforced. II measures included internal business restructuring (e. but inadequate protection to minority shareholders from the dominance of large shareholders. Improving the Legal and Regulatory Framework for Bank Supervision After the liberalization of the financial sector. In particular. Specific recommendations include protecting the rights of minority shareholders. Most companies claim to have adopted international standards of accounting and auditing procedures.2 Policy Recommendations The Government should introduce measures to address the weaknesses in corporate governance identified in this study.48 Corporate Governance and Finance in East Asia. minority shareholders have not been able to oppose controlling shareholders’ decisions to invest in unprofitable projects financed by unhedged foreign currency debts.6. Protecting Minority Shareholders’ Rights The Corporate Law provides sufficient rights and protection for all shareholders. (ii) delineating the functions of the board of directors and commissioners. the legal system is less likely to evolve in a manner that will allow it to protect minority shareholders. cost cutting and business consolidation) and acquisitions by creditors or foreign investors through debt-to-equity swaps and equity infusions. The Corporate Law should be reviewed and amended in the context of pervasive control by large shareholders. Vol.g. but it is not clear whether in practice these standards are in place. the regulatory environment was not prepared to supervise the increasing number of banks and nonbank .. 1. and protecting creditors’ rights. 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. and (iii) strengthening transparency and disclosure requirements.
a new bankruptcy law was passed in the aftermath of the crisis and a Commercial Court was set up to deal with bankruptcy cases. it has been difficult to implement standstills. the banking regulatory framework was inadequate in regulating banks’ dealings with affiliated nonfinancial companies.Chapter 1: Indonesia 49 financial institutions. Because these banks are neither easily convinced nor compelled to submit their claims to the jurisdiction of Indonesian commercial and bankruptcy courts. However. with necessary legal sanctions for violations. This is a significant factor in . the Court has been slow and ineffective in processing bankruptcy suits. the Republic of Korea and Thailand were more successful in getting foreign creditors to collectively solve their problems during the crisis. it is likely that future private financial flows for the corporate sector will continue to conform to a short-term structure. The Government should also continue strengthening the monitoring system for foreign exchange transactions. Protecting Creditors’ Rights To protect creditors’ rights. One way is to set limits on lending activities by banks to affiliated nonfinancial companies. The regulatory framework was also weak in supervising and monitoring foreign transactions. Further. Banks should be required to provide data on such transactions and charged penalties for noncompliance. The Central Bank needs to monitor and control dealings by banks within business groups and improve enforcement methods to prevent circumvention of prudential regulations. Consequently. The tendency of foreign creditors to lend short term is a problem that must be confronted once private capital flows to Indonesia recover. most of banks’ NPLs resulted from credit to companies within the same group. In the first place. When finance companies were used to channel offshore loans in lieu of commercial banks. The ownership of banks (including finance companies) by shareholders of nonfinancial companies undermined the capability of these banks to conduct prudential credit management. orderly restructuring. the Indonesian corporate sector directly owes an inordinate amount and a greater portion of its loans to foreign banks. Because foreign creditors are faced with more information asymmetries than domestic creditors. and liquidation of corporate assets. the Government lost monitoring and control powers over foreign fund flows. recapitalization. in contrast to the Republic of Korea and Thailand. With credit being coursed through the domestic banking system rather than directly to numerous local corporations.
. Only when creditors have the confidence that their rights are protected will they resume financing companies. II explaining the greater depth of the crisis in Indonesia. despite the smaller level of capital inflows (as a percentage of GDP).50 Corporate Governance and Finance in East Asia. Vol. The Bankruptcy Law should thus be reinforced and creative means should be introduced to avoid a prolonged and costly paralysis of corporate activity and financing.
Simeon Djankov. and M. 1999. Yogyakarta. John Wiley and Sons. P. World Bank. Michael Krill. various publications. Indonesia: Sustaining Manufactured Export Growth. 1995. various publications.. Embassy of Indonesia. 14 May 1999. and Remuneration. 1996. Indonesian Capital Market Directory 1992-1998. various publications. 1997. 1999. Jonathan. Lang. Conny Tjandra Rahardja. Jakarta Stock Exchange. 1998. The Impact of Acquisition to Shareholders Wealth: Comparison Between Internal and External Acquisition. The Economist Intelligence Unit. and Richard Turtil. 1995. University of Maryland. Wright. Indonesian Business Data Centre. Unpublished thesis MMUGM. John Wiley and Sons. Asia in Crisis: The Implosion of the Banking and Finance System. Manuscript. . Conglomeration Indonesia: Regeneration and Transformation into World Class Corporate Entities. Institute for Economic and Financial Research. Indonesian Business Data Centre. Financial Sector Practice Department. P. K. Risks. Embassy of Indonesia Homepage. Delhaise.Chapter 1: Indonesia 51 References ADB Programs Department (East). Keasey. Center for International Business Education and Research. Bank Indonesia. The Economist Intelligence Unit. JSX Monthly Statistics. 1998. Corporate Governance: Responsibilities. Indonesia Country Profile. Indonesia Country Report. Letter of Intent of the Government of Indonesia to the IMF. 1997. Working Paper #58. Who Controls East Asian Corporations? Financial Economics Unit. F. 1996. Economy of Indonesia. various publications. and Larry H. Indonesian Central Bureau of Statistics. Stijn. Forest. Claessens. Maryland. Indonesia: An Emerging Market. Economic and Financial Statistics. Large and Medium Manufacturing Statistics. The Private Debt Anatomy.
Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level. This has been the crux of the corporate governance problem in Korea. a practice that was not checked by creditors. and Graham Dwyer for his editorial assistance. David Edwards.2 Republic of Korea Kwang S. The country’s winners would then emerge based only on economic efficiency. timely exit of poor performers from the market. both of ADB. As the Korean currency. the Republic of Korea. The authors wish to thank Juzhong Zhuang. internal control mechanisms. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. . the Government and business sector had good reason to reflect on the causes of the crisis. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits. and corporates were sent reeling.1). Department of Economics. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2.1 Introduction The economic crisis that began in Thailand and swept through Asia starting in the summer of 1997 hit the Republic of Korea (henceforth. Further. or capital market discipline. markets. Chung and Yen Kyun Wang1 2. 1 Professors. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. Korea) in November of that year. Chung-Ang University. Seoul. 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. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. Business managers and controlling shareholders were maximizing firm size at the expense of profits. 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. the Korea Stock Exchange for its help and support in conducting company surveys.
especially chaebols.1 1996 561 163 29. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. II Table 2. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government.1 1997 518 104 20. 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. and improvement of bankruptcy procedures. capital market discipline.9 1994 531 165 31.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC.4 1993 513 174 33. accountability of controlling shareholders and boards of directors. .1 1995 560 163 29. T. 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. This study collects and analyzes data on the Korean economy. The EVAs are the same as the economic profit as explained in T. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades.1 Listed Firms with Positive Economic Value Added. June 1999. Government reform goals for the corporate sector include enhancement of corporate transparency. the corporate sector. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.1 1998 490 164 33. Koller. Weaknesses in the overall corporate governance system in Korea had many ramifications. Vol. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. and J Murrin (1995). where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital.54 Corporate Governance and Finance in East Asia. and individual companies. which distributed and collected the questionnaire. Many firms left some questions unanswered. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. Source: Korea Stock Exchange. Copeland. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace.
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.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. 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.2. and Yim (1998). and naturally adopted an import substitution policy. It traces the country’s economic development. It reviews such elements as shareholders’ rights.2. Section 2.2 presents an overview of the corporate sector.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. The evolution of the modern Korean economy can be divided into four periods. Section 2. Section 2.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. Major economic indicators for some of these periods are shown in Table 2. and employees and their role in shaping corporate governance practices. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. corporate control by the Government. . From 1948 to 1961. creditors. 2. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. which account for a substantial portion of the Korean economy. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. This chapter is composed of six sections. the board of directors system. and other necessities domestically. Section 2.4 contains analyses of corporate financing and its relationship to performance. Yang. clothing. reviewing government policies responsible for the development of the modern corporate sector. It then presents recommendations for further reform in corporate governance and financing.2 2. In the period 19481961. The Government tried to produce food.
332.2 314.8 15.8 (8.9) 1. This goal required very high savings and investment rates.7 14.4 1990-1997 7.1d 9. IMF. II Table 2.102. 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. modernizing the industrial structure.4 10.855.8 24.6 11.4 29. high unemployment and inflation.447. d Refers to 1997.265.1 9.5) 8. and inconsistent economic policies.5 250. International Financial Statistics. the Government was not successful in solving the problems of slow growth.0 41.4 29.3 8.2 32.0 27.8 12.5 38.7 37.2 6.2 1.5) (1. In the Plan. Source: Bank of Korea.9 794.2 452.7 30. largely because of political instability. Vol.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.4 (1. The Government tried . Economic Statistics Yearbook. lack of strong drive.1 29.2 30.2 1980-1989 8.1 15.949.4 24.1 35.0) (297.0) 492. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).56 Corporate Governance and Finance in East Asia.9 — — 21. a Refers to 1971.9) (7.753.9b 15. 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. Export Drive: 1962-1971 Between 1962 and 1971.2 31. and implementing new budget and tax measures. However.1 — = not available.7c 11.2 757. e For maturities of one year or more.2 Key Macroeconomic Indicators Annual Average (percent.8 (724. b Refers to 1979. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.1a 21. c Refers to 1989. and large current account deficits. the Government called for an unprecedented average annual economic growth rate of 7.
the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. but tariff rates were raised to 40 percent in the 1960s. In 1964. Bank deposits increased rapidly.4 percent. The average growth rate of the economy from 1960 to 1964 was 5. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. During the first five-year plan period. 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.3 percent average between 1954 and 1959. a modest improvement over the 4. In 1963-1964. while the average tariff rate was 39 percent. the growth of gross domestic product (GDP) raised domestic savings. However. the import liberalization rate was 55 percent. This change raised the import liberalization rate from 9. resulting in high real interest rates. In 1971. which laid a solid foundation for a steady growth path. up from 30 percent in the late 1950s.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. The well-educated. Exports increased sharply from $41 million in 1961 to $2. imports of consumer goods and luxury items were highly restricted. . abundant. During this period. The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system.2 billion in 1972. due to continuous current account deficits. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. Also. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports.3 percent to 60. channeling funds from curb markets into the banking sector. But the liberalization trend turned out to be short lived as current account deficits continued. These were considerably liberalized in 1967 when Korea joined the General Agreement on Tariffs and Trade (GATT). and cheap labor force was well utilized by the export-led growth strategy. boosting internal investment resources. The positive list system for imports was replaced with a negative list that indicated only those items that could not be imported. The exchange rate system was a kind of crawling peg until 1974.5 percent. but the average growth rate for 1965-1969 shot up to 10 percent. and maximizing mobilization of domestic savings on the other. the Government tried to provide exporting firms with a free trade environment.
overburdened with debts and high interest rates. This strategy formally took off with the announcement of the HCI Promotion Plan in June 1973.6 billion between 1973 and 1981 into these sectors. The Government has since used similar emergency rescue measures for large businesses and banks almost once every 10 years. announcing rescue packages for businesses and banks. By promoting HCIs. The Government targeted six industries—steel. There were three reasons for the switch: first. the Government felt that continuous trade deficits arising from increasing intermediate and capital goods imports could be prevented by developing import substitution industries. electronics. These practices contained an implicit government guarantee that large businesses and banks could never fail. the Government felt the need to strengthen the defense industry. The HCI promotion policy was much more comprehensive than past economic development plans. shipbuilding. and allocating virtually unlimited amounts of credit at below-market rates while controlling the financial system. reducing or exempting debts of farmers and fishermen. it tried to substitute imports and export high value-added HCI products. faced the danger of bankruptcy. and assigned them to specific chaebols. the Government changed its industrial policy emphasis from light industries to heavy and chemical industries (HCIs). The Government took emergency measures. machinery (including automobiles). where preferential export credit was given to almost every exporter. II Heavy and Chemical Industry Promotion: 1972-1979 In the Third Five-Year Economic Development Plan (1972-1976). and giving low interest rate loans to banks from the central bank. Unlike the previous system. In 1972. It promoted HCIs by supplying massive capital for construction and development. less developed countries forced Korea to adjust its industrial structure. It included a detailed construction and investment schedule over a 10-year time frame and mandated coercive implementation.58 Corporate Governance and Finance in East Asia. the domestic economy was stagnant and many businesses. becoming a seed of the economic crisis in 1997. One industrial policy adopted during the heavy and chemical industrialization drive was administered credit rationing. nonferrous metal. These included rescheduling business debts. Third. The Government encouraged a variety of business projects. 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 . investing a total of $9. the emergence of competition of other low-wage. Second. and chemicals—as future core industries. Vol. in the face of a world economic slump.
met increased difficulty.Chapter 2: Korea 59 through state-controlled banks. exacerbated the overcapacity problem. including forced liquidations and mergers and acquisitions (M&As). Evaluations of HCI promotion policies are mixed. fiscal expenditure maintained zero growth. Such an approach gave the Government increased control over the economy. since during the second half of the1980s many of the promoted firms became world-class competitors and exporters. including denationalization of banks. however. Korea recorded current account surpluses and rapid economic growth due to the “three lows”: low value of the US dollar. The severe world recession caused by the second oil shock. The plan of the 1970s was thought to be successful in the long run. Economic Liberalization and Globalization: 1980-1997 In 1979. However. The growth rate of the money supply was reduced drastically. Firms that followed the Government expanded greatly. various measures to increase competition were taken. Cheap credit and distorted prices resulted in overexpansion in the HCIs. faced with high inflation. In order to improve economic efficiency. The industrial and trade policy resulted in high inflation in the 1970s and serious excess capacity problems by 1979. especially between 1979 and 1985. Meanwhile. Gross national product (GNP) growth rates on average were higher in the 1972-1979 compared to 1962-1971 (Table 2. as it had to control only a few large chaebols. and their utilization ratios were very high. and the won depreciated by 20 percent with the adoption of a Basket-Currency Gliding System in 1980. The incentives available became more market-based. the Government adopted comprehensive measures to promote economic stabilization. price controls were abolished. Macroeconomic policies became hostages of the industrial strategy. the policy wasted substantial amounts of resources in the short and medium terms. with many turning into the now well-known chaebols. coupled with political uncertainty due to the assassination of President Park in 1979. the Government restructured some large businesses through forced liquidation and M&As. light manufacturing and service industries were weakened by disadvantages such as a lack of credit. and the large excess capacity of HCIs. In 1986-1989. low . Meanwhile. This required industrial restructuring by the Government. such as widespread underutilization of capacities of HCIs and related plants. imports were further liberalized while tariff rates were lowered. New start-up firms. The two important ones were import liberalization and deregulation of the financial sector. a heavy foreign debt burden.2).
II world interest rates. the Government committed itself to further liberalization of the goods and capital markets. Korea adopted a market average exchange rate system.1 percent. In 1993. Vol. total sales. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems.9 percent. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996.” A large-scale business group is called a chaebol. and total workforce. In 1988. while continuous and large current account surpluses saved Korea from the foreign debt problem. The most important element characterizing chaebols is the concentration of ownership. the importance of chaebols was increasing.9 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). total assets. whose business activities are controlled by an identical person. the import liberalization ratio reached 98. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. The Government tried to adjust economic policies and regulations to meet global standards. 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.2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. The official rate fluctuated within a band. and declaring that it would follow Article XI of GATT.2. 4. In 1990. 46. with the 30 largest in the total economy in 1997 standing as follows: value-added. 47.3 percent. The low value of the dollar led to a low won and high yen. total debts. Korea began participating in many multilateral trade negotiations during the Uruguay Round.60 Corporate Governance and Finance in East Asia.9 percent. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII. Meanwhile. but it chose to liberalize gradually. 45. and low oil prices. 13. 2. giving up its foreign exchange controls related to the current account.1 percent and average tariff rates 8. and acceded to the World Trade Organization (WTO) in 1994. which gradually widened.2 percent. further increasing its pace of import liberalization. Industrial and trade policies were modified to be consistent with WTO.
However.Chapter 2: Korea 61 War II. Chaebols are also excessively diversified. and tax breaks to key industries to promote exports and industrial upgrading. Table 2.1 20. the number of subsidiaries declined drastically due to corporate restructuring. Since the Government controlled most business activities. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. Table 2. In the mid-1970s. Chaebols have a history of substantial concentration of ownership.when the Government put a great deal of emphasis on development of the HCIs. of Subsidiaries per Chaebol 20. of Subsidiaries 604 616 623 669 Average No. The Government provided subsidies. 1993-1996 Year 1993 1994 1995 1996 No. financial assistance. This policy contributed greatly to the expansion of chaebols. and they are aided and supported by one another.8 22. Important managerial decisions are made primarily by owners.3 Subsidiaries of the 30 Largest Chaebols. it was more effective to deal with a small number of companies to secure tangible outcomes.3 Source: The Fair Trade Commission. . Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital. chaebols that maintained a close relationship with the political authorities were able to grow fast. reaching 669 in 1996.5 20. after the financial crisis. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols. the ownership and management of a chaebol’s subsidiaries are not separate. In this sense. One reason for this controlling power is inter-company shareholding among subsidiaries. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries. Since the 1960s. This galvanized the fast growth of chaebols. From the standpoint of the Government.
Related to this is the tendency of chaebols to assist unprofitable firms at the expense of profitable ones. if a chaebol has an unsound financial structure but strong financial links through mutual payment guarantees among their subsidiaries. For example. They had to meet certain requirements in terms of firm size. The law also allowed employees of listed firms to get 20 percent of the subscription rights in offerings of new shares. diversification can make chaebols stable through the portfolio effect. profitability. chaebols can benefit from synergies. years since establishment. which may ultimately lead to the decline of social efficiency. listed companies enjoyed corporate tax rates that were 10 to 20 percentage points lower than those imposed on privately held firms. . in addition to the usual economies of scale. including the “economies of organizational size” inherent in multi-product and multiplant firms. This law was in effect until 1987 when it was partly absorbed into the Capital Market Development Act. Another law that contributed to the development of the stock market was the Act to Expedite the Going Public of Corporations of 1972. In the early years after the enactment of the law. Vol.2. they can reduce uncertainties and dilute risks through sharing of information and diversification. The law also contained provisions to afford tax and other benefits to firms that went public and to impose tax-related penalties on those that refused to comply with government recommendations. internalization of the market that could enhance the internal efficiency of a chaebol may close the market to other firms. Diversification may raise chaebol profitability but could also work to eliminate more efficient competitors because bigger chaebols have a higher capability to enforce unfair methods of competition.62 Corporate Governance and Finance in East Asia. Meanwhile.3 Role of the Capital Market and Foreign Capital In the 1960s. II Theoretically. the Government’s efforts to develop the stock market culminated in the Capital Market Development Act of 1968. etc. the bankruptcy of one or a few marginal subsidiaries could lead to a chain of bankruptcies for the entire chaebol. there are many negative assessments of organizational structures and practices of chaebols. and were allowed extra depreciation charges for tax purposes. However. Since chaebols are engaged in many different businesses. Under this law. 2. the Government reviewed the financial performance of companies and recommended (or ordered) selected ones to go public. On the other hand. This could ensure their stable growth and enhance their investment abilities.
The policy to expand the size of the stock market. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies.2 44. especially those paying small or no dividends.570 95. In this regard. Third. Inc.4 Development of the Stock Market. . 1985-1998 No. Because of government policies and the booming economy. a country fund.0 965. several important policy measures were implemented to promote the development of the stock market. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors. Also that year.1 30. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused. was established to invest in domestic shares beginning in September 1985.370 70.9 34. Korean firms were allowed for the first time to issue in international financial markets equity-related securities such as convertible bonds (CBs) and depository receipts.0 49. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138.1 16.989 137. the stock market grew rapidly during the 1980s. continued until 1989..9 918.020 151.476 79.4 654. however.4 40.217 141. The aggregate Table 2. Second.1 Market Capitalization (W billion) 6.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.4.7 934. First. Beginning 1990. The Korea Fund. the Government announced the gradual opening of the capital market to foreign investors in January 1981.9 833.Chapter 2: Korea 63 During the 1980s and 1990s. 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).151 117.5 406. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. As shown in Table 2.0 79.6 747.798 Market Capitalization as a Ratio to GDP (%) 8.
546 (2. . Table 2.800 (7. The relative size of the stock market diminished to 44 percent in 1990.942) 42. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.382 Permit basis. currency and deposits. due to declining stock prices.326 1.352 471 3. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2. trade credits.5 Private Capital Flows to Korea.858 4.085 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 1986-1989.910) 2. Other investments include loans. but rose again to 34.296) (6.440 1.59 percent in 1998 and to more than 50 percent in the early months of 1999.149 13.817 16.414) 5. However.924 (1. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.953 10.86 percent of GDP in 1997.650 (1.870) (1.239 19.453 (2.2 percent by 1989. The aggregate market value of listed shares bottomed at 16.500 7.123 3.571 2. Source: Balance of Payments. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.017) 1.339) (9.785 (1.642 21. and 1993. The growth in the number of listed firms also slowed in the 1990s.658) (3.141 4.534) 1. Vol.944) 8.001 4.008) (3. and other liabilities. II market value of all listed firms represented only 8 percent of GDP in 1985.542) (1.583 25 10.852) (2.742 (3.126 (1. Bank of Korea.868 (518) (418) 63 1.450 24.875 21.150 5.737 (333) (297) (607) (2) 218 2.553 8.264) (3.433) (9.64 Corporate Governance and Finance in East Asia.287 (340) 73. Table 2.338 4.183 12.255 2.455) 13.413) 56.714 1. and stayed at the 30-40 percent level up to 1996.694) 2.347 3. but increased sharply to 79.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.
weak incentives for attracting FDI. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations. Corporate sector net proft margins increased from 1993 to 1995. but between 1988 and 1993.Chapter 2: Korea 65 Complicated government regulations.6 percent in 1997. the growth rates of equity and sales dropped sharply in 1996 and 1997. The contribution of the corporate sector to GDP was 73. This would lay the foundation for evaluating the effect of corporate governance on performance.China.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector.2. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector. 2. but dropped in 1996 and were negative by 1997. The ratio is generally in the same range for Japan and Korea. The growth rates of total assets. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. (ii) listed firms. following the sharp depreciation of the won. Japan’s was consistently higher.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan.2 percent in 1987. and high production costs were the main reasons for low FDI in Korea.5). equity. portfolio investments amounted to $73. and (iii) chaebols.China and the US. Table 2. Between 1986 and 1989. However. increasing to 76 percent in 1997. other net private capital inflows amounted to $130 billion during 1985-1998. and US.9 billion.6). Taipei. and sales of the aggregate sector during this period were very high (Table 2. The dismal performance of the Korean corporate sector compared to the . excluding FDI. Korea had substantial current account surpluses and experienced net private capital outflow.7 billion and loans $42. Net private capital inflow. Profit rates of Korean firms were relatively low compared to those of Taipei. The same categories will be analyzed in later sections. In addition to FDI. Return on equity (ROE) and return on assets (ROA) showed similar patterns. Of this. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. This indicates that a substantial proportion of debt was denominated in dollars.
6 1.9 2.5 4.1 6.4 2.7 4.7 4.3 308.0 4.0 7.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei. ROA = return on assets (ratio of net income to total assets).8 2.7 15.5 (0.8 21.7 4.8 1.3 — 3.8 3.5 3.5 0.5 1.3 1. Source: Bank of Korea.9) DER = debt-to-equity ratio.0 0.6 1. Financial Statement Analysis Yearbook.0 305.9 2.0 (0.9 13.8 22.9 3.3 11. 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 23.0 13.3 3.9 3.9 8.0 3.7 3.4 — 6.9 18.7 3.9 5.0 10.3 6.1 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).4 1.6 3.2) (0.Table 2.4 1.2 13.0 6.6 318.5 1. Net profit margin = ratio of net income to sales.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.2 9.6 4.3 14.7 325.3 17.5 2.1 — — — = not available.7 1. Source: Bank of Korea.7 15.6 13.4 19. ROE = return on equity (ratio of net income to stockholders’ equity).6 2.6 (4. .9 4.9 16.1 2.9 5. Financial Statement Analysis Yearbook.5 4.2 18.1 5.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.2 13.4 10.4 2. Table 2.3 335.3 21.1 2.3 312. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).2 1.9 16.2 19.9 5.8) 297.8 8.4 1.2 1.9 2.9 18.7 2.3) 5.1 8.5 1.4 4.6 9.6 424.2 1.4 2.3 21.0 8.0 13.5 7.8 1.
5 percent while the aggregate sector recorded only 13. this may be an indication of the bias toward large firms in terms of access to credit.8). The profit margin of listed firms was generally higher than that of the aggregate corporate sector.9). the average ROE was lowest for large firms. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997. ROEs. gas. Growth rates of total assets are generally high. Again. . and transport sectors recorded negative profit rates in 1997. A comparison of performance by firm size reveals some interesting results. sales of listed firms grew 18. trade. In 1997. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. the exception being the electricity. Profit rates of most industries are also quite low. Small listed firms were hardest hit by the financial crisis. with equity in wholesale and retail trade even contracting. Performance followed similar patterns across different industries (Table 2. This may be related to its having the lowest DER. In most years. both ROA and ROE were lower for the listed firms compared to the latter. All sectors experienced a sharp decline in equity and sales growth in 1997. but higher than that of small firms. Net profit margins. However. The superior performance of listed firms in terms of sales growth may be due to large firms’ easy access to credit and the inclusion of financial firms in the listed firms category. The growth performance of large firms for the 1988-1997 period was better than that of medium.6). The other financial ratios follow the general pattern of the aggregate corporate sector.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits.4 percent. with the wholesale and retail trade sector and the construction sector having the highest figures. This preference of Korean firms has its roots in the structure of corporate governance. followed by mediumsized firms and large ones.and small-scale firms (Table 2. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. It is notable that the construction sector’s profit rate began its decline in 1995. a year ahead of the other industries. However. while their average net profit margin was lower than that of medium firms. and steam supply industry.10). construction. The manufacturing. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis.
8 12.3 11.5 28.1 27.7 7.0 18.6 0.3 8.5 19.0 (0.0 2.5 5.3 18.6 12.2 0.9 3.3 1.8 34.6 24.9 31.3 15.6 1.0 1.5 483.5 (0.4 10.5 16.6 3.5 306.8 2.2 6.1 296.4 12.9 16.1 22.2 24.8 10.9 13.8 562.8 461.0 1.6 14.8 0.1 2.7) 2.3 285.0 15.9 (0.2 6.5 1.4 348.5 (5.5 239.4 474.1 (0.5 1.2 18.6) 3.9 19.2 16.4 350.8 22.5 270.4 1.9 2.9 9.3 31.5 432.4 17.6 5.4 (0.0 15.3) (1.8 10.9) 1.6 7.5 338.1 1.0 37.6 14.0 2.6 3.6 6.2) 6.3 11.8 24.5) 0.2 5.6 15.9 16.2 16.3 14.4 0.7 317.9 0.5 23.2 12.8 16.0 12.0 3.5 4.Table 2.3 15.8 14.1 7.0 (4.9 2.6 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 13.4 2.1 0.0 16.8 1.8 14.0) 0.1 290.0) 1.5 286.1 (0.1 396.1 2.0 5.2) 22.7 9.8 526.8 22.4 0.6 14.6 375.6 17.9 340.0 245.4 14.5 569.6) (6.1) (3.3 13.7 5.8 12.8 16.2 423.3 8.3 8.0 2.2 0.9 1.4 15.4 2.0 23.0 24. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.3 10.4 10.4 .8 3.2 20.0 1.9 428.0 254.7 21.1 0.8 302.8 17.5 6.1 28.0 2.2 7.4 5.3 15.6 1.3 25.7 520.0 21.0 9.1 17.4 2.3 8.0 18.2 315.3 14.4 5.6 17.2 25.0 5.8) 0.6 11.2) (0.7 4.2) 15.0 1.2 0.0) 4.0 7.7 30.8 2.1) 0.8 23.1 1.5 473.8 1.3 15.4) 0.1 20.4 2.0 24.5 3.4 5.3 2.0 (0.9 5.6 318.5 (1.8 2.5 5.1 21.6 655.3 288.0 19.9 (0.0 22.7 17.6 12.1 0.4 3.5 14.5 1.8 345.9 14.0 16.0) 0.9 538.9 25.1 1.2 5.0 1.7 294.4 458.2 15.2 241.3 2.4 4.7 22.4 10.2 5.1 1.1 10.5 13.5 1.5 30.2 2.0 1.8 3.6 2.6 0.9 10.9 (0.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.8 16.4 740.1) 3.5 27.9 16.4 291.4 9.3 1.5 1.3 10.8 616.8 32.5 1.8 13.7 0.5 6.7 1.7 514.8 7.9 29.9 10.7 (0.2 (1.7 228.0 22.1 16.8 35.8 Real Estate.4 1.8 24.0 1. Renting.2 20.2 36.4 2.0 22.8 0.7 10.7 16.7 (3.4 10.
5 344.9 1.6 34.5 14.1 2.1 (0.5 13.4 11.8 4.5) 22.4 21.4 2.9 3.9 321.9 8.5 4.2) 9.6 (2.7) (4.5 11.4 (2.1 (11.9 18.2 18.7 19.5 14.9 18.6 (2.7 2.6 6.3 524.3) (1.6 172.7 16.0 21.3 4.8 9.4 1.7 187.1 11.0 14.4 3.5 15.3 543.4 6.6 18.4 341.0 921.1 6.5 15.4 633.4 16.3 18.6 9.3 4.1 15.062. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.2 15.1 1.7 11.5 0.5 539.8 15.3 8.2 18.2 14.5 14.2 1.7 — — — — — 14. b NPM denotes net profit margin.1 14.4 0.4 0.8) (12.9 7.6 4.9) (8.8 12.8 529.7) 0.6 15.7 11.9 4.8 3.4) (1.0 106.0 (1.2) 0.1 15.8 111.4 14.4 367.3 (2.5 8.6 0.6 14.5 47.8 0.3 17.2 698.8 3.0 2.3 4.4 3.1 8.0) 1.6 3.7 0.8 14.7 14.0 Transport.3 2.9 12.4 10.4 15.0 1.1 323.7 0.4 169.6 2.9 332.9 10.4 2.4 (0.6 — — — — — 17.8 8. Gas.4 7.4 0.4 3.0 1.6 12.4 9.5 307. Source: Calculated using data from Bank of Korea.2 10.5 482.2 7.0 1.7 510.6 1.5 612.3) 4.1 (2.3 1.6 20.4 1.2 18.3 — — — — — 10.0 2.6 8.1 21.6 — — — — — 0.6 6.0 5.3 0.5 2.7 116.6 21.4 30.6 512.0 5.3 18.2 — — — — — 2.6 12.8 11.7 — = not available.9 Electricity.1 4.7 11.2 10.6 6.8) 1.6 19.9 (10.0) (0.3 0.3 112.1 11. Financial Statement Analysis Yearbooks.4 — — — — — 448.7 15.0 7.0 98.1) 5.5 11.9 12.4 7.3 23.2 122.9 (11.2 143.8 (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 7. a New equity does not include capital surplus.6 16.6 8.3 34.5 30.3 12.5 (2.7 20.9 9.1 16.5 14.9 4.2 14.3 1.0 89.2 10.6 4.1 17.7 7.4 1.7 2.3) 15.3) 11.9 10.8 14.5 16.6 8.2 11.1) (0.1 3.9 9.3 125.2) 13.4 13.6 1.5 12.5 117.4 6.6 19.5 26.1 12.9 17.9 6.3 3.3 740.6 9.0) 1.1) 1.4 12.8 6.7 7.2 90.2 2.3 19.5 462.8 0.9 17. .9 456. Storage.2 3.1 15.7 12.0 (15.3 9.0 14.8 12.9 8.1) (0.3 8.Table 2.4 12.0 13. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.6 9.8 6.
7 1. had 46 member companies.9 21. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.4 1.5 19.9 6.5 ROE 3. 1985-1997 (percent.3 percent). and net profits (46.11).1 1. In 1995.3 (0.1 6.6 1.7) 0.6 0. 1998. Between 1993 and 1997.0 0.3 4.12).8 5. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. Kis-Fas. In 1997. the top 11-30 chaebols experienced a decline of .8 6.1 1.9 11.70 Corporate Governance and Finance in East Asia.4 1.0 18. debts (47.6 22.9 2.9 Source: Constructed using data from Korea Investors Service.9 1.5 0. The number of Hyundai member companies rose to 57 in 1997.4 1.4 2. The criteria for selection of largest chaebols have changed a few times.5 5.3 2.3 0. of which 16 were publicly listed (Table 2.4 0. and close to half of total assets (46. Generally. but the number of designated groups has been fixed at 30 since 1993. it is the chaebols’ large firms that are listed.9 percent). The smallest group had 16 members in 1995. followed by the top 6-10 (Table 2.2 9.3 15. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.6 (1.9 percent).12).9 0.1 percent of the economy’s total value added (excluding the financial sector). of which four were listed.6 and 2.4) 1. It should also be noted that when the financial crisis struck in 1997.2 0.2 2.9 2.7 1.7 (5.6 3. The top five chaebols registered the highest growth rates.0 3.5 19. the 30 largest chaebols accounted for 13.6 23. Chaebols have been the most important actors and engines of growth in the Korean economy.3 20. the largest chaebol.4 22.1) 4.7 percent) of the corporate sector. II Table 2. Hyundai Group.5 ROA 0. sales (45.2 6.9 Growth and Financial Performance of Listed Companies. Performance of Chaebols This section uses available data on the top 30 chaebols.7 Net Profit Margin 0.6 2.2 9. Vol.9 26.8 24.8 0.
6 9.6 5.8 7.7 2.6 2.0 1.2 (0.8 10.6 8.0) 0.8 1.6 1.1 11. 1988-1997 (percent) ROE Large 9.7 2.2 2.1 2.8 0.3 (0.8) 1.0 10.3 1.7 1.9 5.9 6.3) 0. Source: Korea Investors Service.3 9.7 (0.5 5.9 0.2 0.1) 5.0 6.8 6.7 (1.3 3.0 16.9 14.6 3.5 2.9 25.1 0.4 1.2 3.4 6. Kis-Fas.9 2.4 Medium Small Large Medium Small ROA Growth Performance Large 17.8) 6.5 (1.3 Medium 14.10 Growth and Financial Performance of Listed Companies by Size.0 (4.9 2.5 17.8 0.9 22.9 2.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.5 3.2 12.6 13.2 1.8 0.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.9 0.2) 0.0 1.0 4.1 2.9 1.4 1.6) 0.1 1.1 8.3 6.6 0.9 3.6 2.6 1.5 0.Table 2.3) 5.6 (1.2 13.3 (0.2 13. Others are medium firms.4 11.9 0.0 1.2 7.4 16.8 16.3 11.9) (6.9 (0.2 10.4 3.7 4.8 6. 1998.6 1.6 3.6 0.8 0.9 1.3 15.6 6.8 17.4) 1.4 2.5) 1.0 17.5 5.2 Small 13.0) 1.5 25.0 19.5) 1.9 6.7 3.0 1.6 7.7 (1.5 1.2) (1.2) (1.4 5. .6 (0.3 15.2 2.7 18.8 (5.4 3.0 15.8 3.6 2.
117 4.774 7.177 — 6. 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.853 1997 53.475 2.309 14. Source: Fair Trade Commission.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 43.996 1.423 5. .640 4.427 9.090 6.376 35.131 3.935 2.873 2.951 3.458 6.599 — 2.457 14.287 10.651 38.158 7.313 14.303 3.574 3.158 1.597 351.761 31.433 3.180 2.990 2.129 2.956 3.370 6.346 3.246 11.924 2.501 13.690 3.486 6.927 16.995 2.398 — 2.364 5.147 5.756 5.743 40. 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.395 31.766 3.445 4.Table 2.455 22.677 3.929 12.967 7.910 3.798 — No.
1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.2 20.0 2.2 (16.1) (1.1 19.9 24.3 0.1 (3.7 1.4 (2.3 14.6 25.12 Growth and Financial Performance of the 30 Largest Chaebols.7 15.1) 0.2 0.0 2.2 11.2) 1.5 20.2 0.0 2.5) (0.7 10.3 9.8 27.4 38.1) (0.7 15.0 1.1) (0.9 17.9 3.0) ROA 1.0 6.2 3.Table 2.1 10.1 2.4) 1.7) Source: Bank of Korea.2 1.3 3.9 18.1 (1.5 19.5 (0.0 19.0 0.3) 0.0 17.2) (2.3 0.7) ROE 5.3 11. .9 3.5) (0.7 10.2 (2.8 0.6 19.7 0.3 19.6 1.5 5.6 4.4) (0.8 18.7 13.2 (5.5 2.2 0.1 27.3 27.0) 3.3 1.9 20.6 Financial Performance Net Profit Margin 1.0) 12.2) (0.0 0.9 20.8 Assets 12.4 0.4 12.1) 0.6 18.3 15.3 16.2 (2.4 30.7 4.5 27.5 32.4 26.0 31.1 (2.6 (0.5) (0.3 1.9 1.4) (14.
2. his/her relatives.3. it refers to the degree of concentration and shareholdings in the hands of an “identical person.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. and access to credit. 5 While “ownership concentration” can be defined and measured differently in different contexts. loopholes and inconsistent policies spawned strategic behavior and agency problems. includes the largest shareholder. Vol. However. The better showing of the top five chaebols was a direct result of their dominance in human resources. and government intervention interacted through a set of laws and regulations to bring about the existing structure. the average DER of the 30 largest chaebols reached 519 percent.” in Korea’s legal and regulatory framework. technology. The absence of a well-developed equity market and the provision of subsidized credit. Ownership patterns.13). weak corporate control. from 190 to 3. .95 percent. By the end of 1997.5 Founding families are mostly still the largest shareholders and. Only the top five chaebols registered a positive net profit margin in 1997. chaebols had a higher average DER than the corporate sector as a whole. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. There has been a wide range in DER among chaebols. and led to a high concentration of ownership. II 2 percent in their sales and a very low 4. coupled with weak corporate governance. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. 2. Their worst year was 1997 when ROE hit -15.74 Corporate Governance and Finance in East Asia. resulted in the chaebols’ excessive leverage. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997. 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. except for 1995. a pyramidal structure of corporate ownership is prevalent.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. The Commercial Code stipulates the basic governance framework and applies to all corporations. internal and external control mechanisms.” This “identical person. In general. in this instance.7 percent growth in total assets. and the companies that are under the control of the largest shareholder.765 percent (Table 2. and vulnerable balance sheets. However. more important.
7 354.4 622.8 312.5 343. Byucksan 1996 1. Hanbo 15.5 3. Hanjin 8.1 385.7 688.2 328.Table 2. Hyosung 18. Hansol 23. Doosan 15.6 2. Lotte 11. Daelim 16. Kia 9. Sammi 27.0 218.2 2.6 936.2 292. Hyundai 2. Kukdong Construction 29.0 436. Ssangyong 7. Ssangyong 7. Dongkuk Steel 19. Sunkyung 6. LG 4.6 .3 572. Kumho 12. Daelim 14.5 464. Kohap 25. Daewoo 5. Sunkyung 6. Doosan 13.1 190.5 337. LG 4.7 416. Hanjin 8. Dongah Construction 16.4 175.1 477. Hanwha 10.1 3.6 409. Jinro 20.764.4 192.3 328. Kia 9. Hanil 28.4 556.0 506. Hyosung 18.2 471. Hanwha 10.441.7 621.1 674.2 423.5 383. Samsung 3.855.0 370. Daewoo 5. Haitai 26. Hyundai 2.8 336.4 205. Halla 13. Dongkuk Steel 19.2 346.9 751. Halla 17. Dongah 14.065. Newcore 30.5 2.7 267. Dongbu 24. Tongyang 22. Kolon 21.2 924.244.3 297. Hansol 17.1 278. 1995-1997 (percent) Chaebols 1995 1. Samsung 3.3 315. Jinro Debt-to-Equity Ratio 376. Kumho 12. Lotte 11.9 321.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.6 516.8 313.7 620.0 486.
8 590. Shinho 26. Doosan 15. Keopyong 29.6 416. Haitai 25.5 (1. Dongbu 21. Hyosung 17. Keopyong 29.8 647.6 424.13 (Cont’d) Chaebols 20. .7 1. Dongkuk Steel 20. Kamgwon Industrial 30. Newcore 26. Dongbu 23. Lotte 12.6 590.501.1 472.5 323. Dongah 11.5 576.0 907. bBank of Korea. Anam 22.9 465. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317.3 676.6 335.9 216. Shinho 1997 1.9 490. Miwon 30.5 519.8 399.8 347. Newcore 28. Kolon 19. Halla 13.498.8 338. Ssangyong 8. Kohab 18.214.1 438.600.6 478.4 1.1 375.8 468. Hanil 28.5) 404. Tongyang 24. Samsung 3. Daesang 27.6 Sources: aFair Trade Commission.225.9 578. Financial Statement Analysis Yearbook.8 658. Haitai 25.5 1.4) 513. LG 5.9 472.5 261. SK 6.0 505. Hanjin 7.3 399. Tongyang 24. Hansol 16.8 307. Anam 27. Kolon 21.0 419.1 359. Kohab 22.1 433. Hyundai 2. Jinro 23.Table 2. Daelim 14.5 (893.784. Daewoo 4.3 347.0 305.5 386.3 1.9 1.7 944. Hanwha 9.7 370. Kumho 10.
Chapter 2: Korea 77 When controlling shareholders hold a very small percentage of the shares. Securities companies reduced their holdings over this period of falling stock prices as the size of investment trust companies’ stock portfolios declined. with a given range of managerial shareholdings (for instance. including investment trust companies. that is. Most non-chaebol listed firms in Korea are believed to have ownership concentrations within the 10-30 percent range. the ownership structure can bring about an incentive effect. Among listed nonfinancial companies. The percentage of shares owned by “other corporations. including banks and other financial firms. The reduction can be . The controlling shareholders of chaebols hold comparatively smaller percentages of shares. Composition of Ownership Among listed companies. the percentage of holdings by individuals slipped to 60. i.7 percent by 1997. resorting to extensive use of pyramiding to maintain control.” foreigners. Beyond that range. Thus. The holdings of financial institutions. while those owned by banks. an increase in their ownership may bring their ownership incentives to converge with those of the minority shareholders. and insurance companies increased during the period. fluctuated widely during the period. the Government. individuals were also the largest shareholder group. managerial entrenchment becomes more likely. the entrenchment effect outweighs the incentive effect. the individual owners—the portfolio investors as well as the controlling shareholders and their family members—formed the largest shareholder group (Table 2.6 percent by 1997. However. the year the stock market was in a frenzy due to buying sprees. When managerial holdings are reinforced by artificial control mechanisms such as pyramiding. From 69. and state-owned companies and securities companies declined. and then steadily declined after 1993. Financial institutions owned as much as 28 percent of the total corporate shareholdings in 1992.1 percent. large ownership can also bring about the entrenchment effect. The next important group was “other corporations.e.” followed by banks. the incentive effect once again dominates.14). the entrenchment effect and problems of agency may be more pronounced in chaebols than in independent firms. an entrenched manager is insulated from market pressure and can pursue personal goals without the fear of being replaced.. However. the extent of ownership by these individuals declined gradually after 1988. 10 to 30 percent). Theoretically. but their shares declined to 21. The pattern of distribution changed little through 1992-1997.
14 Ownership Composition of Listed Companies.3 5.8 5.0 5.1 60.2 7.6 Year No.3 1994 521 1.9 5.0 28.5 18. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.3 2.8 59.1 11.5 16.0 9. of Firms The Statea Banks. Listed Nonfinancial Companiesd 1988 406 0.9 37.8 1995 548 2.1 2.2 8.7 4.9 1.7 8.0 4.Table 2.0 7.3 39.3 26. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.0 59.1 1.2 17.2 B.6 16.2 5.9 19.4 34. etc.5 1992 508 2.3 18.2 1.3 1.7 18.8 17.1 3.5 Note: Ownership is based on number of shares.6 16.6 8. investment trust companies.9 2.1 4.6 22.1 18.5 6.2 5.2 18.9 15. .1 8.4 5.3 17.5 1.3 5.5 4.6 16.6 36.2 8.4 5.4 Insurance Firms Other Corporations Foreigners Individuals 39.0 5.0 60.9 4.5 1.5 7.0 8.5 7.3 8.8 5.8 2.7 3.3 17. b “Banks. c Data from Korea Stock Exchange. merchant banks.2 9.2 4.6 1991 505 0.7 59.9 36.6 19.4 1997 551 1.8 4.9 2.1 18. etc.4 13.5 62. a The State covers the Government and state-owned companies.5 12.6 12.7 6.7 9.9 26.0 27.4 14.7 1990 531 0.8 17.1 68.9 1. and finance companies.9 17.5 6.4 18.3 1.1 21.6 13.4 6.1 21.2 9.8 2.6 2. mutual savings.8 59.6 9.3 1996 570 2.7 7. d Constructed from data files of the Korea Listed Companies Association.1 10.2 2.2 3.3 18.6 9.1 17.5 60.2 1993 511 2.4 13.1 8.8 69.7 9.7 14.6 20.” includes commercial banks.b A.5 1989 498 0.
In most instances. and small companies. Before such liberalization. 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.17). However. the holdings of institutional investors were expected to increase significantly with the Government’s introduction of US-type investment companies in 1998 and . The holdings of other corporations are mainly equity investments in affiliate companies. The Government’s and state-owned institutions’ (including some banks) ownership was generally small except in the power sector. did not vary significantly (Table 2. In 1998. medium. as distinguished from individual and foreign investors. and service of motor vehicles (Table 2. whether partial or absolute. However. When independent companies are distinguished from firms affiliated with the 30 largest chaebols. electricity. categorized into large.16). indicating their heavier reliance on inter-firm financing investments. the Government acquired an even bigger share in several banks as part of its program to bail out these distressed institutions. UK.8 percent of listed shares in 1997. and US (Table 2. Foreigners gradually increased their equity shares in 1992 when direct purchases by them were first permitted. The ownership distribution in listed nonfinancial firms. foreign holdings were derived from purchases through country funds and direct capital investments. government ownership in nonfinancial companies was remarkably smaller and more concentrated. with the Government continuing to hold a sizable share in the Korea Electric Power Corporation. indicating their increased investments particularly in the service industries with high growth rates.18). the Government was the sole owner. One minor difference is that the percentage of shareholdings by corporations is slightly higher in large-sized firms.15). held 26.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. Individuals held the majority of the shares in all industries except in telecommunications. Corporate holdings averaged 16 percent throughout 1988-1997. other corporations’ holdings shifted toward service industries. of some banks. Over the years. This trend can be explained by government ownership. there appears to be no significant difference in the overall shareholding patterns between the two groups (Table 2. Compared with its holdings in all listed companies. financial institutions had more shares in the manufacturing sector than in primary industries. Institutional investors. This is low compared with those in Japan. In general.
9 60.Table 2.7 1.5 19.1 4.4 56..5 3.6 8.1 0.7 22.6 3.5 4.0 9.9 4.8 7.4 14.6 11.7 20.8 Individuals 83.3 6.1 1.6 24.5 12.5 — 1.3 62.8 7.2 17.9 42. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.3 0.3 9.4 Banks.7 14.2 7.7 64.8 8.1 0.3 1.7 29.7 2.0 7.7 14. and Printing Chemicals.3 0.0 — 39.1 27.7 59.1 0. Gas.9 66.1 88.8 73. 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 .6 — — 2.5 6.9 55. and App.9 19.2 — — 0.2 0.0 20.9 52.4 7.1 65.2 1.7 2.4 62.8 3.6 18.9 59.3 2.8 7.6 5.1 7.7 2.7 63.8 3.2 0.4 8.1 8.0 9.9 15.0 8.3 10.3 11.0 — 0.2 22.4 1. and Printing Pulp.7 6.0 10.0 0.4 — 0.6 1.2 9.3 57.3 13.2 9.4 2.1 8.4 56.5 0.3 2.9 1.2 54.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.0 9.9 10.3 0.5 85.4 1.0 2.8 7.1 19. Paper.3 1.2 1.9 23.5 17.3 7.5 0.5 7.7 22.1 0. Motor Vehicles Electricity.8 1.2 0.3 4.4 5.0 9. Rubber.15 Ownership Composition of Listed Nonfinancial Firms by Industry.9 8.2 2. Etc.5 — 0.9 16.8 6.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.9 1.4 8.4 8.2 9.3 38.9 0.2 — 0.0 1. Elecl Mach.5 0.5 0.8 7.7 17. Paper. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.8 5.4 0.2 64.2 0.5 — — 0.1 10.7 20.
2 5.4 1.9 20.4 4.6 59.4 6.1 9. Rubber.6 5.6 2.8 11. merchant banks.3 6.8 54.0 6.3 1. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.5 6.1 3. and App.3 1.9 69.1 2.3 65. Gas. Motor Vehicles Electricity. Source: Constructed from data files of the Korea Listed Companies Association.1 — 0.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.6 0.8 0.5 7.6 3.0 1. and Printing Pulp.9 57.0 4.2 13.6 60.5 63.7 2.0 8.5 4.0 11.6 1.2 8. investment trust companies.5 3.8 2.5 12.7 2.6 0.0 43.2 49.4 2.9 0.8 27.2 4.1 4.9 78.1 1. b “Banks. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.4 4.4 45.8 5.1 25.7 5.4 9.2 1.9 20.8 57.” includes commercial banks.0 3.2 7.3 2.1 18.2 0.3 57. etc.8 2.5 — 2.4 — 1.4 2.7 4.1 54.9 2.4 2.3 8.6 6.6 6.3 6.7 1.9 1.1 6.8 6.2 6.5 3. Elecl Mach.8 3.1 9.3 7.5 3.4 16.5 1.4 1.9 7.4 68. Paper.7 2.0 6. a The State covers the government and state-owned companies.2 5.2 1.9 2.9 5.2 4.6 20.7 2.8 5.9 2.6 18.6 2.0 60.8 12.9 6.5 5.4 1.2 3.6 75.3 31.4 0.9 6.9 5.5 0.8 4.0 7.6 14.4 76.7 6.2 0. and Printing Chemicals.9 1.1 2.2 4.2 4.9 18.5 3.7 19.5 4. Paper.1 — 1.2 23.4 58.3 60.5 59.6 2.8 0.1 1.7 23.1 3. mutual savings.3 0.0 5.4 3.8 2.9 1.3 15. .4 20.6 — = not available. Note: Ownership is based on number of shares.6 7.78 81.9 2.4 58. and finance companies.4 43.7 17.9 7.
8 2.4 61.c Securities Firms Insurance Firms Other Corporations Individuals 58. .4 17.5 8. etc. The State covers the government and state-owned companies.8 60. etc.4 2. b Table 2.0 1.5 6.7 8.3 6.4 4. Source: Constructed from data files of the Korea Listed Companies Association.4 2. Others are medium firms.5 4.1 6.5 19.6 60.8 4.7 1.7 6.9 4.0 6.5 18. c “Banks.5 16.7 Control Type No. Securities Firms Insurance Firms 2.4 5. etc. 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. and finance companies.Table 2.4 1.7 0.4 21.3 Banks.” includes commercial banks.9 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.7 Foreigners 4. 1997 (percent) The Stateb Foreigners 4. merchant banks.4 5.7 4.8 1.1 Banks. mutual savings.2 1. 1997 (percent) The State 1.5 2. investment trust companies.9 5.1 8.6 16.8 6.4 Firm Sizea No.5 62.16 Ownership Composition of Listed Nonfinancial Firms by Size.4 61.8 4.1 2.5 Individuals 60.17 Ownership Composition of Listed Nonfinancial Firms by Control Type.0 Other Corporations 16.8 3.
Foreign holdings of Korean shares were 9.1 8.5 45.20). This has had profound implications for corporate governance and the market for corporate control in Korea. But these may . defined as those holding less than 1 percent of shares. while family members accounted for only 30 percent. 1997 (percent) Country Japan Korea Taipei.8 10. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group. minority shareholders.3 6.Chapter 2: Korea 83 Table 2. and the companies under the control of the largest shareholder. At the moment.6 39. corporations held 70 percent of the controlling blocks of shares.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries. his/her family members.China United Kingdom United States Source: Stock Exchange of Korea. In 1997. investors (Table 2.1 financial institutions’ establishment of corporate pension fund accounts.7 16.8 9. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.18 Ownership Composition of Listed Firms in Selected Countries.3 47. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. the majority shareholder group in all listed companies consists of the corporate. Among nonfinancial listed firms. Institutional Investors 42.6 Individuals 23. 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. rather than the individual. only closed-end investment companies and traditional investment trust companies are allowed. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder.3 54.19). including those of the largest shareholder.6 Foreigners 9. for example. Generally.5 20.8 56.4 26.
1 37.0 22.4 7.1 5.9 2.6 22.6 73.0 29.2 26.3 18. and the companies under the control of the largest shareholder.6 5.8 73.2 2.1 14. Source: Stock Exchange of Korea.1 15.19 Ownership Concentration of All Listed Firms.Table 2.0 66.7 16.3 30.8 Individual Subtotal Other Shareholders Corporation 3.3 2.1 21.9 33.7 18. .0 1.5 43.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.3 Subtotal 5.1 32.6 46.9 6.0 2.6 2.7 6. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.7 44.0 25.8 8.9 7.0 69.1 28.6 26.9 3.1 5.7 Note: The majority shareholder includes the largest shareholder. Minority shareholders are those holding less than 1 percent of shares. 1992-1997 (percent) Majority Shareholders Corporation 15.9 32.7 7.0 4.8 72.2 2.4 3.1 23.2 Minority Shareholders Subtotal 71.9 Individual 2.1 4. his/her family members.4 5.
6 58.9 Other Shareholders 18.0 58.Chapter 2: Korea 85 Table 2. and mining categories. thereafter. Across industry.8 57.6 11. Ownership concentration tended to be lower in large compared to medium and small listed firms. In such cases.5 13.8 28. It was highest in medium-sized firms before 1993 and.22). .8 54. Meanwhile.1 50. ownership was relatively diffused due to government regulation. Besides. minority shareholders.3 62.0 22.0 20. which held less than 1 percent of a company’s outstanding shares as of 1997. The percentage of shares held by minority owners (with less than 1 percent of outstanding shares) was highest for large firms at more than 55 percent (Table 2.9 27. the Government has retained a large number of shares.9 29.4 28. 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.8 25.3 25. Majority ownership is also high in the chemicals.21]). In telecommunications.8 Majority Shareholders 27. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53.9 25.8 12. In most industries. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average.4 Source: Constructed from data files of the Korea Listed Companies Association. collectively owned less than 50 percent of an average firm. 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 2.2 15.5 12.20 Ownership Concentration of Listed Nonfinancial Firms.5 60.9 12. in the small firms. The practice of hidden shares seems to have been less prevalent in recent years.7 18.9 48. the majority owner held more than 20 percent of an average firm.4 23. hiding shares offers no additional tax or other benefits.6 57.5 23. rubber and plastics.
Table 2.7 17. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.6 34. Paper. and App.7 27.1 19.7 36.3 39. 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 36.0 21. and Printing Pulp.6 53.6 38.8 31.5 44.1 49.8 41.5 47.8 21.8 44. Gas.1 43.6 19.2 34.3 19.2 19.4 16. Paper.8 55.2 48.6 25. and Printing Chemicals.5 20.2 26.9 44.9 26. 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.2 22.8 51.0 54.2 23.5 23.7 24.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.2 46.0 30.2 20. .8 24.9 10. Motor Vehicles Electricity.1 17.8 25.5 52.5 16.7 29. Rubber.7 26.7 21.4 11.5 41.5 21. Elecl Mach.5 19.0 39.4 53.6 50.3 26.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.8 29.9 Minority Shareholders Majority Shareholders Other Shareholders 12.2 37..0 51.
8 28.4 30.5 19.2 12.5 10.9 12.Table 2.0 66.9 53.2 56.8 52.8 11.0 55.9 16.7 57.4 21.3 19.2 11.9 55.5 26.6 11.9 28.4 30.7 31.5 51.3 26.2 21.5 49.2 Source: Korea Listed Companies Association.7 28.2 21.2 32.7 22.4 29.2 18.1 48.8 27.6 15.3 21.4 51.0 24.8 17.3 25.8 56.4 47.6 24.7 57.6 55.5 27.7 14.1 58.1 16. 1988-1997 (percent) Year Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Medium 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Large 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 No.1 27.2 21.2 26.3 55.7 17.5 12.9 21.6 31. of Firms 66 81 72 76 80 67 78 102 134 115 148 197 219 212 210 217 216 216 215 215 165 213 220 217 218 217 227 230 231 221 Minority Shareholders 53.2 Majority Shareholders 26.5 21.5 12.9 22. .6 62.5 19.9 23.1 15.5 33.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.1 20.9 60.2 55.2 50.3 27.9 56.9 26.0 26.6 59.9 17.8 62.7 16.8 52.2 52.4 30.8 50.5 Other Shareholders 19.5 28.0 59.6 27.6 65.7 15.
Both studies used Tobin’s Q (TQ) for the value of a firm as an index of financial performance. H. the firm destroys value. For example. called “pyramiding”— commonly (though incorrectly) known as “indirect cross-shareholding”— is prevalent in Korea. although turning points in the value of firms are different. TQ has a maximum value. which is the company holding more than 40 percent of outstanding shares of its subsidiary. one company from a chaebol group could obtain debt payment . If SCS is below the range of 20-25 percent. TQ was calculated by dividing the market value of a firm by the substitution price of its assets. Shleifer. H. This type of inter-firm investment. The Code prohibits a subsidiary company from owning shares of its parent company. Where direct cross-shareholding is not allowed. If TQ is higher than 1. TQ increases as the SCS increases. 1988). Kim (1992) found the relation between TQ and SCS to be nonlinear. thus a firm creates value. The study by Kim. which can then pass the equity capital to a third. from the standpoint of the controlling shareholder. one company can still place equity investments in another. One of the merits of pyramiding. TQ is above 1. In Korea. thus a firm destroys value. If SCS reaches 10 percent. J. The pattern of the relationship between SCS and TQ is similar between Korean and US firms (Mork. often at terms unfair to one of the transacting parties. If SCS is below 10 percent. affiliated companies have been able to conduct inter-firm transactions. Inter-Firm Investments and Pyramiding in Chaebols The Commercial Code imposes limits on direct cross-shareholding. Hong. and Kim (1995) reached a similar conclusion. II Ownership Concentration and Financial Performance J.88 Corporate Governance and Finance in East Asia. Hong. and the shareholding of a controlling shareholder (SCS) as the degree of ownership concentration. This refers to the situation wherein Company A holds shares of Company B and simultaneously Company B holds shares of Company A. Then TQ declines until SCS reaches 45 percent and increases until it reaches 50 percent. If SCS is above 20-25 percent. Vol. if TQ is lower than 1. is effective control of a certain group of companies even with a smaller investment. They analyzed firms in which controlling shareholders participate as managers. TQ is below 1. and Vishny. it means the firm creates value. and Kim (1995) studied the empirical relationship between the degree of ownership concentration and financial performance in Korea. The relationship between TQ and SCS shows a similar pattern. Kim (1992) and Kim.
For the same year. the average shareholding of the controlling owners and their families was 8. If we define the internal shareholdings of a . the top 30 chaebols’ shareholding by subsidiaries was 34. In many instances.14. or about four firms each. not individuals. Twenty-two of the 81 respondents were independent. 53 percent were domestic nonfinancial firms. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. Partial results are shown in Table 2.5 percent. Among the subsidiaries or firms receiving investments. 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. there are instances of direct cross-shareholding in Korean firms. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms. Among chaebol affiliated firms. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms.23. 62 percent (16 out of 26) had a corporation as the largest shareholder. standalone setups. or about five subsidiaries each. or an average of 13 firms per company. In the case of the 30 largest chaebols. 59 were parent firms with one or more subsidiaries. together owning an average of 38.4 corporations. together having a total of 292 domestic subsidiaries. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. 34 percent were foreign companies. Thus. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. although they are likely to be insignificant. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. Until recently. Of the 81 respondents. and about 11 percent were domestic financial institutions. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. For the whole sample. The fact that corporations. Among the 81 listed firms in the ADB survey.5 corporations and two individuals.5 percent of shares. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. Thus.Chapter 2: Korea 89 guarantees from other members of the group at no cost.9 percent of shares. The extent of pyramiding can be seen in some of the previous tables. together owning an average of 37. the top five shareholders consisted of 2. and 319 foreign subsidiaries. 59 parent companies collectively had investments in 759 firms.5 percent as of 1997. for example. In Table 2.
5 18. A few companies reported less than five largest shareholders.3 26.2 25.7 39.7 5.0 3. .8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.8 37.4 1.5 24.0 21.7 0.1 3.Table 2. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.4 11.7 37.8 38.9 21.0 13.4 38.5 2.9 29.8 31.8 18.9 34.5 4. 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 20.6 16.7 19. a Number of shareholders.6 3.5 38.5 2.0 2.4 42.6 34.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.2 37.5 2.0 1.5 31.5 4.8 8.0 3.6 3.9 5.5 1.0 1.4 21.4 2.1 22.1 1.0 17.3 12. 1999 Five Largest Shareholders No.4 25.5 2.6 3.4 18.
.6 33.4 10. 1989.24 Internal Shareholdings of the 30 Largest Chaebols. H. The family and member companies’ shareholdings have been declining over time.7 9.0 8.2 1994 42.2 15. 15 October 1998.2 33.5 percent.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. the ownership patterns can be described as follows. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent.7 31. 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. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission.4 1990 45. 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.5 Judging from the historical record. Tamio.1 1997 43. the controlling families owned 8. Jae Woo. New York: Praeger. 34. As of 1997. 1998.5 34. Chicago.2 12.4 1993 43. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. 79-95.8 33. pp.” In Korean Managerial Dynamics. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. Hattori (1989) identified three patterns based on data in the early 1980s. Chung and H. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute. C. 6 7 Hattori. Table 2. Lee.7 1992 46. it appears that the chaebol families have had a strong desire to expand their business bases. edited by K.5 percent and member companies. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family. 1997. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family. “Japanese Zaibatsu and Korean Chaebols. Based on these studies.” Paper presented at the Annual Conference of Financial Management Association. Table 2.8 40.4 13. Ungki Lim. Lee.24 shows the average internal shareholdings in the 30 largest chaebols. 1987 56.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns.
it had 18 listed and 39 private companies. consisting of eight listed and 16 privately held firms as of 1997. financial. A nonprofit foundation under the family’s control is the largest shareholder of one of the base companies. Also. is an example of this type. or merged into. Kia Motors was the base company and had such strategic shareholders as Ford Motors of the US and Mazda of Japan. The Hanwha Group can be classified as such a company. holdings of the nonprofit foundation. Hyundai Motors acquired Kia Motors via an international auction. there is no controlling shareholder. But the former chief executive officer (CEO). One of the . Sun Hong Kim. The Hanjin Group. Vol.” Under this type of ownership pattern. The family itself holds shares in some subsidiaries. Most of its member firms were acquired by. The fourth type (Type D) is “management control. Investments between the lower level subsidiaries are rare. and his management team exercised full control over the group without much interference from major investors. As of 1997. investments made by the base companies. The Kia Group was about the only management-controlled group but was out of existence by 1999. called the “indirect control via base company. which in turn hold shares in some of the other subsidiaries. The second (Type B). It consists of seven listed and 24 privately held firms.92 Corporate Governance and Finance in East Asia. other firms. and subsidiaries’ equity participation. Its controlling family holds shares in three base companies through which they exercise control over the other member firms. For example. Here the family is the controlling shareholder of one or more strategic base companies that have enough equity participation in the subsidiaries. completely dissolved under financial distress. The controlling family has sizable investments in two base companies and smaller investments in many others. and business activities. The two base companies have investments in three other base companies. subsidiaries have extensive investments in other subsidiaries. Thus.” shows a simple pyramidal structure. the family controls the group’s member companies by its own shareholdings. II The first (Type A) is called “direct family ownership. Chaebol Reforms Various measures have been taken to improve the transparency of chaebols with regard to accounting. The third (Type C) is “indirect control via complex shareholding.” Here the family directly controls a base company and a nonprofit foundation. which then make investments in the subsidiaries.” A family owns a substantial portion of shares of member firms and becomes the controlling shareholder of each. The Hyundai Group exemplifies this.
thus hurting the shareholders of stronger firms. 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. following the amendment of the law. . there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. However. only operating holding companies were allowed to be established. bankruptcy reorganization. At this early stage. the Fair Trade Act). They hindered early exits (liquidation. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. This limit was also applicable to banks and insurance companies. The Government is also considering whether to allow consolidated taxation for pure holding companies. Initially. Until the end of 1998. The prohibition of holding companies was also abolished in 1999.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. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. One condition requires that the DER of the holding company should not exceed 100 percent. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. It remains to be seen whether they will adopt the holding company structure in the future. Existing guarantees had to be resolved by March 2000. Also. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. and limited the amount of total investments made by a member firm of a chaebol in other firms to less than 40 percent of its net assets. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. These amendments prohibited holding companies and direct cross-shareholding. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. A third disallows multiple layering of holding companies. This was the reason why chaebols chose to employ pyramidal structures.
In 1998. who is universally called the “group chairman. but the larger and stronger ones still operate their newly named “restructuring headquarters” under the control of the group chairperson. planned for capital raising and allocation on a groupwide basis. Some chaebols have disintegrated or shrunk in size. It also acted as the secretariat for the unofficial “presidential meeting” of the member firm presidents.” The group chairman operated through these offices and treated the individual member firms as if they were the divisions of a single legal entity. until urgent restructuring is complete. boards of directors. Their operating costs were borne by the member companies rather than by the controlling shareholder. Since the economic crisis. The staff of these organizations were employees of member firms.2 Internal Management and Control Monitoring of corporate management by shareholders. Some chaebols operated “group management boards” attended by top executives (presidents or chairpersons) of larger member firms. there have been no significant changes. even though they were legally independent with their own board of directors and the outside shareholder groups were not identical. chaebols dismantled their “planning and coordination offices” or “chairman’s offices” under pressure from the Government. usually in the rank of a company president. Chaebols maintain that the restructuring headquarters will exist only for a limited period. These offices were legally informal and functioned as the headquarters of chaebols. and the capital market was almost nonexistent until the recent reform . which put together the accounts of all members of a chaebol.) of nonviable member firms and helped afford a disproportionate advantage to chaebols in obtaining favorable bank loans because (it was generally believed) the Government would not let large chaebols go bankrupt.94 Corporate Governance and Finance in East Asia. The office established strategies for the group as a whole. Vol. unlike the regular consolidated statements that only cover those firms that are related through direct equity participation.3. The Fair Trade Commission has been deeply involved in promoting managerial transparency by exercising its power to investigate and levy penalties on “unfair internal transactions” among member firms of chaebols. 2. II etc. The chairman’s office had its own chief executive officer. and transferred funds generated by one firm to another. the Commission has strengthened its investigative activities to eradicate cross-subsidization and wealth transfer activities among group members. Despite chaebols’ decision to dismantle the chairman’s offices. The 30 largest chaebols are now required to publish “combined” financial statements.
the representative director was also the chairperson of the board. had their own governance problems. Under such circumstances. this was complicated by the prevailing attitude that large companies. Thus. were too big to fail. Legal provisions to protect investors were limited. the concept of fiduciary duty of managers was not well established. Even where the largest shareholder is not the representative director. the controlling shareholder (or a member of the controlling group) was the legally registered representative director in 354 out of 551 nonfinancial listed firms. only the Government could play an effective role in monitoring corporations. The board elects one or more representative directors from among the board members. but some large ones have two or more. he or she generally approves major decisions made by the management. and takeover codes were not accommodative to active monitoring. the creditors did not declare defaults.Chapter 2: Korea 95 efforts. Loan agreements and debt indentures did not include strict covenants. Meanwhile. However. or at least acts as the de facto CEO. the controlling shareholder is officially the representative director and the CEO. The Government’s policy and securities law provisions to protect control rights of the incumbent management had been in place until the early 1990s. As of 1997. except for banks. Professionalism in management was not well developed and managers were content with receiving orders from controlling shareholders. Even when the covenants were violated. creditors were not active in monitoring debtor firms and relied mainly on guarantees and collateral. in most Korean firms. Most companies have one representative director. With few exceptions. . especially chaebols. This implies that the typical agency problems in Korean corporations stem from conflicts of interest between inside (the largest) and outside (minority) shareholders. control is not separate from ownership. There are many reasons for this. corporations should have a board of directors consisting of at least three members. Directors are elected at the general shareholders meeting for a term not exceeding three years. In most listed companies. as the major creditors. Banks. Board of Directors General Characteristics of the Boards Under the Commercial Code. This policy managed to hamper any monitoring initiatives from the capital market.
the listing rules of the Korea Stock Exchange were revised to require that listed companies have one or more “independent outside directors” by the 1998 annual shareholders meeting. Despite the qualification requirements. almost all companies succeeded in adopting cumulative voting. and their positions (accept or reject) on matters voted on in board meetings. In the 1999 annual shareholders meetings. A few large companies had more than 50 directors. the stock exchange recently amended the listing rules to require that companies disclose a detailed profile of the candidate and the person who made the nomination. Recent Reform Efforts on the Board System In 1997. there is concern that newly elected outside directors still lack independence from the management or the controlling shareholder. cumulative voting is not mandatory and a company can exclude itself from its application by amending its charter. other than the representative director(s). The Commercial Code was also revised in 1998 to introduce cumulative voting for the election of directors. However. it has been common practice that candidates for directorship are handpicked by the controlling shareholder/CEO from among the senior managers and are automatically approved at the general shareholders meeting. the attendance rate of outside directors. 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. Further. 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. With the boards consisting only of insiders. 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. II When the Commercial Code first introduced the corporate board system in the 1960s. However. Vol. 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 1999.96 Corporate Governance and Finance in East Asia. Moreover. In order to address this concern. 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. . companies have to disclose in their annual reports the frequency of board meetings. members of the board. all of whom were managers.
1 percent of outstanding shares of a listed company. this committee adopted the Code of Best Practice in Corporate Governance. Directors were also chosen on the basis of their relationship with the controlling . the Corporate Governance Reform Committee. 88 percent had plans to hold elections in the near future. Meanwhile. The Commercial Code is being amended to allow a choice between the audit committee system and the current internal auditor system. Almost all (92 percent) of the respondents had one or more outside directors and 70 percent were elected after the Asian financial crisis. Among others. The average board had 8. On average. Among the firms with no outside directors.4 directors. inside directors owned 16. and a nominating committee. was established under the auspices of the Ministry of Finance and Economy and the Korea Stock Exchange. having no controlling shareholders. 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 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. which had extended financial support in their recent recapitalization efforts. they had a parent/child relationship in 20 percent of the cases.Chapter 2: Korea 97 The committee structure of the board as found in the US has not yet been adopted by listed companies. a blue-ribbon committee. Directors were most frequently elected because of their professional expertise (74 percent of the respondents marked this answer). Where the chairperson was not the CEO. the chairperson of the board was also the CEO and on average held 10. he or she held 6. In March 1999. This is because most banks. who would comprise at least 50 percent of the boards.5 percent of the shares.1 percent and outside directors 1. the Korean Code recommends that large listed firms should have at least three independent directors. In September of the same year. These results are in accordance with the new listing rules introduced in 1998. are required to have a majority of outside directors. The controlling shareholder of some banks is the Government.2 percent and the CEO 14. the OECD principles of corporate governance were the minimum standard for the Korean Code of Best Practice. an audit committee. although some banks recently have established board committees. Where the two were separate.
Members of controlling shareholder families or their trusted company personnel often act as directors for multiple chaebol firm boards. Less frequently. and shareholding (10 percent). These were established only recently. In some instances. the management nominated director candidates (64 percent of the directors). However. The general practice is that shareholders approve the upper limit on the total amount to be paid to all directors. among the 81 sample firms. including stock options.98 Corporate Governance and Finance in East Asia. Remuneration for chairpersons include only fixed fees in 76 percent of the sample firms. Some directors were nominated by significant shareholders (18 percent) or introduced (and elected) at the shareholders meeting. Most frequently. About five directors per firm have been in office for more than one term. The current chairperson has been in office for 6. Chairpersons of the board were elected on the basis of professional expertise (33 percent of the firms).2 years on average. According to the Commercial Code. one person was sitting on nine boards and this person was the CEO of a chaebol firm. The survey results indicate that boards determine remuneration packages for chairpersons in 42 percent of the firms. in 23 percent. This rather long tenure must be due to their status as controlling shareholders in most firms. election of directors was based on shareholdings (7 percent) and status as founder (7 percent). in some firms. In a very small number of firms. and fixed fees plus performance-related pay. In 1997. In 13 percent. In 91 percent of the sample firms. the board had a nomination and an audit committee. founders of the company acted as the chairperson (22 percent). The board or the management then determines compensation packages for individual directors. II shareholder (30 percent). . As discussed earlier. compensation for directors must be approved by the annual shareholders meeting for each fiscal year. Vol. most firms just began to elect a small number of outside directors to meet a new requirement in the listing rules and thus have no experience in the AngloAmerican type of board processes. the 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). The reason for this high frequency of interlocking directorship is that many listed firms belong to chaebols. In most firms. the board had no committees. the term of appointment of directors and board chairpersons is three years. the management determines the remuneration. relationship with controlling shareholders (21 percent). a total of 562 directors were sitting on two or more corporate boards. In one case.
the payment is about five times the CEO’s annual salary. and fixed salary plus performance-related pay including stock options in 13 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. These results show that the incentive compensation scheme for professional CEOs is not well developed in Korean firms. 86 percent of the firms answered positively when asked whether the largest shareholder was CEO. he or she was selected on the basis of professional expertise in 15 firms. . CEO is also the founder in 52 percent of the firms. the survey tells a slightly different story than is generally believed in Korea. In less than 20 percent of the firms. CEO was given shares by the family. who is not the chairperson. CEOs generally maintain their positions for a long time because they are frequently the founders or largest shareholders of their firms. In such cases. In 20 percent. he or she does not enjoy much power.Chapter 2: Korea 99 Management CEO In the survey sample. compensation is by fixed salary in 74 percent of the firms. When CEO is not the chairperson. It indicates that CEO. According to the survey. CEO decides on important matters after consulting the chairperson in the majority (55 percent) of the firms. CEO simply follows the orders of the chairperson. In 4 percent of the cases. In cases where CEO is not the largest shareholder and chairperson.2 years. In the survey. in which there is no controlling shareholder. fixed salary plus net profit-related bonus in 9 percent. A smaller number of firms consider maximization of a company’s market share and looking after the interests of such stakeholders as creditors and employees as very important. CEO generally has the ultimate power to decide on corporate affairs. Ensuring that a company serves the public interest is considered a less important responsibility of CEO. In the 25 firms where CEO was not the chairperson of the board. In 21 percent of cases. In a handful of sample firms. it was proposed by CEO and approved by the board. and was appointed by the Government in five firms. The remuneration package was proposed by the board (and approved by the annual general meeting) in 56 percent of the firms. and in another 21 percent CEO bought shares in the market. CEOs have been in their positions for an average of 9. However. decides on important matters on his/her own in 13 out of the 44 firms. shareholding in three firms. CEO is entitled to a large sum in cases his/ her contract is terminated before its expiration.
executives sometimes have the opportunity to buy company shares at favorable prices because the board of directors (CEO. from IMF and the World Bank.100 Corporate Governance and Finance in East Asia. Usually CEO suggests the maximum amount of all the directors’ compensation at the shareholders meeting to get approval and then sets the base salary and bonus for individual executives. This action was in response to calls by international investors and. but as of March 1999 only 27 firms actually had given stock options to their executives or employees. However. Korean firms have rarely used shares for executive compensation. The commission has played an active role in introducing new rules on corporate governance. disclosure. 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. Senior managers were even often called directors although they were not official members of the board. and . and accounting standards. One area has been to enhance the reliability of financial statements of corporations in line with internationally accepted standards. II Senior Executives In the past. in particular. Penalties for fraudulent financial reports were increased. The bonus is supposed to be linked to company performance. 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. it was common for all senior executives to be elected as directors at the shareholders meeting. in practice) allocates the unsubscribed portion of new shares issued in rights offerings to executives. but in practice is fixed and understood as part of a fixed salary. 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. About 40 percent of the listed companies had amended their charters to introduce incentive stock options by the 1999 shareholders meetings. Reforms in accounting standards since May 1998 have proceeded in several areas: (i) revision of financial accounting standards that are primary sources of the Korean Generally Accepted Accounting Principles. Vol. (ii) establishment of accounting standards for financial institutions.
The internal auditors are supposed to play the role of the audit committee found in the board of directors in US corporations without being members of the board. The 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. Internal and External Auditing The Commercial Code requires a corporation to have at least one internal auditor elected at the general shareholders meeting. Those that never adopted international standards show their willingness to do so once the Government introduces international standards. financial institutions must report their securities holdings at market value and recognize 100 percent of unrealized holding gains or losses in the current year’s income statement. Consolidated reporting was introduced before the outbreak of the crisis. The revised accounting standards apply to the firms subject to external auditing for the fiscal year starting on or after January 1999. they also have the power and duty to monitor the activities of executive directors.Chapter 2: Korea 101 (iii) establishment of accounting standards for “combined” financial statements of chaebols. 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 . 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. Most of the companies following all or some of the international standards in the past adopted such standards before the crisis started. Thus. 41 percent of the companies believed that they have followed some international accounting standards. The primary sources of reference in the revision were International Accounting Standards and US Accounting Standards. however. In practice. but 49 percent confessed that they have not followed international standards at all. In the ADB survey. Korean listed companies with subsidiaries are required to compile consolidated balance sheets. Only 10 percent of the respondents have followed all international accounting standards. The External Audit Act and its Decree require financial statements of corporations with total assets of W7 billion or more to be prepared and audited according to the financial accounting standards and working rules set by FSC.
Big Korean accounting firms are affiliated with US accounting firms. Accepting these arguments. the Korean Code of Best Practice also recommends that large firms adopt the audit committee structure with two thirds of its members consisting of independent directors. The Commercial Code will be revised to allow corporations to choose from the two options: the internal auditor or the board audit committee system. underdeveloped market discipline for accounting firms. 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. II controlling shareholder/CEO. does not have the power to hire and fire the managers. . In the ADB survey. About 100 listed firms will be subject to this requirement. If the company changes its external auditor for reasons that are not listed in the relevant regulation. Vol. but since 1998 a committee consisting of internal auditors. and creditors selects it. the board of directors had the power to appoint an external auditing firm. as a monitor of management in the Korean (and also the Japanese) system.6 years. In order to increase independence. This is because the auditor.102 Corporate Governance and Finance in East Asia. and lack of strong professional ethics in the accounting profession. outside directors. almost all firms affirmed that the external auditor is independent from the company. 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. however. If the status of internal auditors is elevated to that of independent board members. External auditors are selected for a term of three years. Listed and registered corporations must publish financial statements audited by external accounting firms. Previously. The general organizational/social culture in Korea abhors conflict and may also have hindered effective functioning of internal auditors. 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. there were many cases where external auditors failed to detect omissions and false numbers in financial statements of listed firms. The problem of misconduct on the part of the external auditor was caused partly by weak penalties on wrongdoing. In the past. this problem will largely disappear. The internal auditor in the Korean corporate system can be argued to be inferior to the Anglo-American audit committee and the German supervisory board. The current external auditors have been associated with the surveyed companies for an average of 4. then the Securities and Futures Commission can appoint a new one. But this problem can be mitigated if auditors function under the umbrella of the board.
for some firms. About one fifth of the listed firms issued nonvoting preferred shares. in general.Chapter 2: Korea 103 2. No companies have so far introduced voting by mail. Internet. However. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. representing 62. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). These voters represented only 5.53 percent of the total shareholdings. The above results indicate that. However. voting by the Depository can influence the outcome of votes because an “ordinary resolution” of the general shareholders meeting requires a majority of the votes attending and one quarter of total votes outstanding.93 percent of the shareholders but 26.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. small shareholders do not attend the annual meeting and that.77 percent of the shares. charter amendments. One common share should have one vote. The Korea Securities Depository can exercise the voting rights of shares left thereto by the investors (beneficial owners) if the owner of the share does not indicate his or her intention to vote personally. A total of 326 shareholders per firm.79 percent of the shareholders.” Companies can increase the number . The Depository represented 20 percent of the shares attending the meetings. Approval of mergers and major divestitures. corporations cannot issue common shares without voting rights.” The survey shows that the Korea Securities Depository holds 69. amendments of the articles of incorporation require a “special resolution.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. respectively. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. the Depository is instrumental in getting resolutions passed.21 percent of total shares issued. The management is the most important proxy. Under the Commercial Code. the Depository is subject to “shadow voting. or telephone. or 10. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. Thus.3. The securities companies and banks are the second and third. and dismissal of directors and internal auditors require a “special resolution. This shows that a relatively larger number of shareholders send in their proxies. attended the last annual general meeting.
Only two out of 62 respondents to this question have had cases in which proposals were rejected. and for access to unpublished accounting books and records. the Tiger Fund. an institutional investor based in the US. Shareholder Protection Before the economic crisis. In four out of 62 respondents.5 percent.01 percent. Various measures have since been taken to improve investor protection. the board of directors decides on issues of shares within the limit of the authorized capital. Vol. mergers and acquisition plans. but these can be waived by an amendment of the articles of incorporation. the requirement was lowered from 1 to 0. The company also agreed to the right of the fund . This coalition also attempted to cooperate with domestic and foreign institutional investors to find their way into general shareholders meetings. 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. from 3 to 1. was able to force a change in the charter of SK Telecom. Changes in the authorized capital require an amendment of the articles of incorporation. an activist citizens’ coalition has brought shareholder derivative suits against several large listed firms. laws and regulations were generally very loose in protecting the rights of minority shareholders.104 Corporate Governance and Finance in East Asia. It also attended the shareholders meeting of several companies to present the views of outside shareholders. or block charter amendments considered harmful to minority shareholders. the annual general meeting passed a resolution that was not proposed by the management nor the board of directors but rather by shareholders. dividend proposals. II of votes required for a resolution to amend the articles. and major investment projects (only five firms answered this question).0 percent. The charges included self-dealing by a controlling shareholder and unfair subsidization of affiliated companies by a chaebol firm. Due to the changes in rules for investor protection. In February 1998 and again in March. the Securities and Exchange Act was revised to lower the representation requirement for shareholder derivative suits from 1 to 0. Those that are most likely to be rejected relate to election of directors. This citizens’ coalition actively contacted the management of selected companies and negotiated measures to protect shareholders. As an example. demand changes in business policy. Proposals put forward by management are rarely rejected at the general meetings. However. For recommendations for dismissal of directors and internal auditors. Shareholders have preemptive rights.
there was the usual conflict of interest problem and the trustee did not have the incentive to strictly enforce the covenants. and not strictly enforced. 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. the Government had for some time pushed for the enactment of class action suits on false statements and omissions in disclosure materials. Banks have played some limited role in monitoring the investment activities of chaebols. 2. loans to directors.Chapter 2: Korea 105 to recommend two directors to the corporate board. However. The Code has also been amended to state more clearly the fiduciary duty (of care and loyalty) of the management. The laws and regulations of the country protect shareholders from interested transactions. it now appears that it has backed away from its earlier efforts to introduce legislation on class action suits. In fact. and transactions with major shareholders. Before the amendment. creditors did not interfere with the management of a debtor. controlling shareholders have become more susceptible to liability claims by other (minority) shareholders.3. affiliated lending or guarantees. managers were considered to be subject to the duty of care. In 1974. simple. For further protection of investors. After the economic crisis. underwriting securities firms acted also as trustees. but it was not entirely clear whether they had the duty of loyalty as well. Banks themselves were poorly governed and bank managements had little incentive to monitor borrowers. This has strengthened the accountability of controlling shareholders as de facto CEOs. bond indentures are only a few pages long compared to a few dozen pages found in advanced bond markets. mergers and acquisitions. These have to be disclosed under the Securities and Exchange Act or approved by shareholders under the Commercial Code and other laws.4 Control by Creditors Role of Creditors in Corporate Monitoring Traditionally. 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. . As for bond issues. The covenants in loan agreements and bond indentures were very loose. Thus. This was one of the most significant developments with respect to shareholder activism in the Korean capital market.
Purchase of real estate should be financed by equity capital and not by borrowed funds. creditors now have a bigger say in court proceedings for receivership and composition. Some proponents argue that creditors should have the right to send their representatives to boards of directors of borrowers. The firms subject to the system are required to get the approval of the main bank prior to purchasing real estate. The objective of the system is to improve the financial condition of the largest business groups and promote the soundness of bank management. The 10 largest business groups are required to select no more than three core companies in consultation with their respective main banks. the main bank system was introduced and has been applied to the 51 largest business groups to which banks extended more than W250 billion in loans and payment guarantees. including. and purchases of real estate. In 1994 the approval requirement was abolished. as discussed earlier. Under the system. on average. a main bank is charged with collecting and analyzing financial information of the firm and delivering its opinion on various applications and matters requiring consultation among lenders to the firm. there have been concerns that the Government might use the system to intervene in the management of the business groups. The main bank should also monitor and restrict extension of loans to the controlling shareholder and other firms in the group. However. ADB Survey Results on Borrowing and Lending Practices The ADB survey shows that a typical nonfinancial company is associated with various types of creditors. 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. In turn. Besides the setting up of an “External Auditors Committee” by firms. Emphasis on the monitoring role of banks has been growing since the beginning of the Asian crisis. recently banks have been increasingly interested and successful in electing former bank officers as outside directors of firms that underwent workout processes. 10 nonbank . 11 banks. II acquisitions. In 1996. However. On the other hand. the main banks should review the feasibility and financing plans of projects undertaken by the core companies and monitor their financial conditions and prospects. Vol. this proposal has only a slim chance of being accepted by the Government or legislature.106 Corporate Governance and Finance in East Asia.
Relationships with affiliated companies providing guarantees or collateral include ownership of each other’s shares. Creditors usually exercise their influence through covenants relating to the use of loans. mutual guarantee agreements. whereas seven of the 17 nonfinancial corporations are. holding shares of another company by both the borrower and the guarantor. and other financial institutions. holding companies. A few creditors exercise influence through covenants relating to major decisions by the company. When loans could not be repaid on time. collateral was taken away. while a third think that creditors have weak influence. 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. About 60 percent of the firms have experienced renegotiation of loan repayment with creditors during the last five years. and 17 nonfinancial corporations. Most firms feel that requirements for collateral have been tightened since the crisis started. collateral is more likely to be required of loans for working capital than for fixed investments. NBFIs infrequently ask for collateral. or creditors filed for receivership. Breakdown of loan guarantors is as follows: about 40 percent of loans are without any guarantees. Most of the financial institutions are not affiliates of the borrowing company. in order of importance: affiliated companies. Most of the 43 firms with renegotiation experience were able to borrow from the same creditors afterwards. or through their shareholdings. The assistance came from. One tenth of the firms received assistance from the Government in loan applications. banks are most likely to require collateral. controlling shareholders. and purchase or supply of raw materials. For more than half of such firms. The borrower’s relationship with most banks has lasted for more than five years. subsidiaries. Only a few feel that creditors have very strong influence. most frequently in the form of loan guarantees and less frequently by arrangement of guarantees by a third party. 35 percent are guaranteed by the company itself (by collateral and purchase of guarantee insurance). payments were usually rescheduled through negotiation without any penalty. Among the creditors. renegotiation took place after the crisis. 16 percent . For a small number of firms. penalty was involved in rescheduling. More than half of the firms think that creditors have no influence on their management and decision making. About half of the respondents received assistance from other sources in the form of loan guarantees and/or provision of collateral.Chapter 2: Korea 107 financial institutions (NBFIs).
Behind these new strengthened roles of creditors is the newly set-up FSC. Separate from but emulating the CRA. and in continued monitoring of debtors. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols.3. In this connection. 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 leading creditor banks will continuously monitor the progress in implementing the signed Plans. Representative of the policy was the stipulation under the Securities and Exchange Act that no one can accumulate more than 10 percent of the voting shares of a listed company . the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. Under a contract signed between the creditors and the debtor.108 Corporate Governance and Finance in East Asia. Third. including commercial and merchant banks. and 1 percent by the Government. the main vehicle for implementing the workout concept (or the London Approach) is the Corporate Restructuring Agreement (CRA) signed by 210 financial institutions in July 1998. the 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 Korean Government maintained a policy of protecting the incumbent management of listed companies. banks and other institutional lenders are playing more important roles than ever before. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. are summarized below. major creditors. In cases where the creditors are unable to reach an agreement on a workout plan. especially banks. 4 percent by subsidiaries. the delegation has the right to approve wide-ranging financial activities of the firm. 2. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation. This committee was set up in accordance with the provisions of the CRA. have been the driving forces for restructuring activities of the largest 64 chaebols. Vol. will get involved in the restructuring and workout processes. II by other affiliated companies.5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. 2 percent by holding companies. Second. First.
Companies have also utilized share repurchases. but were completely eliminated in 1998. The incumbent controlling shareholders used various tactics such as issuing privately placed CBs. a total of 13 hostile takeover attempts occurred. 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. . The policy to protect the incumbent owners/managers was formally dropped when the Securities and Exchange Act was amended in 1994 to abolish the 10 percent limit. The reasons for failure are diverse. As far as institutional arrangements are concerned. turning to white knights. The shareholders already owning more than 10 percent at the time the company went public were exceptions to the rule. Between 1994 and 1997. Korea does not have the mandatory takeover rules applying to those who amass more than 30 percent of the shares outstanding (until 1998.Chapter 2: Korea 109 unless he or she obtains prior approval of the Securities and Exchange Commission. Poison pills cannot be used mainly because companies cannot distribute stock options as dividends to shareholders. Unlike the UK. corporations cannot limit the voting rights of large shareholders to a given maximum. 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. listed firms rely mainly on shareholdings by the largest shareholder. hostile takeovers by tender offers began to appear in the capital market. Limits on acquisitions of shares of a Korean firm by a single investor were gradually increased over a six-year period beginning in 1992. Unlike Germany. and announcing competitive tender offers by the controlling shareholder. However. more than half of these attempts failed. 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. A company cannot issue new shares to a third party without first amending the corporate charter. Privately placed CBs cannot be converted into shares in one year. it can be safely stated that Korea now has one of the most accommodating capital markets with respect to hostile takeovers in the region. For takeover defense. 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. Takeover Activity As soon as the Act was amended. Stock purchases by tender offer were also exempted.
7 percent on average as of the end of 1997 for nonfinancial listed firms). Currently the limit is 3 percent. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board.110 Corporate Governance and Finance in East Asia.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. the limit will be eliminated when it is fully privatized in two years. Vol. 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. Many of the takeover targets in the past did not have a controlling shareholder (group). Some had two or more large shareholders who had joint control of the firm but could not cooperate. For the steel company. The Government-owned listed companies. Hostile takeovers in Korea will be rare in the future. was newly listed. 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. 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. Another reason is that many listed firms belong to chaebols. in which the Government still holds the largest ownership. In 1999. an electric power company. For the others. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. . As of the end of 1997. 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. a steel company. II The Securities and Exchange Act was revised in 1998 to abolish the 10 percent limit on share repurchases and the Government simultaneously eliminated the limit on foreign ownership of shares of listed firms. except for the banks. In 1998. 2. As of February 1999. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. It is harder now to find such firms.3. In their charters. Korea Telecom. and a bank had government ownership. Charter amendments have also been employed by some firms to limit the maximum number of directors. One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26.
the main bank system. The Government has frequently imposed restrictions on the use of capital markets by large companies. In addition. the Government. For example. 2. was amended in 1997 to introduce a board structure consisting of a majority of nonexecutive directors. Even where employees hold . Meanwhile. and approved by the Chairperson of the Planning and Budget Commission.1). nominated by the minister in charge of the company in question.3. controlled the total amount of corporate bonds issued per month and allocated amounts to individual corporations. administering through a self-regulatory committee of the securities industry. 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. Labor is not represented in corporate boards.Chapter 2: Korea 111 The Government used to appoint a few public officials to the boards of state-owned corporations. more state-owned corporations became subject to this new board structure. The objective of the system was to improve the financial condition of the chaebols and to promote the soundness of bank management. This was aimed at limiting the supply of bonds thereby stabilizing interest rates. which was introduced in 1996. It was abolished before the economic crisis but another regulation. went into effect in 1998 to prevent them from absorbing too much of the funds available in the market. The Government’s right to send public officials to the boards was eliminated. There were also limits on the amount raised and the number of issues per year.3.7 Employee Participation in Corporate Governance Employee participation in corporate governance is very limited. Further. But this rule. There is no active debate or discussion going on about this potentially difficult issue. The nonexecutive directors are now recommended by a committee. as applied to four large corporations. is being applied to the 51 largest business groups to which the banks extended more than W250 billion in loans and payment guarantees. 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. which limits the total amount of bonds issued by the five largest chaebols. especially those belonging to chaebols. only qualified firms could issue new shares. Beginning in 1999.
Vol. Two thirds of the respondents had an organized union. carried out at the enterprise level.5 in 1990. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. they delegate their voting rights to plans’ representatives. In these firms.1 in 1997. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. About half of these firms considered the influence of the union on the management of the company to be weak. but 27 percent of them felt that it was strong. 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. Under the Capital Market Development Act of 1968. the council meetings have been superficial. Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. and 2. 2. The union had no influence on the management in 17 percent of the firms. which were generally much lower than estimated values. II shares of their companies through employee stock ownership plans. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal.112 Corporate Governance and Finance in East Asia. In actuality.654 employees per firm on average. Trade unions are organized on an enterprise basis. The relevant regulation was amended recently in order to facilitate voting by individual employees. of which 2 percent were senior managers. The respondents of the ADB survey had 2. union members account for 54 percent of the employees. employers are required to meet with representatives of labor unions at least once every three months. operation. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. there are two federations of labor unions. 32 percent technicians and professional staff. the management usually consults the union on major issues relating to the management. and development of the company. in principle. and 66 percent manual workers. In 70 percent of the firms with organized unions. Local unions in the same industry have established industrial labor federations.9 in 1980. Under the Labor Management Council Law. The percentage of shares held by the employee stock ownership plans in listed companies was 1. Under another law enacted in 1972 to induce private companies to go public. Collective bargaining is. In 1987. At the national level. . The typical collective bargaining agreement has a one-year duration. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees.
Chapter 2: Korea 113
Corporate Financing7 Overview of the Financial System
The foundation of the modern financial system in Korea was laid during the early 1950s. Specialized banks were established during the 1960s to facilitate capital mobilization and strengthen financial support for underdeveloped or strategically important sectors. Most NBFIs were introduced during the 1970s to diversify financing sources, promote the development of the money market, and attract funds into the organized market. From the early 1980s, several commercial banks and NBFIs were added as part of a series of broad measures to spur financial liberalization and internationalization. These measures coincided with a shift from a government-oriented economic policy toward a market-oriented stance. Recently, the Korean financial system has been undergoing substantial changes through a comprehensive financial reform program. This program was agreed upon by the Korean Government and IMF upon the signing of a financial aid package. At present, financial institutions in Korea may be divided into three categories by function: the central bank (the Bank of Korea); banking institutions, including commercial and specialized banks; and NBFIs, including development, savings, investment, insurance, and other institutions. Corporations raise funds through direct loans from the banks and NBFIs, and by transactions with the public through the money market, stock market, and bond market. Banks To a certain extent commercial banks have engaged in long-term financing in addition to their short-term banking operations. They still tend to depend heavily on borrowings from the Bank of Korea to cover persistent shortages in their own loanable funds, although the ratio of these borrowings to their total sources of funds has decreased. Commercial banks in Korea may, as in most countries, engage in a wide range of business. In addition to their core activities, they also handle such businesses as guarantees and acceptances, own-account securities investment, and receipt and disbursement of Treasury funds as agencies of the Bank of Korea. Specific authorization is required for each area of nonbank business they engage in: such as trust ac7
The authors gratefully acknowledge the help of Prof. Bong-Han Yoon who contributed several sections of this part.
114 Corporate Governance and Finance in East Asia, Vol. II
counts, credit card business, and some aspects of securities business. Specialized banks, which function as deposit money banks alongside commercial banks, conduct a similar range of business in addition to their own areas. From the early 1980s, banking institutions moved into a number of new business areas and developed a variety of innovative products to raise their competitiveness against NBFIs, and to meet the growing and diversified demand for financial products. Examples are credit cards, sale of commercial bills discounted by themselves, factoring business, trust business, certificates of deposit (CDs) business, and sale of cover bills. They also entered such security businesses as sales of government, public, and corporate bonds under repurchase agreements; the acceptance, discount, and sale of trade bills; and lead underwriting and over-the-counter sales of government and public bonds. In the early 1980s, the trust business, which had been limited to Bank of Seoul and Trust Company, was opened to all banks. Nonbank Financial Institutions NBFIs can be broadly classified into the following categories: (i) development institutions comprising the Korea Development Bank and the ExportImport Bank of Korea; (ii) savings institutions including the trust accounts of banking institutions, mutual savings and finance companies, credit unions, mutual credit facilities, and postal savings; (iii) investment companies comprising investment trust companies and merchant banking institutions; and (iv) contractual institutions such as insurance companies and pension funds. In addition, there are various nonbank institutions that handle specialized lending such as leasing, factoring, credit cards, consumer loans, housing loans, and venture financing without receiving deposits. NBFIs have increased their share of total funds supplied since the 1980s as they have been permitted greater freedom in management and operations. The market share of banking institutions in terms of Korean won deposits dropped sharply from about 71 percent in 1980 to 30 percent in 1997; while that of NBFIs increased from 29 percent to 70 percent during the corresponding period. Differences in regulatory treatment accounted for the greater freedom in management for the NBFIs. They were allowed relatively greater flexibility in their management of assets and liabilities and, most important, were permitted to apply higher interest rates on their deposits and loans. Evenness in regulatory treatment concerning such interest rates has, however, largely been achieved following the completion of a four-stage plan for deregulation of interest rates from 1991 to 1997.
Chapter 2: Korea 115
Money Market The money market is composed of the call market and a wide range of other short-term financial markets including those for Treasury Bills, Monetary Stabilization Bonds (MSBs), negotiable CDs, repurchase agreements (RPs), commercial papers (CPs), trade bills, and cover bills. The beginning of the organized money market in Korea dates from when MSBs and Treasury bills were first issued in 1961 and 1967, respectively. However, the money market remained underdeveloped until the early 1970s when the Government took a series of measures designed to channel curb market funds into financial institutions and to systematically organize the short-term financial market. In 1972, with the passage of the Short-Term Financing Business Act and the establishment of investment and finance companies, the sale of papers issued by nonfinancial business firms and investment and finance companies was initiated. This was a first step toward the formation of an advanced money market. In 1974, negotiable CDs (large-value time deposits at banks) were introduced. In addition, call transactions, which had previously taken place between individual banks, were put on a systematic basis. In 1977, the Korea Securities Finance Corporation initiated repurchase agreements with securities companies involving bonds on a shortterm basis. Various new financial instruments, including CPs, were introduced in the early 1980s. Since 1985, there has been a sharp increase in the outstanding balance of money market instruments. This is chiefly due to product innovation and expansion in the number of financial institutions handling such instruments. The volume of money market transactions expanded from W7,995 billion in 1985 to W44,201 billion in 1990, and W98,100 billion in 1995 (as of the end of June). Stock Market Activity in the primary (new issues) stock market was extremely brisk during the period 1986 through 1989. The value of shares sold in IPOs and in rights offerings by listed companies grew 48 times from W294 billion in 1985 to W14,176 billion in 1989. But the stock market sagged in 1990, resulting in a decline in IPOs and seasoned issues. The composite stock price index declined substantially during 1990-1992 due to continued labormanagement disputes and a slowdown in economic growth. Though the market recovered temporarily from 1993 to 1995, it again went into a slump
116 Corporate Governance and Finance in East Asia, Vol. II
after 1996 until the index hit 350 in December 1997 with the onset of the financial crisis. A new stock market was organized in April 1987 to provide a new means of trading stocks for small- and medium-sized companies and venture businesses not eligible for listing on the Korea Stock Exchange. A corporation satisfying less stringent criteria can register with the Korean Securities Dealers Association under the sponsorship of at least two securities companies. This market, named KOSDAQ, is not exactly an over-thecounter (OTC) market in that, unlike the National Association of Securities Dealers Automated Quotations (NASDAQ) in the US, there are no active dealers for registered shares. Still, investors are assured of a certain degree of liquidity of the shares registered at the KOSDAQ. Though the KOSDAQ is still in its infancy, it has been showing a great potential for growth by providing liquidity to shares of small and large firms before they are eventually listed on the Korea Stock Exchange. Despite the considerable growth and good performance of the Korean stock market, many problems were exposed with the onset of the financial crisis in 1997. The major problems may be identified in the following areas: (i) corporate disclosure system; (ii) reliability of accounting information; (iii) protection of small shareholders; and (iv) inactive takeover markets. Bond Market Public and corporate bonds are issued in the Korean bond market. Public bonds include government and other bonds that are issued by provincial and municipal governments, government-owned enterprises, and government-owned financial institutions. All public bonds are implicitly or explicitly guaranteed by the central Government. Corporate bonds are those issued by private companies under the Commercial Code. The value of listed public bonds became larger than listed corporate bonds in 1986 and remains to be so. The secondary bond market consists of the exchange and the OTC market. However, as in most other countries, the OTC market has dominated trading in bonds. Almost all of the bond transactions still take place on the OTC market despite government efforts to develop a separate exchange market for bonds. Most corporate bonds were issued as guaranteed bonds where the payment of principal and interest is guaranteed by financial institutions. Nonguaranteed bonds or debentures accounted for only 15 percent of the
Chapter 2: Korea 117
total issued in 1997, although their proportion reached 30 percent in 1995. This implies that most bonds were issued according to similar conditions regardless of the financial standing of the issuing company and that the bond rating system has not been well developed in Korea. However, all of this is changing. Bond rating agencies are now applying tighter criteria. Banks have strengthened their credit reviews in extending debt payment guarantees because of tighter regulatory and market pressures on their own financial conditions. Most securities companies have all but stopped extending guarantees. One of the dramatic changes in the bond market after the IMF bailout is that most corporate bonds are now issued on a nonguaranteed basis. The proportion of nonguaranteed bonds accounted for 69 percent of the total offerings of corporate bonds in 1998. This is in contrast with the prebailout period, when the proportion of guaranteed bonds was more than 80 percent of the total offerings. One problem for the corporate bond market is that most bonds are issued with maturities of less than four years. The maturity of corporate bonds should be lengthened to generate stable longterm funds for corporations. Financial Deregulation Discriminatory government regulations in the financial sector were prevalent during the 1970s. Entry into financial industries such as commercial banking, investment banking, securities brokerage, merchant banking, and insurance was strictly controlled. Ownership of commercial banks and their internal governance structures were controlled for many decades. These factors resulted in a serious structural imbalance in the financial industry. It diminished the role and profitability of banks while encouraging growth of NBFIs. In addition, the capital structure of business firms worsened and the unorganized money market rapidly expanded. In order to reduce government intervention and to restore the balanced development of the financial market, interest rate deregulation was initiated in June 1981. A significant advance occurred in December 1988, when most of the lending rates of banks and NBFIs were liberalized. Only interest rates on long-term deposits were regulated to avoid excessive competition among financial institutions. Interest rates on remaining deposits were gradually deregulated. However, in 1989, when interest rates rose rapidly and macroeconomic conditions deteriorated, the Government again placed extensive control over interest rate movements, including window guidance. In August 1991, the Government announced the Four-Stage
the Government simplified various directives and instructions regulating personnel management.5 percent in November 1981. implementing the first stage in November 1991. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets.2. as a first step toward liberalization of capital account transactions. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. With the privatization of nationwide commercial banks. finance companies. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. the Korean Government announced its Financial Liberalization and Market Opening Plan. and the 30 largest chaebols. depreciation. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. Also. The capital market. especially the domestic bond market. revision of the credit control system. Meanwhile.2 Patterns of Corporate Financing Corporate Financing Practices In this section.4.1). Moreover. budget. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. Vol. and organization of commercial banks. Some policy loans were also abolished. In addition. II Interest Rate Deregulation Plan. 2. In June 1993. Since 1985. which resulted in the establishment of a number of new banks. mutual savings. was liberalized drastically in 1998 after the financial crisis.118 Corporate Governance and Finance in East Asia. short-term finance companies. . the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. It included such important issues as interest rate deregulation. Internal funds include retained earnings. etc. The Government adopted a cautious approach. Korean firms have been allowed to issue CBs in international financial markets. listed companies. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. development of the money market. On the basis of flows of funds. and liberalization of foreign and capital transactions. the business scope of financial institutions was greatly widened from the early 1980s.
This high proportion deprived Korean businesses of flexibility during recession periods due to high financial costs. Table 2. New equity financing ratio (NEFR) is the ratio of change in equity (stocks issued + equity other than stocks) to change in total assets.4 percent in the precrisis period 1988-1997. Financing Patterns of the Aggregate Corporate Sector Table 2.26 shows the four measures of corporate financing calculated from Table 2. except in 1991. Securities finance became a more important source from 1988 onwards.25. The SFR averaged 28. and 1997. In 1988 when the stock market boomed. Before 1988. particularly in the 1990s in response to the liberalization of the capital market. except for the stock market boom of 19871988. the proportion of borrowings from NBFIs fell to its lowest value at 4 percent. Additional equity capital used to finance growth reduces the financial cost and the financial risk of investment. The corporate sector used . 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. and allowances) and new equity capital. depreciation. financing by corporate bonds and CPs was more significant than by new equity. but it remained less than 10 percent of total financing.25 shows the flow of funds of the nonfinancial corporate sector in Korea during 1988-1997. Incremental equity financing ratio (IEFR) is the ratio of change in stockholders’ equity to change in total assets or 1-IDFR. but do not include capital surplus (asset revaluation allowance and the excess of current value over issue value of stock). the proportion of foreign borrowings in total finance rose steadily. depreciation.Chapter 2: Korea 119 and net capital transfers from the Government. The share of external financing. In securities finance. Incremental debt financing ratio (IDFR) is the ratio of change in total borrowings to change in total assets. capital surplus. Meanwhile. It measures the degree of financing growth in total assets by additional debts. particularly in the short term. the corporate sector’s most important source of external finance was bank borrowings. It measures the degree of financing growth in total assets by additional equity. on average. comprising internally generated capital (retained earnings. Equity capital represents the shareholders’ commitment to the business. including all sources other than retained earnings. was 71 percent during the period. This means that internal funds after dividend payment were insufficient to finance growth in total assets. and government transfers. 1994.
2 6.4 27.0 (0.1 0.9 2.0 70. 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 13.7 15.8 1.4 9.6) 5.8 1.1 2.4 2.7 14.4 8.3 3.7 2.7 2.2 13.1 — 27. .5 2.6 0.3 72.0 9.2 14.3 10.1 10.3 5.2 — 28.6 77.4 2.8 30.7 14. and net capital transfers from the Government. Bank of Korea.9 10.7 71.1 3.0 9.3 6.9 9.1 3.7 6.5 9.2 10.4 71.3 2.7 1.9 73.4 (2.3 25.5 0.1 (0.25 Flow of Funds of the Nonfinancial Corporate Sector.3 1.0 0.7 11.6 0.3 6.0 2.6 4.3) 15.0 3.6 8.8 8.2 1.3 — 30.4 3.5 29. depreciation.9 38.2 13.2 6.2 0.2 26.6 3.4 11.4) 13.7 — — — — 9.1 3.0 — — — — 8.0 5.6 4.1) 4.7 10.7 1.1 27.1 36.6 (0.6 0.0) 12.3 1. which is the excess of current value over issue value of stock.4 2.6 5.9 6.4 27.0 3.9 34.4 — 28.3 3.4 1.9 0.1 0.4 21.3) 11.7 73.0 22.1 23.1) 6.7 (0.2 15.0 3.7 4.1 8.3 27.4 2.0 1. and Flow of Funds.5 16.8 4.2 — — — — 9.6 4.8 56.4 (0.7 1989 1990 1991 1992 1993 1994 1995 1996 22.0 11.6 9.Table 2.8 17.8 1.1 1.3 16.1 — — — — 12.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.7) 11.3 1.7 2. Source: Understanding Flow of Fund Accounts.7 8.9 72.9 28.7 8. a Includes retained earnings.8 27.8 -2.8 — 26.1 17.8 15.1 72.2 2.5 2.6 25.1 1. b Includes capital surplus.3 6.8 (0. Bank of Korea.1 12.5 0.7 32.3 — — — — 8.6 9.4 1.6 2. 1988-1997 (percent) 1988 43. 1994.7 10.6 9.6 0.0 17.7 7.2 5.9 10.6 11.7 4.5 13.0 1997 26.0 10.5 2.3 30.6 3.5 2.6 14.1 1.4 10.5 16.4 27.5 0.0 0.6 10.0 16.6 11.1 (1.8 0.4 15.4 0.6 1.1) 4.1 2.2 (0.8 1.8 1.7 12.4 0.2 34.7 10.
average SFR was 37. Bank of Korea. but plunged to 5.6 percent.7 percent in 1997. It dropped to 28 percent the following year.0 27. declining to 26.7 26. The balance.5 percent.9 60.3 27. Incremental financing from equity was 40.2 IDFR 36. in the manufacturing sector.1 percent in 1988 during the stock market boom.4 percent (Table 2.9 22. indicating a high financial risk position. dropping to 26.3 59.26 Financing Patterns of the Nonfinancial Corporate Sector. Across industry.9 46. but also continuously fell.6 percent.3 12.2 37. On average.3 60. respectively. Its IEFR and NEFR dropped to 23.7 40.4 percent.6 percent and 1.5 percent in 1997.1 39.0 57.5 68.4 12.3 73. Manufacturing financed 54. Lower income diminished the industry’s equity position toward crisis year 1997. IDFR reached 73. additional equity to finance 12.3 59.27). There were significant time trends.7 9.7 28. While SFRs. respectively. higher than the aggregate 28.5 31. was financed by additional debts. Source: Calculations from Understanding Flow of Fund Accounts.7 40.3 11.7 40. 45.4 NEFRa 20.8 28.8 10.5 12.7 30.8 percent of its total asset growth through debts.9 percent by 1997 when net profit margins were negative. an average of 59. NEFR registered 20. and Flow of Funds. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.4 37.0 42.4 27.1 17. SFR peaked at 44 percent.4 percent.6 26. In periods of high economic growth such as in 1988. NEFRs.8 62.2 percent of the growth in total assets.5 and 76.4 IEFR 63. and IEFRs were declining.2 percent of incremental asset growth was financed by equity.1 12.9 28.6 Excludes capital surplus. 1994.1 53.1 26.6 percent over the 10-year period. the corporate sector relied heavily on external financing for its expansion. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years.Chapter 2: Korea 121 Table 2.0 5. Bank of Korea.6 62. . and the total debt ratio was much higher in 1996 and 1997 at 62.0 11.3 percent in 1997. higher than the aggregate 40.
6 36. explaining partly the collapses of several construction companies in 1995.6 4.0 57.6 53.7 percent in 1996.4 37. Categorized according to company size. Vol.4 3.9 percent.6 45.6 37. which decreased to 8. II The construction industry showed the most cyclical pattern in annual asset growth.9 6. from 17.1 29. the two sectors also had low equity financing ratios and high debt financing ratios.122 Corporate Governance and Finance in East Asia.4 63. In 1997.7 37.5 23.27 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. Equity financed an average 25. then increased to 20. the proportion of short-term borrowings in total financing has been high.4 47.2 . their average SFR was higher. Financing patterns of the wholesale.1 percent of total asset growth for the period. and fell to about 10 percent in 1997.7 47.7 47.0 42. one year ahead of the other industries.2 62. storage.5 NEFRa 9. Since 1992.2 3. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997.2 percent in 1993.8 IEFR 65. gas. Table 2.2 5. large firms showed more cyclical patterns in these financing ratios than small.0 3. and hotels sector and realty/renting/business activities sector were similar.2 21.8 percent in crisis year 1997. retail.5 7.and medium-sized firms. On the other hand.6 62.0 30.7 37.3 28.6 3. It had the highest average SFR in 1988 at 31.4 54.4 45. Total debt financed an average 74.5 1.8 4.4 46. Since large firms were more profitable. and low total debt and short-term borrowing ratios.5 76. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent.6 53.3 52.8 50.9 IDFR 34. this dropped further to 15. and steam) and the transportation.6 54.6 37. and communication sector had relatively high incremental equity ratios. the utilities (electricity.0 42.8 percent in 1990.9 percent of asset growth.
3 7.2 70.5 1.9 80.3 57.7 15. Storage.0 40.5 1996 42.5 23.9 16.2 46.6 9.5 70.Table 2.3 4.9 1993 63.9 29.9 15.9 Average 19.27 (Cont’d) Year SFRa NEFRa IDFR 53.3 4.6 8. Household Goods.7 1994 53.6 7.0 10.5 12.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.4 62.1 19.0 1990 12.2 3.0 1992 24.2 74.7 15.9 47.7 78.9 1.6 73.0 3.2 10.3 1996 16.9 9.2 Average 53.0 1.3 21.8 76.8 1994 15.7 1997 8.0 68.1 66.1 1991 14.5 29.5 21.5 87.9 30.3 10.0 34.7 1989 26. Hotels 1988 33.0 65.8 2.0 60.9 1992 56.0 17.6 37.8 25.7 53.7 7.1 59.0 82.0 4.7 Wholesale/Retail Trade.3 (9.2 5.2 23.3 19.6 2.9 20.1 70.8 1991 51.9 52.9 1.4 2.3 84.4) 2.4 28.1 Trasport.8 70.1 25.5 76.5 1993 22.7 41.6 71.8 74.2 1995 16.6 8.4 1995 53.1 84.8 54.4 IEFR 46.5 62. and Communication 1988 64.7 78.9 2.8 9.0 1990 50.0 74.2 18.1 4.6 14.0 .5 20.2 25.2 4.7 80.9 33.9 1.2 20.3 47.9 1989 63.8 4.6 1997 29.0 31.2 8.8 29.1 69.8 81.7 42.4 26.6 37.2 29.3 8.6 9.0 0.6 4.7 6.
0 79.124 Corporate Governance and Finance in East Asia.9 28.2 63. and Business 1988 51.8) (35.6 1997 23.and short-term borrowings of these firms shot up in that period.4 1994 72.6 7.7 1996 18.3 207.8 1990 19.9 Average 75.4 0.0 21.4) 3.7 69.7 70.0 0.6 1.0 (0.0 33.8 36.3 85.1 1993 55.1 1991 56.7 14. Vol. a Excludes capital surplus.4 7.1 70.0 1992 51.6 1991 18.7 18.0 46.0 1997 24.3 3. SFR = self-financing ratio.6 Real Estate.6 52. II Table 2.4 47.3 62. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.4 IEFR 69.0 53. when large firms had much lower equity financing ratios and higher debt financing ratios than small.6 1990 82.1 1989 34.7 1994 8.5 77. .8 17.1 34. NEFR = new equity financing ratio.4 5.1 0.9 64.0 1.0 43.6 IDFR = incremental debt financing ratio. Financial Statement Analysis Yearbooks. Their average IEFR was also higher and IDFR smaller. Renting.9 29.9 IDFR 31.3 81.8 1993 11. The large firms had a higher proportion of external financing in 1996-1997.9 45.1 42.3 29.4 0 0 0 0 1.3 31.3 7.7 37.0 67.6 1995 17.9 57.4 (107.8) 7.5 22.5 8.1 54.1 71.4 1995 62.9 65.27 (Cont’d) Year SFRa NEFRa 6. however.and mediumscale firms.8 Average 22.3 Electricity.0 0. Long. and Steam Supply 1988 118. Source: Calculated using data from Bank of Korea.8 135. The trend was reversed in 1996-1997.2 1992 18.0 56. Gas.3 92.6 1989 118.1 35. IEFR = incremental equity financing ratio.4 1.4 1996 45.
for listed companies. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols. The chaebols’ drive to expand their empires resulted in heavy borrowings.5 percent and their total external financing. External financing reached 94.2 percent. the top 11-30 chaebols had the highest guarantees commitments at 207. In 1997.8 percent of their total finance in 1997.1 percent of their equity capital. the lowest ratio of 58. . and using cross-payment guarantees among affiliated companies.Chapter 2: Korea 125 Financing Patterns of the Publicly Listed Firms The average SFR of listed companies in 1994-1997 was much lower than that of the corporate sector as a whole (Table 2. They were able to borrow easily from banks by issuing corporate bonds and CP. Financing Patterns of Chaebols For chaebols. the IDFR of listed companies increased to 93. The largest borrowers were the top 11-30 chaebols.7 percent for all listed companies. at an average 70. the top 6-10 chaebols.7 percent. the average SFR was 28. and higher than that of listed companies (Table 2. but higher than that of listed companies.9 percent.9 percent. 153. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments.3 percent of their equity capital in 1997 (Table 2.8 percent. All of the top 30 chaebols relied heavily on short-term borrowings. In 1997.6 percent of total asset growth.5 percent is lower than that of the corporate sector in general.7 percent. and were large borrowers. The average IEFR of the top 30 chaebols of 29. Group-member firms borrowed less. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. Their shortterm borrowings accounted for 86. about the same as that of the corporate sector as a whole.28). and the top five chaebols. compared with the entire corporate sector’s 35 percent and 65. 91.30). Cross-payment guarantees have been declining since 1993 and reached 91.4 percent.6 percent. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies. The average IEFR and IDFR were 10.29). The debt financing ratio of listed companies was high since they relied more on external financing. In 1996-1997. respectively. The proportion of their short-term financing averaged 72.3 and 89. compared with 89.
5 2. Largest Business Groups in Korea.5 8.6 IEFR 42.8 89.3 IDFR 57.3 28. 1994-1998 (percent) SFRa IDFR 85.9 6.2 10. Table 2.7 1.5 8.7 12.6 0.1 1.1 8.9 NEFRa IEFR 14.4 1.7 13. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.8 22. Korea Federation of Industries.2 1.5 91.4 12.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.4 88.29 Financing Patterns of the Top 30 Chaebols.2 36.4 38.6 1.6 11. 1994-1997 (percent) SFRa 41. Source: Calculated using data of Seung No Choi.5 2.2 23.1 93.Table 2.3 1.2 NEFRa 1.4 29.3 5.9 7.6 61.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.6 70. .28 Financing Patterns of Listed Companies.3 86.8 76.
Korean firms preferred debt financing (bank and nonbank borrowings). the Korean economy was plagued with high inflation. Factors Influencing Corporate Financing Choices Until recently. and reserves and retained earnings. especially in the 1970s when real interest rates of bank loans were negative.9 — — — 1994 258. inefficient investment and excessive diversification of corporations. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices.3 200. poor financial and corporate governance resulted in overlending by banks. Few firms ranked loans from NBFIs as their first preference. And fifth. Further.3 58. Fourth. According to the ADB survey. bond issues. bond issues. First.9 153.0 1997 91.1 — = not available.7 150. Second. rights issues. . Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. more than half of bank loans were priority loans with low interest rates. Firms now prefer internal funds and new equity capital. so that the firms engaged in lobbying to gain access to them.30 Cross-Payment Guarantees of the Top 30 Chaebols.1 — — — 1995 161.9 — — — 1996 105. and extended loans based on cross-payment guarantees. loans from banks. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees. in order of ranking. company preferences in financing investment projects before the crisis were.3 64. Financial institutions did not strictly screen their loan projects and monitor their debtors. These are followed by loans from banks. and loans from NBFIs. There were several reasons for this. Source: Fair Trade Commission and the Federation of Korean Industries. Third. the Government applied high tax rates on net profits of corporations.Chapter 2: Korea 127 Table 2. This change implies that firms now give more attention to financial risks. and underdevelopment of the stock market. Interest payments on debts were considered a loss when calculating taxes. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469.0 207. the Government provided implicit guarantees on bank lending and large businesses.
These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general). the percentage of foreign currency denominated debt in the portfolio was 14. 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 1996.36 percent on average for these companies. and reduction in tax burden. ensuring the liquidity of the company. they survived for two to three . and others (29 percent) expected the local currency to appreciate in value. For these firms.5 percent at the end of 1997. in selecting financing sources. Vol. II In seeking external financing. A futures exchange launched in 1999 trades foreign exchange options. even with a heavy debt burden.128 Corporate Governance and Finance in East Asia. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. Only a few firms sought foreign loans because domestic loans were not available. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. Among those that never hedged against exchange rate risks. Other factors include. 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.3 Financial Structure. 2. more than half (53 percent) hedged against exchange rate fluctuations. Korea now provides a better environment for financial risk management. Nonetheless. According to the survey. This preference has changed little after the crisis. in order of importance. many firms (or 42 percent) never considered hedging. and futures and other financial derivatives. firms give their first consideration to minimization of transaction and interest costs. Among the responding companies that had foreign currency denominated loans. some (36 percent) thought that a hedging facility was not available or not working properly.4. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. maintenance of the existing ownership structure. Diversification. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks.
except in 1991. 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. Table 2. (ii) In terms of net income to total assets. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. . 1999). (i) In terms of total borrowings to total assets. the top five chaebols’ ratios were much higher. Among the main findings were the following. In order to determine the relationship between financing patterns and corporate performance.2. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses. (iv) In terms of EBITDA to total assets. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms.. 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. They were also higher than those of the top five chaebols until 1992. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. except in 19931995 when semiconductor prices were extraordinarily high.13). Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). but the ratios of independent firms were much lower. Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. But since 1992. They were also higher than those of the top five chaebols until 1991. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2. The extremely high leverage and the ability of chaebols to survive for several years with huge debts are evidence of poor internal governance of both the corporate and financial institutions.3. Nam et al. as well as lax financial supervision (Nam et al. However.
second highest in the top 6-30. too. The diversification of chaebols under workout was much lower than that of the top 6-30. Vol. except in the recession years of 1996-1997. net profit margins of the top 31-72 chaebols were always higher than those of the top 6-30. In terms of the net profit margin (the ratio of net profits to sales revenue). The diversification of the top five chaebols remained at about the same level within the period. Chaebols have been subsidizing new or low-profit industries by transferring resources from high-profit industries through inside dealings. Indicators such as increasing debt-to-equity ratios. Meanwhile. This indicates that excessive diversification and inefficient investment of the top 30 chaebols resulted in relatively low net profit margins (Table 2. But the net profit margins of the top 31-72 chaebols were higher than those of the top five in 1985-1992. The degree of diversification of chaebols that fell into default. court receivership. the top 6-30 and 31-72 chaebols gradually increased their diversification beginning 1990. Factors related to weak corporate governance were closely intertwined with shortcomings in macroeconomic policy and vulnerabilities in the financial sector. During 1985-1997. rising nonperforming loans (NPLs) and falling . 2.130 Corporate Governance and Finance in East Asia. had easier access to credit than the top 31-72 chaebols. had a significant role. the top five chaebols outperformed the top 6-30 chaebols for most of 1985-1997. however. and composition was lower than that of the top 6-30 but higher than that of the top 31-72 chaebols on average. and lowest in the top 3172 chaebols. The differences in the degrees of diversification among the three groups are substantial.5 The Corporate Sector in the Financial Crisis This section looks at the various causes of the crisis in 1997. the degree of diversification was highest in the top five chaebols. and easier access to cheap credit. 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.31). II Corporate Performance and Diversification As a chaebol further diversified into nonrelated areas. larger research and development expenditure. debt guarantees for free. then declined to levels lower than those of the top five in the years of economic downturn 1993-1997. its profit rate declined. or outright transfer of resources due to poor corporate governance practices. Government intervention. Their subsidiaries.
8) 0.8 3.0 (7.4) (1.9) 2.1 (4.1 0.3) 12.1) (1.6 0.3 (0.0 1.8 (0.0 1.6) (0.3 1.1 1.7) (1.6) 0.2 1.8) (11.5 1.3 3.0 0.2) 1.7) (0.6 (0.0 4.5) 0.6) 0.4 1.6 0.7 0.0) (0.6 0.8 0.8) (20.0 0.1 0.7 2.1 1.9) (9. Court Receivership.2) (0.2 1995 3.3 1.9 1.3) 0.9 0. Beyond the Limit.0) (3.6) 0.2 (0. Chung Ang University.8) (1.1 0. Management Research Institute.2 (1.4 (2.1) 2.3 0.1) (2.3 1.5) (1.7 (1.5) (0.6) (20.4 2.1 1.0 6.1 (0.2) (13.8 1.7) 0.3) 0.8) (3.0 (2.6 0.3 1.7) 0. 1998.8) 0.6) (0.7 0.4) (1.9) 2.8 0.6 3.3) 1.3) (0.6 0.3 1.2 4.5 1.4) (2.1 2.8 (0.3 (0.2) (4.0) 0.0) 0.5 1.5 (4.4 (1. Background and Task of Structural Adjustment.1) 1.1 1.9 0.7 1.8) 0.8 0.1 1.7 0.9) (8.0) 0.8) 2.5 (0.5 (0.2) 0.8) (0.6 0.7 3.8 3.2 1.2 0.1 (3.2 1.2) 1.5) (2.4 (0.1) (5.1) 2.5 (6.1 4.7 0.8) (37.3) 0.4) (0.5 2.2) (13.6 0.3 (0.9) 2.9 1.7 (0.3) (0.9) (1.6 1.7 1.1 1.2) (0.1 0.8 0.4 (0.3) 0.4 (1.1 (1.6 (10.8 1990 0.8) (1.1) — = not available.8 1.3 0.2) 1.2 (0.7 — (0.4 0.6 (0.5 1.3) 1.1) 0.5) (2.3) (1.3 1.7 0.0) (4.9 1.8) 1997 0.2) (4.9 8.4 1.7 1.3 0.3 (0.0 1987 1.3 1.1 0.9) 0.0 1992 1994 1.5 1. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.4 1.4 (1.3) 0.3 0.6 1. Source: Whan Whang.0) (0.2 1.1 (4.7 0.1) (1.6 7.0 (0.6 0.5) (7.4 0.5 (0.11.9 0.4 0.8) 0.5 0.4) (4.8 (0.31 Net Profit Margins of Chaebols.4 1996 0.2) 2.6 1.7 (4.6 5.8) (4.2 1.3 0.3 1.1 0.1) 1.6 1.2) 2.3) (12.5 4.3 1.3) 0.1 0.8) 0.9 0.8) 1.4) (6.6 1.4) (1.6 1989 1.3) 0.2) (3.2 (0.5 (0.6) (12.3 1.7) (0.2 1.1 0.6) (12.1 1.9 1.1 (9. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.2 (0.1 0.4 (0.7 1.1) 0.2 (17.7 (0.3 1.4 0.1) (6.Table 2.8 0.9 (0. p.6) 0.3 (3.2) (4.4 1. .
. internal auditors cannot be expected to perform their function independently of management. 2. Ownership concentration also had ramifications on corporate transparency. II corporate profitability were signs that the Korean economy had reached the edge of a slippery slope.132 Corporate Governance and Finance in East Asia. the boards of all listed companies were composed of insiders only. Vol. 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. But in 1998. after the crisis. a committee composed of internal auditors. The hold was tightened by the practice wherein candidates for directors were handpicked from among the managers by the controlling shareholder. the recently adopted Code of Best Practice in Corporate Governance recommends the strengthening of the board system. A remote trigger in the Thai crisis was all that took to push the economy over the edge.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. 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. They were then almost automatically elected at the general shareholders meeting.5. 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. outside directors. Along with government policies to protect the status quo. Moreover. Thus. and to the development of the market for corporate control. a firm’s board of directors had the power to appoint an external auditor. and creditors should select (recommend) the external auditor. Now. Thus. Until 1997. Until 1997. Meanwhile. this has led to entrenched management. The most serious problem among most Korean listed firms has been that a controlling shareholder acting as CEO could never be replaced. the independence and objectivity of the external auditor were often questioned.
and restrictions on hostile takeovers. a large issuance of preferred stocks with no voting rights. restrictions of voting rights of shares of institutional investors. There were no effective monitoring mechanisms for its management. The purpose was to increase the size of the stock market by having financially sound private firms go public with an assurance that they would not be taken over. usually a member of the founding family. profitable firms within a chaebol tended to subsidize unprofitable firms. as a whole. These internal dealings made strong firms weak and helped marginal firms survive. when a large diversified chaebol. 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. One reason is that the percentage of inside shareholdings for an average listed firm is very high. In this situation. Dominance of Chaebols A chaebol is tightly controlled by the largest shareholder. the Government maintained a policy of protecting the incumbent management of a listed company. Traditionally. hostile takeovers in Korea will likely be rare in the future. However. however. Meanwhile. Banks did not function as monitors of corporate management although they were shareholders as well as the most influential creditors. and some differences in Korea’s generally accepted accounting principles from international standards. Many of the takeover targets in the past did not have a controlling shareholder. These included restrictions of shareholdings of institutional investors. Under the direction of the controlling shareholder. Diversification can reduce chaebols’ risks through the portfolio effect.Chapter 2: Korea 133 There had been some devices to protect management so that companies could indulge in business activities without fear of takeover. corporate accounting information was not reliable due to the lack of independence of external auditors. Another reason is that firms affiliated with a chaebol are generally regarded as difficult targets as the other members of the group will come to the rescue or act as a white knight. Many changes were introduced to promote M&A in the 1990s. individuals. participated in the stock market as short-term traders rather than long-term investors. has an unsound capital structure and . prevalent window dressing practices. regulatory and practical difficulty in implementing proxy voting. as well as institutions.
capital. share issues. The Government’s supervision and regulation of financial institutions were poor. 2. while (non-chaebol) independent firms had much lower borrowing ratios. 2. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. Financing preferences changed drastically after the crisis. and other individual markets. II strong financial links among its member firms through investments and cross-guarantees. prevalence of rent-seeking and morally hazardous behavior by economic decision makers. and a high degree of inefficiency in the economy. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. Vol. As mentioned earlier. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. the typical chaebol firm had an extremely high DER. as the latter are well established in most business areas. However.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 choices of listed firms in order of preference were bank loans. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates.134 Corporate Governance and Finance in East Asia. Such problems may eventually cause ripples through the entire economy. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. Further.5. The new preference ordering is as . Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. and internal funds. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. bond issues.5.
the top 30 chaebols showed a DER of 519 percent. which is far higher than the average ratio of around 400 percent for nonfinancial listed firms. consisted of high proportions of policy loans. 63 percent of which was short-term. the Government and the Bank of Korea defended the currency. total foreign debt amounted to $157. Bank loans. Although the ratio of stock market capitalization to GDP in Korea was not very different from those in the Philippines and Thailand. The poor state of corporate governance in the banking and financial sectors was responsible for overlending by banks and NBFIs through perfunctory screening of loan applications. In November 1997. share issues. 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. which were the most important financing source until 1987. large-scale bailouts of financially distressed firms. 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. obviously contributed to overlending and aggravated the situation. The financing choice of listed firms was also influenced by the underdevelopment of the stock market. .Chapter 2: Korea 135 follows: internal funds. and bond issues. as evidenced by occasional. The ratio of external debts to GDP reached 48 percent at the end of 1998. The lending practices of banks. which generally required guarantees or collateral. the exchange rate (won/dollar) increased sharply and the financial crisis erupted in Korea. As of the end of 1997. were advantageous to chaebols because they were in an “ideal” position to meet the loan requirement through cross-guarantees among their member firms. The high proportion of foreign debt led to a mismatch problem where borrowers were unhedged against foreign exchange risk. At the end of 1996. bank loans. Implicit guarantees by the Government on bank loans to large businesses.5 billion. The preference for debt finance also led to a relatively large foreign debt. In the international financial market. However. After the financial crisis erupted in Indonesia and Thailand. reducing foreign exchange reserves to a dangerous level. won/dollar nondeliverable forward rates increased rapidly. Nonpolicy loans were also considered to be cheap because of interest rate regulations. overseas borrowing became difficult and higher interest rates were charged on foreign borrowing. 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. signaling a bearish speculative move on the won. Other factors also contributed to this preference.
The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. were low in 1996 and 1997. the NPL ratio8 of banks and other financial institutions began to increase. Before the crisis. nine out of the 30 top chaebols failed. has given rise to various types of self-dealings by the controlling shareholder. without strictly evaluating the creditworthiness of businesses and the profitability of projects. They utilized mutual payment guarantees among their affiliates and believed that they would never fail.200 in 1997. The inevitable result of inefficient investment was a fall in corporate profits. Meanwhile. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. In 1997 they became negative. The Government could hardly help them because of the number and magnitude of business failures. excluding the financial sector.000 from December 1997 to February 1998. Overlending and inefficient investment were also a result of moral hazard due to implicit government guarantees and “too big to fail” legacies to large businesses. they are defined as loans for which interest payments are overdue by three months or more. Financial Sector Vulnerability Because of financial losses in the corporate sector. and shareholders’ equity of all industries.1 percent in 1996. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. Fixed loans are those for which interest is not received for six months or longer.136 Corporate Governance and Finance in East Asia. It jumped to 17. According to the “six months” definition. II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. The banks and merchant banks lent to large businesses. starting 1 July 1998. total assets. Doubtful loans are those for which interest is not received for six months or longer. reaching highs of 6 percent in 1997 and 8.7 percent in 1997. then 20. and returned to about 1. and there is no collateral.000 per year starting 1992. the NPL ratio reached 7. especially chaebols. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. the NPL ratio of commercial banks increased rapidly from 4.32). The monthly number reached more than 3. Further.000 during January-September of 1998. and estimated losses. Following the “three months” definition. Vol. . and the pursuit of growth through excessive diversification and inefficient investment. decelerated from March 1998.6 percent in June 1998. However. legal and other barriers prevented the exit of financially nonviable firms.000 in September 1998 (Table 2. and there is collateral. the ratios of net profits to sales. Moreover. These were the definitions until 30 June 1998.
859 3. As a result they had largely overvalued currencies.238 4.647 8.053 5.979 8.890 4.856 7. 2.769 9. the ratio reached 7-8 percent.210 1.754 3.386 5. those of domestic banks were lower in the 1990s.255 13. Source: Bank of Korea.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.751 1. 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. low efficiency. This was mainly due to the high ratios of NPLs. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action. and Taipei.Chapter 2: Korea 137 Table 2.107 6.457 2.553 3.544 2. and continuous and large current account deficits.502 11. In 1990-1993.517 2.259 2.265 6. Meanwhile.33).250 2.131 1.5.159 10.759 6.114 811 706 696 866 1.657 3.69 20.573 3. The current account deficits in terms .673 Construction 380 354 242 195 294 585 1.855 6. European countries. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.China.133 3.472 2.244 3.992 11. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.850 3.637 6.32 Number of Firms with Dishonored Checks. and large government-directed loans.027 Manufacturing 1. This speculation was said to be one of the causes of the financial crisis in Korea.135 1. Compared to ROAs and ROEs of domestic branches of foreign banks.985 Services 3. and declined to 4-6 percent in 1994-1996 (Table 2. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US.589 171.
The main result of the rigid labor market was a “high-cost and lowefficiency” economy. Businesses served as a social safety net. Korea -4. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997.584 Fixed (A)a 5. Land prices and real estate rents were also high compared to trading partners.221 8.827 289. of percentage of GDP were as follows: Malaysia -8. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.176 7.639 1.6 percent (1995). which led to large corporate losses.China.138 Corporate Governance and Finance in East Asia.310 6. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.0 7.0 8.1 6.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7.584 2. In addition to the overvaluation of the won. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.652 29. although per capita income in Korea was much lower.1 7.562 18. Mass layoffs became legally possible only after the economic crisis.736 8. even in times of economic slowdown.266 10.739 241. II Table 2.929 11. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei.705 160.832 337.997 9.170 1. because of the rigid labor market.0 7. In 1997. and 30 percent in 1996.954 9.475 143.116 1.556 118.4 5.077 NPL Ratio (%) 8.910 1. and Indonesia -3.520 194. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90. the ratio of short-term debt to foreign reserves was very high.190 9. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.649 375.6 percent (1995).2 4. Meanwhile large businesses could not legally lay off workers. . Thailand -8.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.484 11.537 10.China.430 12.192 Doubtful (B)b 952 1.33 Nonperforming Loans of General Banks. Related to this.1 percent (1995). Vol.390 12.8 percent (1996). Source: Bank of Korea.160 11.874 22.600 10.8 5.
6. ‘Voluntary’ Restructuring Chaebols have been under pressure from the Government to abolish their informal group headquarters to increase the managerial independence of member firms.6 2. 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. 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. . 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. has been actively utilizing its influence to motivate institutions to coordinate debtor firms’ restructuring activities. Nonviable firms and financial institutions. Corporations. and subsidizing money-losing units. Downsizing by curtailing employment has been prevalent. 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. A guideline informally promulgated by FSC required the 30 largest chaebols to lower their DER of 412. However. including banks. To achieve this.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 percent as of the end of June 1998 to no more than 200 percent by the end of 1999. They have also been urged to divest themselves of strategically ill-fitting businesses and sell equity holdings of attractive business units to foreign firms to reduce debts. embarked on their own restructuring programs and/or implemented restructuring demands of the creditor banks.Chapter 2: Korea 139 2. the excessive amount of debt of Korean corporations had to be reduced to a sustainable level. The FSC—later called the Financial Supervisory Service (FSS)— which is in charge of prudential regulation of financial institutions. Ailing banks needed to be recapitalized after the huge amount of NPLs was disposed.
or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. In their first review. This number was at 779 firms in April and grew to 1. Locally. Internationally. A debtor whose liquidation value was estimated to be greater than its going concern value was subject to “exit”—meaning the creditors would altogether stop lending and not allow renewal of the existing debt. The data also show that about 24 percent of acquisition negotiations ended up in actual deals. II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. More important.045 in October. Vol. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. the creditor . Noticing this disincentive. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. On the other hand. In many cases. 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. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure.140 Corporate Governance and Finance in East Asia. potential foreign buyers waited for the price of acquisition targets to come down further. The reasons are manifold. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998. Banks did not have the incentive to force financially nonviable firms to liquidate. 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. More than 59 percent of potential buyers were foreign firms.281 in April to 2. the number of potential sellers decreased somewhat from 2. banks and other creditors were reluctant to absorb losses realized by debt compositions.138 by the end of October. 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.
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. Among the sell-offs. By the end of 1998. workouts are being applied to non-chaebol firms identified as financially weak.Chapter 2: Korea 141 banks selected 55 firms as targets for exit. and 16 non-chaebol corporations that had been selected as possible workout candidates. Corporate Workouts Workouts in the forms of debt rescheduling. More than 200 financial institutions signed the Corporate Restructuring Agreement to carry out corporate workouts with the top 6-64 chaebols. The workout plans were completed for most firms by early 1999. creditor banks completed evaluation of the financial status of 35 subsidiaries belonging to 13 chaebols. Upon completion of the evaluation. 11 were merged into other group members. the results thus far have not entirely been as desired. write-offs. Also. by their creditors. Based on these plans. not only for the design of corporate workout programs but also their implementation. The plans were put into action immediately following finalization. but viable. These included 20 firms from the top five chaebols and 32 from the top 6-30 chaebols. the creditor banks drafted their own restructuring plans with assistance from outside advisory groups led by foreign investment banks. interest reductions. 24 were liquidated. two were acquired by newly organized employee stock ownership plans. A portion of the Technical Assistance Loan of $33 million. and 12 were sold off to other firms. Although the intention of the Government and the banks was to effect immediate liquidation of these selected firms. Among the 55 firms selected. Negotiations were then held between the chaebols and the creditors’ councils to finalize the financial structure improvement plans. . 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. FSC has been monitoring the processes from a prudential regulation standpoint. and/or conversion of debt into equity have been applied to those firms that are considered to be viable in the long run and have voluntarily entered into negotiations with creditor banks. The creditor banks and the advisory groups also drafted such plans for the top 6-64 chaebols. three filed for courtsupervised bankruptcy reorganization. provided by the World Bank.
it is hoped. Thus. Big deals have been elevated to the status of the most important means of effective corporate restructuring. First. uncertainty over the future . Foreign Acquisitions Confidence in the Korean economy depends critically on the lowering of the level of corporate debt. Big deals would. This figure contrasts sharply with the total of $700 million for all of 1997.5 billion on agreement basis during the 10-month period after December 1997. some of the acquisition agreements have been discarded for various reasons. oil refineries. Restrictions on foreign ownership of land were also abolished. the Government has been urging the largest chaebols to strike “big deals” or business swaps among themselves to consolidate overlapping manufacturing facilities. most of the big deals have entered their final stages of negotiation. Hyundai Motor Corporation won the international auction of Kia Motors in its third bidding and Daewoo Motors agreed to acquire Samsung Motors. and equity participation—reached about $8. In another. labor union demands of the seller were not acceptable to the transacting parties. automobiles. and petrochemicals. On 3 September 1998. As of April 1999. In the case of automobiles. In one case. Foreign investment—in the form of acquisition of controlling interests. enable chaebols to streamline their overly diversified operations and focus on several core business areas. Korea adopted and implemented policies to open its capital market completely. These deals could eliminate excess capacity in such industries as semiconductors. purchase of divested assets. II creditor banks and the corporations will devise detailed workout programs based on the rehabilitation plans submitted by the corporations. In the early days after the outbreak of the crisis. chaebols did announce their agreements on big deals in seven industries excluding the automobile industry. vessel engines. railroad cars.142 Corporate Governance and Finance in East Asia. the foreign buyer demanded specific protections against adverse developments in the business environment. power plant facilities. Big Deals Ever since the outbreak of the economic crisis. Vol. aircraft. The less than satisfactory state of foreign capital infusion in the early days stems from a number of factors. However. inducement of foreign direct investments was considered to be the most effective means of achieving that end.
these goals were: (i) to enhance managerial transparency. Fifth. and (v) to improve the accountability of controlling shareholders and the board. 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. As set forth in the agreement. the improved procedures stipulated in the Bankruptcy Reorganization Act and the Composition Act reduced what had previously been legalistic exit barriers. Sixth. Seventh. Overhaul of Bankruptcy Procedures In February 1998. Fourth. In effect. but it also has important implications with respect to corporate workouts.Chapter 2: Korea 143 course of the Korean economy remains high. foreign buyers usually employed discounted cash flow methods of valuation while local sellers often put greater emphasis on replacement costs of assets. Third. (ii) to remove cross-guarantees of loans among group members. some of the potential acquirers demanded terms that were unreasonable or unacceptable from the sellers’ point of view. many of the businesses that Korean firms put on sale did not prove to be attractive to foreign firms. the Government and chaebols reached an agreement on the goals of restructuring and reform efforts. With this in mind. (iii) to reduce financial leverage.6. 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. (iv) to focus on a small number of core businesses.2 Policy Measures for Corporate Reform Goals and Policy Measures for Reform in the Corporate Sector Based on their assessments of what caused the economic crisis in Korea and what needs to be done to overcome it. foreign buyers were concerned with the inflexibility of the labor market. 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. 2. Not only does this represent progress in terms of an improved institutional framework for market competition. legal procedures pertaining to corporate rehabilitation and bankruptcy filings were simplified to expedite rulings on the exit of nonviable firms and to ensure better representation of creditor banks in the resolution process for court receivership or court-supervised composition. The presence of .
II an expeditious exit scheme is expected to better induce negotiation for workouts between creditor banks and corporations. a “Management Committee. etc. the changes in the institutional setting for corporate reorganization will enable creditors and debtors to promptly respond to the development of financial problems. Also. . (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. thereby preventing abuses by controlling shareholders/managers of financially distressed firms. the right to revoke court receivership is allowed to the creditors. number of 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. Also. The changes in the reorganization procedures can be summarized as follows. Third.01 percent in May 1998. In the past this stage usually extended for as long as two to three years. the maximum grace period on loans to the firm being reorganized was shortened to 10 from 20 years. Second. (ii) legal changes have been made so that domestic accounting practices conform to international standards. Fourth. accounting. Korea’s Economic Progress Report. if a final reorganization plan is not worked out within one year from the date of the court order placing a firm in receivership. First.144 Corporate Governance and Finance in East Asia. Improving Transparency and Corporate Governance9 Transparency and accountability in corporate governance will be promoted by the following measures: (i) consolidated financial statements are required beginning 1999. (iv) restrictions on institutional investors’ voting rights were eliminated in June 1998. Fifth. The purpose of this rule is to shorten the reorganization planning period. the court may annul its previous decision and force the firm into immediate liquidation. the Composition Act was amended to narrow the eligibility of applying for court-supervised composition. Vol. October 1998. The creditors can form a “Creditors Committee” among themselves to allow them to participate in the decision processes in court. The court can refuse to accept the application for composition if it finds it inappropriate considering the size of corporate assets.” comprised of experts in the legal. and economics professions should be organized to provide for expeditious proceedings in court. (iii) the representation requirement for shareholder derivative suits was drastically relaxed from 1 percent to 0.
Capital Market Liberalization Since 1998. (iv) during April and May 1998. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. various supporting measures. 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. 514 listed companies had appointed 677 outside directors). only 31 out of 1. In addition. As for promotion. (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. (v) by the end of May 1999. including financial subsidization. have been instituted for FDI: . which was passed in August 1998. (vii) by the end of March 1998.148 industries remain closed. Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998. including tax exemptions and reductions. According to the law. These new standards are and will continue to be strictly enforced. administrative procedures for FDI will be dramatically simplified and made transparent. 21 industries were further liberalized or newly opened to FDI (now. and (viii) as of 1 April 1998. Korea has rapidly liberalized the capital market by adopting the following measures: (i) the ceiling on foreign equity ownership was completely eliminated in May 1998. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. financial institutions could no longer require cross-debt guarantees. to FDI). either partially or fully. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. 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. beginning on 1 April 1999. 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. an additional nine industries will be opened or further liberalized.
will be provided to foreign firms in the FIZ. The primary aims of the law are the liberalization of the capital account and the development of the foreign exchange market.146 Corporate Governance and Finance in East Asia. Three-year government bonds will be used to establish a benchmark. Liberalization of Foreign Exchange Transactions In September 1998 the Foreign Exchange Management Act was replaced by the Foreign Exchange Transaction Act. The location of the FIZ will be determined at the request of foreign investors. Also. These bonds will be issued . however. are not risk-free. II (i) (ii) (iii) Tax exemption and reduction: Corporate and income taxes will be exempted or reduced for FDI in target industries. To minimize potential risks. Various support measures. Low cost rental facility: National and public real properties will be rented to foreign-invested firms for up to 50 years. the Korean Government is strengthening prudent regulations and market monitoring. as well as building an early warning system. These liberalization measures. the Government intends to supplement these measures with a sound macroeconomic policy in order to secure more effective protection against systemic risks. Capital Market Augmentation Bond Market The Government recently introduced a policy plan to deepen Korea’s bond market. for 10 years (full exemption for the first seven years and 50 percent tax reduction for the remaining three years). Vol. Various local taxes will also be exempted or reduced for eight to 15 years at the discretion of local governments. The majority of government bonds to be issued in the next two to three years will carry a maturity of three years. Free Investment Zone (FIZ): A free investment zone will be developed to accommodate large-scale FDI. such as the high-tech industry. including infrastructure and tax support. The law allows rental cost exemptions and reductions for FDI. It aims to establish a benchmark by consolidating various government bonds.
Related legislation was put into effect in September 1998. If interest rates stabilize at a low level. Prior to the introduction of this system. It is now easy for private investors. Moody’s signed a joint venture contract with Korea Investors Service. to establish closed-end investment companies.6 trillion in these funds: W0. but may be extended as required. Twenty-five domestic financial institutions. invested a total of W1. As a pilot program. and is promoting joint ventures between foreign and domestic agencies. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. financial institutions . with only minor standard exceptions. The Government established specific qualification criteria and selected the primary dealers in 1999. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998. In August 1998. 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.6 trillion for the debt restructuring fund. including the Korea Development Bank.Chapter 2: Korea 147 monthly. Mutual funds (or open-end investment companies) will be allowed starting 2001. and W1 trillion divided equally between the three balanced funds. both domestic and foreign. they will be managed by foreign investment management companies. To ensure transparency and efficiency of the fund operations. According to the law. In order to promote a greater market demand for government bonds. and the demand for longerterm bonds increases in the future. It also opened the credit rating service market to foreign competition. a primary dealers system will be introduced for healthy financial institutions. These are expected to operate for the next three years. This law will not only provide an effective institutional environment for the disposal of NPLs. but it will also help improve financial institutions’ risk management.
Policies aiming to improve the corporate governance system should take into account the high ownership concentration often created by pyramiding. this regulation may not be effective in curtailing pyramidal structures. etc. In principle. A investing in B. However. It would be more desirable for the market-oriented measures to be put into place and strictly enforced. A good governance system is essential for the healthy growth of corporations and financial institutions. can utilize ABS. On the other hand. However. However. 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. the role of the board of directors as the internal control mechanism must loom large in corporate governance.) and the level of interfirm investments is very high. is inevitable. unless the limit is tight and binding. and C investing in D. 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. the government intervention will have to be refocused so that it only sets the rules of the game in the marketplace. this can only be a temporary measure. 2. As markets become more efficient. II and qualified public corporations. There must be stronger rules to control agency problems. One way of strengthening independence of the boards is to require that listed companies accept nominations for directors by institutional .g. Vol. More important.6.148 Corporate Governance and Finance in East Asia. when the limit is binding. such as the Korea Asset Management Corporation (KAMCO). as stipulated by the government measure.3 Policy Recommendations Poorly performing markets and the resulting lack of market discipline justified the government intervention in recent corporate and financial restructuring activities. cross-subsidization. For instance. B investing in C. greater efforts to improve corporate governance are preferable to regulation of interfirm investment.. Selfdealings. there is another view that placing a maximum limit on interfirm investments. then the regulation will inhibit efficient investment of firms. The corporate governance structure cannot be expected to function efficiently if this issue is not addressed. which is the case for many chaebols. Direct controls of interfirm investments and/or pyramidal ownership structures will not be persuasive. foreign business corporations with good credit standing are now also permitted to issue ABS. considering that there is no other effective way to limit circular investments among chaebol affiliates (e.
The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. September/ October 1997. Proposed: A Governance Monitor. Since the economic crisis. The Corporate Board. 1997). One way of motivating institutions to do this is to 10 M. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. Listing rules may recommend that all or large listed companies adopt an audit committee. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. 1997. 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. Further. using audit.Chapter 2: Korea 149 investors or their trade associations. governance. 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. it will have to include making self-dealings by directors and officers. and other committees. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. and requiring that all directors hold shares of their companies. Class action suits are an efficient means for corporate monitoring. Institutional investors will play an increasingly important role in corporate governance. 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. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. . and also negligence of external (independent) auditors actionable. various measures have been implemented to promote investors’ rights. pp. If and when the law is introduced. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. 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. Latham. 23-26.
and other NBFIs are subsidiaries of chaebols— especially the five largest ones. and compliance officers. 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. In the coming years. strengthen its supervisory activities. strengthening incentive compensation schemes for executives. 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. the Government will have to come up with appropriate policy measures to solve these problems. Rights of minority shareholders should also be strengthened for these institutions. securities companies. and thus cannot be expected to be actively involved in monitoring portfolio firms. insurance companies. and impose stronger penalties on violations of the rules on portfolio investments. by all nonfinancial companies (or “industrial capital”). more drastic in nature. The Government recently proposed the revision of bankruptcy-related laws. etc. reviewing independence and expertise of candidates for outside directors. 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. Another measure. Vol. Application of more stringent bankruptcy-related rules to firms in financial distress will effect greater discipline over corporate management. The institutions’ respective trade associations. Also. possibly.150 Corporate Governance and Finance in East Asia. Shareholdings concentrated in investment companies and other institutional investors pose a serious dilemma. objecting to certain defensive measures proposed by the management. 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. These guidelines would recommend shareholder activism and faithful discharge of fiduciary duties by actively participating in shareholder voting. Many of the larger investment trust companies. an audit committee. II provide comprehensive guidelines for their actions in matters related to corporate governance. An efficient means to control problems arising from ownership of financial institutions by industrial capital is to strengthen the accountability and fiduciary duty of the very management of these institutions. The Government can also lower the limits on investments in affiliated companies. is to restrict ownership of investment trust companies and NBFIs by the five largest chaebols and. .
which could provide alternative sources of long-term corporate finance. This means that the Government can control the banks and. Many corporations are burdened with excessive debt and. Many concepts regarding good corporate governance are still new to a lot of market players in Korea. and introducing disincentive schemes for excessive borrowings. excessively diversified into nonrelated business areas. Chaebols are overly indebted. In turn. The Government should put more efforts into developing the capital market. and thus full-scale education programs should be developed. the banks have great leverage over the management of debtor firms. large firms. In order to minimize government intervention in bank and corporate management. and (iii) a good corporate governance system to protect investors. For this.Chapter 2: Korea 151 There still exist widespread concerns that the Government will continue to exercise a great deal of discretionary power over banks. the important issues to be addressed are: (i) improvement of the corporate disclosure system. and consistently show low profit rates. such as application of higher interest rates by banks to chaebols with higher DERs. and financial institutions. To facilitate the development of the Korean stock market. The current obligatory system of disclosure that emphasizes “hard” . lessening the degree of double taxation of dividends (or further reducing personal income taxes on dividends). to concentrate instead on a small number of core businesses. private firms. Banks need to play a bigger role than they do at present in monitoring corporate investment and management. through them. 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. therefore are vulnerable to economic shocks. the elimination of implicit guarantees for financial support to chaebols. Such measures include providing an effective corporate governance system. The Government needs to sell off at the earliest feasible dates the bank shares that it acquired in the course of recapitalizing banks. reduction of protection of domestic markets and entry barriers. and stop unfair internal transactions. (ii) provision of reliable accounting information. bank managers should be made accountable to shareholders but not to the Government. Bank boards also need to be made more independent from management. 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 substantially reduce the proportion of policy loans from bank loans. An effective policy package is needed for chaebols to dispose of marginal firms with low profitability at the earliest date.
The establishment of a Corruption Prevention Institute will be helpful in this regard. At the same time. The development of the OTC bond market requires a well-developed dealer system. II information on past performance needs to be transformed into a system in which corporations voluntarily announce “soft” information on future prospects.152 Corporate Governance and Finance in East Asia. Policies are needed to help develop more reliable services by bond rating agencies. data on quotations and trading volumes. and bureaucrats. Maintaining current account surpluses for a considerable period is needed to pay back foreign debts. and labor productivity should be considered. no economic reforms will be effective. Prevalent corruption. politicians. The function of securities companies as dealers of bonds should be improved. Overvaluation of exchange rates should be avoided in order for export and import-substitution industries to stay internationally competitive. profitability of export industries and real effective exchange rates that account for changes in nominal exchange rates. The network should cover not only the exchange market but also OTC transactions of investors and dealers. especially among business people. One of the significant changes in the bond market after the economic crisis is that most corporate bonds are now issued nonguaranteed and on the basis of credit quality of the issuer. the information system of the bond market should be better organized to transmit. Without successfully addressing this problem. Another problem with the corporate bond market is that most bonds are issued with maturities of less than four years. wage rates. . is considered to be one of the major causes of the economic crisis. More effective punitive means need to be devised to penalize both corporations in violation of disclosure rules and the officers in charge. These should be lengthened to make them a source of stable long-term funds. Vol. reasons for different degrees of corruption in various countries. In determining optimal exchange rates. on a real time basis. penalties on violations of disclosure rules are not effective enough to have a significant impact. Future research could include causes of corruption. and measures to reduce corruption. Currently.
1997. Cho. Korea’s Financial System. N. 1997. Korea’s Chaebol. Tomio. Market Concentration and Diversification of Business Groups. H. 1999. Evolutionary Chaebol. D. S. 1995. S. 1998. S. W. An Empirical Evidence on Value of a Firm and Ownership Structure. Lee. Understanding Flow of Fund Accounts. 1992. T. S. Maeil Daily Economic Newspapers. Jua. Corporate Restructuring. C. Proposed: A Governance Monitor..Chapter 2: Korea 153 References Bank of Korea. Kim. Lee (eds. Ju Hyun. and 1998 issues.. Choi. Chung and H. W. 1994. Financial Studies. 1989. September/October 1997. pp. A Study on the Relationship between Ownership Structure of a Firm and Value of a Firm. New York: Praeger. 1995. edited by K. KERI. KERI. The Corporate Board. 7995. S. Bibong Publishing Co. New York: Praeger. S. Economic Statistics Yearbook. Center for Free Enterprise. 1998. various issues. Kim. . Chung. Korean Managerial Dynamics. I. Cho. Lee. H. Kang. Bank of Korea. H. September 1998. International Financial Statistics.). 1997. Latham. and J. Kim. D. Chon. Hong. Hattori. Bank of Korea. and K. Financial Statement Analysis Yearbook. Jae Woo. Kwon. W. September 1998. Financial Studies. 1996. Bank of Korea. pp. Korea Economic Research Institute. 1996. W. 1997. Korea Economic Research Institute. 1996. Hong Moon Sa. H. Japanese Zaibatsu and Korean Chaebols. K.. various issues. various issues. M. H. various issues. 1989. K. Determinants of Diversification of Korean Business Groups. C. Chon. Survey of Facility Investment Plan. Lee. Is the Fair Trade Policy Fair? Korea Economic Research Institute. and H. 79-95. Korea Development Bank. pp. in Korean Managerial Dynamics. I. 23-26. Korea’s Large Conglomerates. International Monetary Fund. KERI. C. Y. 1993. September 1997.
Kim. C. J. Annual Conference of Financial Management Association. Beyond the Limit. Joh. Korea Institute for Industrial Economics and Trade. 2nd Sangnam Forum.. KIET Occasional Paper No. and J. Y. Nam. Korea’s Economic Progress Report. . Lee. J. March 1999. The Pattern of Ownership Structure and their Characteristics in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Corporate Governance in Korea. 1998. 1999. November 1996. Kang. Lim. A New Trade and Industrial Policy in the Globalization of Korea. C. K. 1999. Yim. Lee. October 1998. K. Real Exchange Rate and Policy Measures. S. Vol. U. Kim. and J. I. Korea’s Trade and Industrial Policies: 1948-1998. I. S. J. Y. Management Research Institute. Ministry of Finance and Economy. Yonsei University. K.. Ungki. Yang.154 Corporate Governance and Finance in East Asia. Business Groups in Korea: Characteristics and Government Policy. H. Background and Task of Structural Adjustment. Lim. Chung Ang University. and H. September 1998. 1998.. W. KIEP Working Paper 98-05. Wang. Seoul. Korea Finance Institute. 1998. S. H. II Lee. Chicago. Y. 1996. 1998. 1996. Sohn. October 1998. Whan. S. Conference on Corporate Governance in Asia: A Comparative Perspective. January 1995. 1995. Korea Institute for International Economic Policy. Capital Liberalization. Whang. Korea Development Institute and World Bank. 23. Ungki. Korea Institute for International Economics and Trade. The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols.
and David Webb of the London School of Economics for their guidance and supervision in conducting the study..1 Introduction In recent years. Denise B. aiming at eventually limiting the Government’s role to economic policy setting and allowing the private sector to conduct most economic activity. state-sanctioned monopolies. the Philippine nonfinancial corporate sector had managed its borrowing risks relatively well by largely avoiding imprudent use of debts and risky investments. When the Asian crisis erupted in 1997. Issues such as State ownership of businesses. the Philippine corporate sector has played a leading role in the government’s efforts to get the country on track toward sustainable economic development. the Philippines. PSR Consulting. and Lea Sumulong and Graham Dwyer for their editorial assistance. after the completion of debt negotiations with the IMF and Paris Club. Pineda. Serrana. Saldaña1 3. From 1993 to 1996. and government subsidies were tackled during that period. 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. The Asian financial crisis revealed that. This has come about following a political and economic upheaval from 1983 to 1987. Inc. overall. for their research assistance. the Philippine economy and corporate sector were in a relatively sound financial position. Roble. The Government pursued the privatization of various state-owned corporations as part of its financial rehabilitation programs sponsored by the World Bank and the International Monetary Fund (IMF). the PSR Consulting. staff. . and Liza V.3 The Philippines Cesar G. 1 Principal. The author wishes to thank Juzhong Zhuang. the Philippine Stock Exchange for its help and support in conducting company surveys. The lifting of the debt moratorium in 1991. both of ADB. allowed the Government and the corporate sector to gradually access foreign debt markets after a long absence. David Edwards. about a decade before the recent Asian crisis. Inc. Companies of other Asian countries were already using these markets to finance investment and growth. in particular Francisco C.
Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. But protectionist policies made labor relatively more expensive and. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. Vol. The policy was crafted by the martial law regime at that time. Companies were profitable because of protection from foreign competition.2. the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. composed mostly of families previously in trading businesses. While new manufacturing industries were successfully established. Banks have significant presence as members of affiliated business groups. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. To implement these policies. It analyzes the impact of corporate governance on company financial performance and financing. This study reviews the Philippine corporate sector in terms of its historical development.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. on family-based and controlled conglomerates. the Government overvalued the local currency and imposed high import tariffs. companies were necessarily large and capital-intensive. An industrial elite. which leads to their easing of due diligence and monitoring standards when lending to group members. emerged to influence industrial policies. therefore. their growth could not be sustained. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. Companies finance long-term investments with short-term debt.156 Corporate Governance and Finance in East Asia. The Board of Investments (BOI) was created to draw up an investment priorities . 3. and responses to the financial crisis. II Still. These early industrialists naturally opposed any initiative to reduce tariffs. and on the financial crisis. usually with the acquiescence of bank creditors.2 3. Corporate financing relies excessively on bank loans. patterns of financing. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies. control by internal and external governance agents. patterns of ownership. regulatory framework.
assumed ownership of the largest petroleum refining company. dominance by large companies. and oriented toward exports. the “pioneer” industries identified in the IPP. Following government initiatives in the control of the infrastructure and utilities sectors. In many industries. Nevertheless. made less associated with capital investments. including the reduction of tariffs. The FIA allowed foreign equity investment in many areas and at the same time provided a transparent. the legislative body passed the Foreign Investment Act (FIA). It limited the bureaucratic cost and discretion that accompanied the necessary approvals of foreign investments. and initiated the development of alternative energy sources in response to the oil crises. The 1980s were marked by a peaceful transition of political power. the Government continuously revised the enabling law of BOI so that incentives were reduced in number.e. quantitative restrictions. Reforms in policies. the top three companies accounted for a disproportionately large share of total sales and assets. and import licensing requirements. clearly shifted economic management toward reliance on markets rather than on decisions by bureaucrats in the Government.” No strategic industry could take off without the Government’s participation in its management and operations. the Government narrowed the range of tariff rates by commodity categories and reduced the average tariff rate from 28 to 20 percent. organizing industries into sectors and picking “winners. In the early 1990s.Chapter 3: Philippines 157 plan (IPP) to encourage private sector investments by offering tax and other incentives. Starting in 1981.. Probably the most significant effects of tariff protection and biases for capital intensity were the corporate sector’s high degree of concentration. Better access to cheaper imported raw materials improved the competitiveness of local manufacturers. and orientation toward domestic markets. advance notice of areas where the country disallowed or restricted foreign investment. Exports were not competitive because of the high costs of imported materials. the State took over the generation and distribution of electricity. Quantitative restrictions and tariff protection of preferred industries remained firmly in place. In 1991. 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 . BOI incentives retained a strong bias in favor of capital-intensive enterprises and domestic-oriented industries. The Government signaled through the IPP its intent to shape the future industrial landscape. Foreign ownership was allowed only in industries with high technological and market barriers. i.
2) 4.000 Philippine companies grew 17.6) 0.7) 10.8 8.6 7.2) 0.0 (0.2 Thailand 11.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.2).8 10.2 Korea. Rep.7 Malaysia 9. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.4 4.0 7.1 5.7 5.1).2 7.3 2.9 6.158 Corporate Governance and Finance in East Asia. . only nonfinancial companies were used. In this section.5) 3. Vol.0 (6. II market. only to be unsettled by the crisis of 1997.8 5. This rate of growth was sustained by a comparable 18. net sales of the top 1.5 8.7) (10.5) 5.3 9.2 9.1 GDP Growth of Southeast Asian Countries.3 8.4 Philippines 3.8 5.1 5. Key Indicators of Developing Asian and Pacific Countries 2000. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries. Its growth rate began to catch up with others in 1996.1 8.0 8.2 7.1 4. With economic reforms introduced in the 1980s and 1990s. Table 3.0 8.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.5 percent per year (Table 3.2. 3.2 8.7 (13.5 9. A comparison of the Philippines’ economic performance in terms of real gross domestic product (GDP) growth with selected countries in Southeast Asia places the succeeding review of the corporate sector’s performance in context.9 (1.000 Corporations covers financial and nonfinancial companies.2 Source: ADB.3 9. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.9 7.8 4.8 8.3 7.2 During 1988-1997.5 (7.7 8.000 corporations. however.2 (0.9 5. which was taken as a representation of the Philippine corporate sector.5 8. of 9.
net profit margin = net income/net sales.332.3 382.1 73 5.9 629.209.4 555.7 28.5 446.000 Companies.1 1.8 26.5 51 4.4 898 1.6 954.9 480.1 5.3 121 12.9 149 6.7 20.6 18.9 896 2.123.5 Leverage = total liabilities/stockholders’ equity.2 Compound Growth (%) 17.781.7 903 0. return on equity (ROE) = net income/ stockholders’ equity.2 Growth and Financial Performance of the Top 1.1 615.6 290.9 617.1 66 12.6 35.9 898 1.3 941.7 443.4 411.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.5 887 0.6 426.4 8.341.7 1.5 1.4 1.4 861.1 54 11.1 197 14.5 192.000 Corporations in the Philippines.8 411.0 1.9 18.104.22.1682.561.9 96.8 6.3 306.978.893.317.Table 3.1 714.177.6 5.2 1. .8 902 1.8 618.160.2 4.6 144.6 896 0.697.5 1.6 75 6.5 14.1 881.191.2 2.6 1.7 73 6.5 1.647.4 602.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14. Source: SEC-BusinessWorld Annual Survey of Top 1.1 51.2 2.2 136.5 119 12. return on assets (ROA) = net income/total assets.8 77 7.8 4.3 46.6 102 16.5 4.6 149 12.1 181 11.4 188.1 Other Indicators No.8 741.9 3.2 707.9 78 6.1 72.6 900 1.7 218.3 68 7.1 33.6 109 12.4 776. of Companies Sales per Company (P billion) 899 0.6 1990 1991 1992 1993 1994 1995 1996 1997 1.1 468.0 148.9 2.5 64.2 27. 1988-1997 1989 519.5 72 7.2 378.3 862.2 338. turnover = net sales/total assets.2 900.4 3.1 6.8 5.7 1.3 60 10.8 22.2 Average 146 12.5 508.1 4.7 238.394.3 107 13.1 1.0 900 1.4 260.9 952.0 1.3 898 1.4 63.5 570.1 95.5 193.
4 24. Return on equity (ROE) and return on assets (ROA) averaged 12.000 companies averaged 7. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.697 1.352 1.3 The Corporate Sector and Gross Domestic Product.1 Net Sales (P billion) 465 519 630 741 862 954 1. Assuming Table 3.3 percent.7 percent. respectively. Net profit margins for the top 1. but the extent of the increase was not as dramatic as in other Asian countries. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. This is high compared with developed countries but compares favorably with other Asian countries.979 17.3).8 19. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997.248 1. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994.5 Value-added is assumed to be 30 percent of net sales. Further.5 16.178 1.160 Corporate Governance and Finance in East Asia.474 1. and the SEC-BusinessWorld Annual Survey of Top 1. for the 10-year period. Asset growth was funded by debt that grew at an average of 20.9 percent for the period.077 1.6 percent and 5. II assets. leverage increased from 109 percent in 1996 to 149 percent in 1997.9 21.693 1.5 Ratio of Estimated Value Addeda to GDP (%) 17. These rates of return are high compared with other Asian countries.9 23.8 percent per year.394 1. Key Indicators of Developing Asian and Pacific Countries 1999.1 19. Sources: ADB. and by equity that grew at a higher average annual rate of 26. . Vol.2 percent.4 20.906 2.000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1. Total assets grew at an average annual rate of 22.427 13.5 17.8 17.172 2.000 Corporations in the Philippines. 1988-1997 Top 1. various years.
1 Financial Ratios (%) Leverage 89 ROE 15.5 Other Indicators Share of Sales (%) 17.0 28.9 26. various years.3 42.4 Stockholders’ Equity 32.8 606 0. these figures suggest a significant and increasing contribution of the corporate sector to GDP. 1988-1997 Indicators Publicly Listed Privately Owned Rate. and (iv) privately owned.0 31. %) 17.Chapter 3: Philippines 161 a constant ratio of value added to sales.4 Total Liabilities 26.0 142 22.000 Corporations in the Philippines. of Companies 73 Sales per Company (P billion) 2.8 ForeignOwned 21.5 23 4.3 11.7 2.5 27. (iii) Government-owned.4 28.8 22.3 22.5 Retained Earnings 30.3 146 6.0 5.9 158 13. . privately owned companies constituted the largest group (Table 3.4).1 ROA 8.4 Fixed Assets 19.0 5. The premise is that these variables have a direct bearing on corporate performance and growth.8 No.8 3.8 2.5 GovernmentOwned 4.0 4.2 103 5.7 22.9 196 1. Averaging 42.9 17.8 Growth Indicators (Compound Annual Growth Net Sales 20. The foreign-owned companies were the Table 3.0 Net Income 19. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed.0 Turnover 53 Net Profit Margin 15. size.1 12.9 22.3 27.3 22. (ii) foreign-owned.5 Source: SEC-BusinessWorld Annual Survey of the Top 1. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.8 14.2 9. corporate control structure.6 Total Assets 29.8 percent of the corporate sector’s total sales between 1988 and 1997.3 9.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.1 22 10.4 190 5. A study of company performance by ownership type.
With an average leverage ratio of 142 percent. compared with P2. II second largest at about 27.3 percent. they generated the highest return on investments. Their ROA and ROE were both more than twice as high as those of government-owned companies. foreign-owned companies borrowed more than publicly listed ones. a level high by Western standards but at par with those of other Asian countries. or 38 percent. and the second lowest asset turnover. The government-owned companies had the highest leverage at 190 percent but lowest ROA and ROE because these are primarily public utilities and companies in the energy sector where turnover is low. reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income.162 Corporate Governance and Finance in East Asia. the second best ROE and ROA.5 percent.5 percent average growth rate of the entire corporate sector. with an average ROE of 22. while there were few of them.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997. these companies were comparatively large. These were mostly large public utilities. Privately-owned and Government-owned companies grew at slower rates.75 billion per company for foreign-owned companies. registered the largest per company sales at about P9 billion in 1997. selling an average of P4. Publicly listed companies had a minor though steadily increasing share in total sales. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). were among the top 1.000 companies in 1997. but lower than those of foreignowned and publicly listed companies. Vol.9 percent. 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. meaning that the remaining 62 percent were relatively small in sales and assets. . and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. 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. Publicly listed companies had the lowest leverage at 89 percent. followed by publicly listed ones. However. The compound annual sales growth rate was 21.2 percent and ROA of 9. exceeding the 17. the asset base is large. But by being most efficient in employing assets. the highest net profit margin of 15. Governmentowned companies in the top 1. Bases Conversion Development Authority. and low return on investment is the norm.1 billion per company in 1997.000 list. The privately-owned companies had a high average leverage ratio of 158 percent.
%) Net Sales 20. and small companies. compared with 32.8 ROA 8.7 Stockholders’ Equity 34.3 percent for the conglomerates.0 166 15.6 26.0 55.2 Net Income 21.Chapter 3: Philippines 163 Performance by Control Structure By control structure. 1988-1997 Indicators Group Member Independent 18.0 22. Performance by Firm Size By firm size.5).8 Growth Indicators (Compound Annual Growth Rate. the corporate sector is divided into large. various years. medium.1 Retained Earnings 32.2 23.8 6.5 Growth and Financial Performance of the Corporate Sector by Control Structure. depending on assets and sales. But the conglomerates were larger measured in sales per company.3 Total Liabilities 30.3 Other Indicators Share in Sales (%) 32.000 Corporations in the Philippines.4 24.7 2. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997.2 Fixed Assets 25. a company can be a member of a conglomerate or independent. of Company 159 Sales per Company (P billion) 2. had a lower leverage ratio.3 Financial Ratios (%) Leverage 98 ROE 15.3 No.7 Total Assets 32.1 124 5. Sales and resources of the .0 25. grew faster.0 Turnover 67 Net Profit Margin 12. and achieved higher returns on invested assets than independent companies (Table 3.1 Source: SEC-BusinessWorld Annual Survey of Top 1.6 715 0. Table 3.
0 156 16.0 730 0.1 No. defined in this study as the next 200 largest companies in the top 1.6 31. II Philippine corporate sector are highly concentrated among the large companies.4 28.4 Total Liabilities 18. sales of mediumsized companies grew faster than large companies. which.0 32.2 29. averaging 16 percent. of Companies 79 Sales per Company (P billion) 7. Medium-sized companies.7 44. Sales per company in this group averaged P13. 1988-1997 Indicators Large Medium 19.4 billion in 1997. while small companies. averaged a far less P3 billion in per company sales. .3 Turnover 65 Net Profit Margin 8. indicating that they deployed resources more efficiently than large and small companies.9 Financial Ratios (%) Leverage 158 ROE 13. Medium-sized companies also performed better in terms of ROE.6 47.000 list. Large companies accounted for 56.3 Source: SEC-BusinessWorld Annual Survey of Top 1.9 32.1 4. referring to the remaining companies in the list.2 Other Indicators Share in Sales (%) 56.000 list. although they comprised only 8.5 73 6.6 36.6).5 Total Assets 18.6 Small 19. %) Net Sales 15.1 81 9.9 26.0 7.5 25.1 percent of the total sales of the corporate sector.2 Stockholders’ Equity 18.1 25.5 12.3 Fixed Assets 15.7 Net Income 1.2 25.9 Retained Earnings 13. averaged only P920 million in per company sales during the same year. Vol. Table 3.6 49.5 128 10.000 Corporations in the Philippines.164 Corporate Governance and Finance in East Asia. However.9 89 1. various years. for this study. are defined as the largest 100 companies in the top 1.6 Growth and Financial Performance of the Corporate Sector by Firm Size.5 Growth Indicators (Compound Annual Growth Rate.8 percent of the total number of companies in the list (Table 3.1 ROA 5.
and assets was much higher for the real estate and property. with their ROE dropping to 3. but lower than that of construction. unlike their counterparts in other Asian countries.7 percent in 1996 to 8. Net income declined from P54. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales. and the construction sectors than for the manufacturing. compared with 9. but suffered its largest decline in net profits in 1997. real estate. Sales revenue and net income declined from P76. assets. and equity up to 1996.2 billion in 1997 for this sector. The sector showed consistent growth in sales. ROE dropped from 10.8 percent. Large.7 percent in 1997 for medium-sized companies. averaging 10. and utilities and services sectors. manufacturing. utilities. But small companies’ leverage was significantly lower. reflecting to some extent a “bubble” phenomena in the former two sectors. The Asian financial crisis affected large companies most severely. Poor returns appear to have been caused by the low profit margin at 6.7.5 percent for medium-sized companies and 8. and utilities and services sectors.1 percent. at 156 percent. and profitability in 1997 when the crisis started. Growth of sales. profits. at -12.7 billion and P35. Performance by Industry This study also looked at corporate performance by industry. showed the lowest ROE. and construction.1 billion in 1996 to P4.6 percent.8 the previous year. specifically those industries least and most affected by the financial crisis.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. Mediumsized companies’ leverage level was slightly lower. net income.2 percent for large ones.Chapter 3: Philippines 165 Small companies. as indicated by the negative annual growth. at 158 percent on average during 1988-1997. are shown in Table 3. at 128 percent for the period.e. net income. The real estate and property sector also suffered significantly in sales.8 billion in . of net income. For small companies. although the largest in number.4 percent in 1997 from 11. Leverage was the highest for large companies. The growth and financial performance of selected industries.8 percent in 1997. from 14. i.7 percent a year earlier.. ROE dropped to 7. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. especially during the period 1994-1996.
4 19.2 12.6 No.3 55. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.6 Growth Indicators (Compound Annual Growth Rate.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 28.9 5. 1988-1997 Utilities Real Estate and and Services Property 39.7 percent to 10.3 20.2 8.7 Net Income (12. 1996 to P56.8 Stockholders’ Equity 21.7 ROA 5.3 Retained Earnings 17.6 69 16.8) 17.4 percent.9 2.4 16. 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 1997.000 Corporations in the Philippines. Vol.8 48.7 Growth and Financial Performance of the Corporate Sector by Industry.1 2. .2 37. and was also much more limited compared with the property sectors in other Asian countries.9 2.6 Financial Ratios (%) Leverage 142 181 ROE 13.2 45. As a result. of Company 454 17 Sales per Company (P billion) 1. various years.1 10. II Table 3.6 Total Liabilities 18.7 Indicators Manufacturing Construction 27.8 41.000 companies’ total sales on average during 19881997.1 24 42.9 23. the sector’s ROE dropped from 15.3 Fixed Assets 20. %) Net Sales 16. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.5 Other Indicators Share in Sales (%) 82.0 23.0 31 0.4 Total Assets 19.5 12. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.7 52.0 21.7 billion in 1997.7 10.7 19.3 5. respectively.0 25.0 Turnover 112 24 Net Profit Margin 5.7 83 2.4 3.7 192 9.9 17.2 28 0.166 Corporate Governance and Finance in East Asia.9 billion and P24.
(iii) principal office. unlike in neighboring countries hit by the Asian crisis. Overall. Under the Code. It provides the basic constitutional structure for the organization. and the Insolvency Law. nationalities. (vii) number. and residences of incorporators and directors.3 Legal and Regulatory Framework The Corporation Code of 1980 is the main law governing the corporate sector. and restrictions.3 which serve as the company’s declaration that the minimum percentage of authorized capital required by law has been subscribed and paid-up. The currency devaluation bloated the foreign currency-denominated loans of these companies. and dissolution of corporations. and amount of authorized capital stock. (iv) term of existence. and residences of original subscribers. 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. Two other pertinent laws are Presidential Decree (PD) 902-A. the Code requires a corporation 3 A company’s articles of incorporation should include: (i) corporate name. contains some provisions affecting corporations’ dealings with banks. the Corporation Code of 1980 is a compilation of important juridical rulings. administrative regulations. 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. The General Banking Law.2. reaching up to 313 percent in 1997. nationalities. (ii) purpose of the corporation. (vi) names. It specifies the minimum information to be indicated in the articles of incorporation. the ownership of Filipino citizens in the corporation is not less than the legally required percentage of capital stock. and (viii) names. For publicly listed companies. Corporation Code of 1980 Supplanting the old Corporation Law of 1906. par value. operation. the leverage of all four industries was low. . which regulates banks and nonbank financial institutions except insurance companies. which is also the organic law governing the operations of SEC. and recognized rules on corporate practices.Chapter 3: Philippines 167 The utilities sector had the second highest leverage during 19881997 at 181 percent on average. privileges. 3. One month after registration. which was based on American corporate law. the Revised Securities Act (RSA) and PSE’s public listing requirements also apply. and amount subscribed and paid by each. (v) number of directors (not less than five nor more than 15).
4 Some of the items that a corporation may provide in its bylaws are the following: (i) time. and employees. 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. However. must be general. manner of voting. and public policy. shareholders may delegate this power to the board of directors by a two-thirds vote of outstanding capital stock. (ii) required quorum in shareholders’ meetings. A majority of the outstanding shares of shareholders must vote to authorize amendments to the bylaws. and (vii) manner of issuing certificates in the case of stock corporations. II to adopt a code of bylaws or rules for its internal governance. . (iii) qualifications.168 Corporate Governance and Finance in East Asia. PD 902-A expanded SEC’s mandate to include absolute jurisdiction. (vi) penalties for violation of the bylaws. or officers. (ii) controversies arising out of intra-corporate relations. To be valid. the corporation’s articles of incorporation. In 1976. among shareholders. In addition. place. Securities and Exchange Commission: PD 902-A SEC is the government agency responsible for implementation of the Corporation Code. and compensation of directors. and should not impair vested rights. Its mandate is to supervise corporations in order to encourage investments and protect investors. duties. supervision (regulatory). Vol. and reasonable. It implements rules and regulations that protect minority shareholders from possible fraud and misbehavior by controlling shareholders. between the shareholders and the corporation. the bylaws must be consistent with the law. (iv) time for holding annual election of directors and manner of giving the election notice. and control (adjudicative) of all corporations. (v) manner of election or appointment and term of office of all officers other than directors. and forms of proxies and manner of voting them. (iii) controversies in the election or appointments of directors and officers of corporations.4 Philippine corporate law distinguishes between management decisions that require only a majority vote of the board and major decisions that require a two-thirds majority vote of shareholders. uniform. and between the corporation and the State concerning its franchise or right to exist. officers. directors. PD 902-A also granted SEC the exclusive jurisdiction to hear and decide cases involving: (i) complaints about devices or schemes employed by the board of directors and officers amounting to fraud and misrepresentation that may be detrimental to the interest of the public or shareholders. and manner of calling and conducting regular or special meetings of the directors and shareholders.
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The last item of PD 902-A is the special jurisdiction granted to SEC over applications by corporations for “suspension of payments” to creditors, a role of the regular courts that was originally part of the Insolvency Law. Under this authority to approve applications for suspension of payments, SEC has the power to appoint rehabilitation receivers or management committees for petitioning corporations. A presidential writ issued in 1981 placed SEC under the supervision of the Ministry of Finance, but in 1998, control of the agency was returned to the Office of the President. Insolvency Law The Insolvency Law is designed to effect an equitable distribution of insolvent debtors’ properties among their creditors. It permits debtors to be discharged from their liabilities to enable them to start afresh with property set apart for them from assets to be used as payment to creditors. The regular courts have jurisdiction for insolvency proceedings including suspension of payments for individual debtors. A debtor can petition the court to suspend payment of debts or to be discharged from liabilities and debts by voluntary or involuntary insolvency proceedings. Revised Securities Act: Law on Securities Dealing Like its predecessor, the 45-year-old Securities Act, the RSA was patterned after several US securities acts. The RSA is primarily designed to prevent the exploitation of investors through the sale of unsound or fraudulent securities. For this purpose, the law requires full and accurate disclosure of all material facts concerning the issuer and the securities it proposes to sell, and prohibits misrepresentations, manipulations, and other fraudulent practices in the sale of securities. To enforce these regulations, the law requires the registration of securities. The registration requirement covers full and accurate disclosure of the character of the securities to be sold to the public, including detailed information regarding past dealings between the issuer and its directors, officers, and principal shareholders. Public Listing Rules of the Philippine Stock Exchange PSE is the country’s facility for secondary trading of shares of publicly listed companies. In 1998, SEC, which originally supervised PSE, granted the exchange the status of a “self-regulated” organization. Thus, PSE now
170 Corporate Governance and Finance in East Asia, Vol. II
has the authority, within general guidelines set by SEC, to set rules and regulations for PSE members and listed companies. The general requirements for maintenance of listed status include submission of financial reports that conform with generally accepted accounting principles (GAAP) and regulations established by PSE, and compliance with laws relating to securities and exchange regulations, board resolutions, and agreements executed with the agency. Violations of PSE requirements are subject to sanctions, including delisting. PSE is responsible for ensuring that listed companies follow the exchange’s rules of disclosure and fair treatment of investors. It has the power to impose sanctions on any company that fails or erroneously discloses material information that affects the rights and benefits of investors and misrepresents information in its application, prospectus, financial statements, or reports. In the area of corporate governance, PSE requires corporations to resolve, and, where possible, eliminate arrangements within groups of companies and own-company dealings that can lead to conflicts of interest. Upon complaints by minority investors, PSE can review the deals in question, using such criteria as benefits to the company, adequate disclosure to shareholders, and internal control procedures to ensure fair and reasonable terms. Banking Laws Affecting Corporations Some aspects of banking laws affect the governance of corporations. The important ones concern: (i) the capacity of officers of corporations to assume positions as members of the board of directors of banks, (ii) limits on ownership of banks by nonfinancial corporations, (iii) limits of lending by banks to corporations, and (iv) rules on lending to directors and other insiders. The General Banking Law governs the regulation of the establishment, management, and operations of banks. As the highest policymaking body of the banking system, the Monetary Board prescribes the qualifications of bank directors and reviews the qualifications of those appointed as bank directors and officers. It could disqualify anyone found, for whatever reason, unfit for the position. There are no other restrictions on corporate officers to be appointed as members of the board of directors of banks. A corporation, including its wholly or majority-owned subsidiaries, can own common shares of banks up to a maximum of 30 percent of banks’ voting stock. In the event that the corporation is majority-owned by one person or by relatives, the limit is 20 percent of banks’ voting shares.
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.
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
or 3 percent of the total. In 111 companies. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. which are mostly privately owned and controlled by family-based shareholder blocs. Vol. 66 percent (signifying strategic control).2 percent of outstanding shares of publicly listed companies. the top five shareholders owned more than 50 percent of the voting shares. Individuals did not constitute a significant shareholder group among the top five shareholders.9 shows that in 44 companies. or 80 percent (only nominally publicly listed) of outstanding shares. the top 20 shareholders collectively owned a majority of a company’s shares. II analysis of the number of companies in which the top one. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. or about 30 percent of the total. Who are the top one. nonfinancial corporations held majority control. a single owner owned more than 80 percent of outstanding shares. or 14 percent of the total. or almost 75 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. holding only an average of 2. The largest group is nonfinancial corporations. Table 3.1 percent of publicly listed companies in the Philippines in 1997. five. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. a single shareholder held operating control of a company. including pure holding companies. or 78 percent of the total. controlling an average of 52. large and family-based shareholders pool the family’s ownership over many . and share prices are sensitive to movements of foreign funds. a single shareholder held two-thirds majority control. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders.10. In four companies. and 20 shareholders? In Table 3.174 Corporate Governance and Finance in East Asia. In four of 11 nonfinancial sectors. the top five controlling shareholders were classified into eight groups. With such high levels of ownership concentration. In 76 companies. In 21 companies. the top five shareholders held more than two-thirds majority control of a company. There are advantages to establishing pure holding companies. In 116 companies. five. Through these. or 20 shareholders owned more than 50 percent (signifying operating control). or 51 percent of the total. The shares of publicly listed companies are thinly traded and illiquid.
and two companies in the property sector. Beverage. and Trading Holding Power Transportation Property Total — = not available. 1997 % of Firms with Top Shareholders Controlling more than 50% of Shares Top 1 30 40 50 20 31 — 14 24 30 90 80 86 72 73 50 57 72 74 100 87 93 36 82 100 100 80 78 20 13 43 8 14 — — 8 14 70 60 57 48 49 50 14 52 51 Top 5 Top 20a Top 1 Top 5 Top 20a 90 80 86 36 76 100 71 76 72 % of Firms with Top Shareholders Controlling more than 66% of Shares % of Firms with Top Shareholders Controlling more than 80% of Shares Top 1 — 13 7 — 2 — — — 3 Top 5 40 33 50 28 27 50 — 28 30 Top 20a 60 67 64 20 47 50 43 36 45 Sector Communication Construction Food. 10 manufacturing companies.9 Ownership Concentration at Critical Levels of Control Over Publicly Listed Companies. a Data for top 20 shareholders were not available for five holding companies. . and Tobacco Manufacturing. Distribution.Table 3. Source: PSE databank.
0 0.5 26.5 0.0 5. Beverage.0 10.0 0.6 0. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.7 0. and Tobacco Holding Companies Manufacturing.1 9.2 3.0 0.3 0.6 2.6 0.0 0.0 4.6 5.0 5.0 1.6 18.4 5.6 2.2 3.2 0. .9 52.8 11.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.0 0.6 0.6 0. Recreation.0 0.3 0.2 0.4 2.8 21.5 2.7 67.4 29.0 2.7 3.8 0.2 59.0 1.4 19.9 6.4 8.9 0.5 4.1 0.6 33.4 0.8 66.1 0.7 0.3 0. and Trading Hotel.7 0.1 7.0 0.2 0.1 5.0 1.0 0.3 37.0 1.0 0.3 5.6 9.2 3.0 0.3 1.6 12.0 7. Distribution.7 1.3 12.3 1.5 13.2 3.0 1.7 0.0 0.0 0.0 5.0 1.6 0.2 10.2 1.3 0.6 1.9 0.0 45.0 5.6 0.5 53.0 0. Source: PSE Databank.1 6.Table 3.7 0.1 a Weighted by market capitalization.5 12.5 4.1 1.6 0.2 5.5 0.1 8.0 0.0 2.0 1.8 0.7 0.7 3.3 5.0 0. and Other Services Property Mining Oil Average Shareholdinga 33.3 26.2 0.4 1.0 1.2 0.3 0.9 36.3 2.8 0.
financial institutions did not have a significant ownership in nonfinancial corporations. Investment trust funds were the most important institutional investors. Holding companies as a sector had the largest market capitalization in PSE in 1997. with an average of only 7. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. Because of limited ownership by institutional investors. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets. respectively. As a group. there was no real market for investment information. They can also better manage their income taxes because income from affiliated companies passes through a holding company.Chapter 3: Philippines 177 companies and share in the risks and profits of the group.6 percent of market capitalization in 1997. Such advantages have contributed to the popularity of holding companies among publicly listed companies.5 to 12. accounting for P258.3 percent). and insurance companies (0.2 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. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce.6 billion or 26. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4.1 percent). commercial banks (1. 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. 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. while still allowing the public to own minority shares.7 percent of shareholdings). . securities brokers (1.7 percent of market capitalization of the nonfinancial publicly listed companies.2 percent in 1997. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS). Holding companies were themselves 66 percent owned by other nonfinancial corporations.1 percent). The investment funds’ presence in these sectors ranged from 8. 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. and San Miguel Corporation (SMC) in food and beverages. Petron and MERALCO in power and energy. The 7.
Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group.000 corporations’ sales. suggesting that business groups are common in all major markets.4 percent of the top 1. Prudential regulations. using data on the Philippines’ top 1. Large shareholders and their families own these banks directly or through their controlled companies. so far limiting their involvement to selected products.7 6 7 The study used publicly available shareholder information and published reports.000 companies. liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks. Some 20 financial institutions were affiliated with these groups. remain in force to control excessive lending of banks to insiders. but they comprised only 23. A common feature of corporate ownership of a business group is the centrality of a commercial bank. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). The Central Bank deregulated interest rates and foreign exchange. However. identified the companies belonging to each of these groups. This is significant considering that there were only 31 local commercial banks in the country in 1997. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. For this reason. Commercial banks hold the largest share. including 16 commercial banks. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. To understand the ownership and governance characteristics of family-owned business groups. suggesting that most publicly listed companies are parts of business groups.178 Corporate Governance and Finance in East Asia. 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. and increased the capital requirements for all types of banks.11). many companies in family-owned groups are not publicly listed. Still.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. Family-based groups have larger companies since their total sales were about 33. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. . including SBL and DOSRI rules. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. Corporate financing depends on intermediation by banks. and tracked the financial performance of each company from 1992 to 1997. All major industries were represented. Vol.000 Corporations in the Philippines. of the financial resources in the country.8 percent of total companies in number. the study put together a list of prominent business groups. Most family businesses that went public did so because they wanted to raise capital and to gain the prestige associated with being a public company. about three fourths.
broadcasting (49. and Henry Sy—as examples. In 1997. as discussed in previous sections. Lopez. and for the Henry Sy group. Also. Significantly. namely. retail merchandising (69. and more than 20 percent for the Lopez group and Henry Sy group.12).000 corporations in 1997.Chapter 3: Philippines 179 Compared with other Asian countries. construction. the two were closely related through their affiliations to business groups. the principal owner of SMC. the largest family-based business group was the Ayala Corporation Group. including business groups and independent companies. 25 out of the 50 top corporate entities were familybased groups.6 percent of the total sales of the top 1. Lopez. the three largest entities were family-based groups. Commercial banks are often affiliated to a particular business group. Gokongwei. real estate. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. a substantial proportion of group profits came from its financial subsidiaries. the nonfinancial sector was real estate (60. with 27 affiliated companies in the top 1. In terms of number of companies.4 percent of the group’s 1997 profits). for the Gokongwei Group. Cojuangco.000. For the Ayala group. which was majority-owned by the Henry Sy group. Foreign-owned companies mainly serve the export markets. for the Lopez group.000 companies. Together. the largest was the Eduardo Cojuangco group. ranged according to their sales (Table 3. or an average of about 12 per group. in most .1 percent). The main constraint may be the availability of family members that could be drawn for top management positions. To show this. with the exception of Banco de Oro. and Ayala.2 percent). Family-based business groups are most dominant in sectors such as manufacturing. for each of these groups. the top 10 family-based business groups had only 119 companies in the top 1. the study used the four largest business groups—Ayala. and banking. In the meantime. In terms of sales. These corporate entities accounted for 53. the biggest private company in the Philippines. it was manufacturing (36. 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. an average group in the Philippines has fewer member companies. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. It is also noteworthy that.8 percent).
Table 3. Eduardo Cojuangco Lopez Family Group Ayala Corp.2 1.2 1. and packaging Power distribution and mass communications Real estate.6 2. real estate.2 16. and mining Management. 6.0 13. agriculture. Real estate.5 6. of Affiliated Companies Total Sales (P billion) 123. power.9 3.4 48.4 10. and personal care prods Shipping. 3. food.9 2. beverages.7 98. 8.5 17.6 3. Beverages.5 47. 10.3 2.5 26.1 4.5 2.8 84.0 26.5 46. Consunji 4 3 Food and dairy products Construction and mining 10.5 44. 15.4 .3 3. 11. Sector Orientation. construction. 16.5 13.4 6. and Affiliated Bank of Selected Business Groups. food.5 49.0 17. 17. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. 5. 2. telecom.0 Average Sales Per Company (P billion) 6. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M.6 3. beverages. 14.3 11. and food Food.1 2.6 7. 7.1 4. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. and tourism Credit card 18.0 5. 9. coconut oil.3 15. and dairy products Investments. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines. 13. 4. Flagship Company.11 Total and Per Company Sales.
3 2. mining.2 6. 28. 21.9 7.0 0. 33. distribution.4 3.7 0.0 2.6 2.1 805.8 1. Ramos Gaisano Family Group Felipe Yap Felipe F. 34. 30.4 5.8 1.9 0. P.1 2. 24. 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 8.0 1.6 3.6 5. 27. 35. 22. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore.7 1. 23. . Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.9 1. 25.1 1.6 0.5 2. 36. 32. 38. SEC-BusinessWorld Annual Survey of Top 1. 29.7 0.1 1.1 0.9 1.8 6.3 2.0 5.000 Corporations (1997).4 1.9 0.7 3.7 0. 31.7 4. and various company annual reports.5 8.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.8 1.2 1. 39. 26.9 6.3 7. 20.2 4. 37. 4 238 1.9 1.4 3.19.
19. 4. 11. 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. 14. 7. 2. 17. 9. Uytengsu/General Milling Group David M. 1. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go W. 6. and Affiliated Bank of Selected Business Groups. 20. 1997 Business Group Size Classa Flagship Company Affiliate Bankb UCPB PCIBank BPI Metrobank/Global Bank PCIBank Banco de Oro Allied Bank Bank of Commerce Asian Bank PDCP Bank Union Bank Consumer Bank (Savings Bank) RCBC Asian Bank Equitable Banking Corp.Table 3. 10. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 15. 12. Flagship Company. 8. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . Alaska Milk Corporation DM Consunji. Eduardo Cojuangco Lopez Family Group Ayala Corp. 5.11 (continuation) Total and Per Company Sales. 3. 16. 21. 18. 13. Sector Orientation. Inc.
31. small = less than P1. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. Refers to commercial banks. 22. 24. 39. 38. Inc.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp.48 billion. 37. 34. a b Size class is measured in terms of sales: Large = greater than P4. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. Cruz & Co.65 billion. 36. Kepphil Shipyard Inc. unless otherwise indicated.. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/Fil-Estate Group Medium Medium Small Medium Medium Small Small Small Small Medium Small Medium Small Small Small Small Small Small Rustans Solid Group Filinvest Philex Mining Megaworld Properties Jaka Investment Corporation Uniwide Corporation Guoco Ceramics Ever Gotesco Republic Cement PhilRealty National Bookstore Gaisano Department Store Lepanto Consolidated Mining F. 33. 32. 35. F. 27. Ramos Gaisano Family Group Felipe Yap Felipe F. 29. medium = P1. 25. Sources: PSE Databank. PT&T Corp. and various company annual reports. SEC-BusinessWorld Annual Survey of Top 1. 28. Fil-Estate Development Inc. 30.65 billion to P4. P.48 billion. . 26.000 Corporations (1997). 23.
and food Food. Philippine National Bank Mercury Drug Corp. 20. and packaging Power distribution. and telecommunications Department store and banking Airlines.8 53. of the Phils. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp.5 26.Table 3. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp. 9. 4. car manufacturing. 19.5 15.5 46.4 48.5 47.1 17.8 22. food. 7.1 60.0 38. 11. 3.8 84. construction. food. and personal care products Shipping. beverages. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 14. 12. 6. agriculture. 23. 10.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. and bank Real estate.0 37. Beverages. 16. 18. 24.6 18. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils. 2. banking. telecommunication. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.5 44. Fujitsu Computer Products Corp.5 77.0 24.2 16. 17. and mining Gold and other precious metal refining .5 17. and dairy products Investments.7 98. bank. mass communications. 13. 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. 22. and real estate Banking.4 19.3 15.). coconut oil. 5. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. Inc. food. First Pacific/Metro Pacific Group 21. 8.).2 Business Group Business Group Business Group Government. Texas Instruments (Phils. 15.2 49. Inc.6 26.12 Control Structure of the Top 50 Corporate Entities. power. beverages.
25.6 12.4 10.7 10. Consunji Uniden Philippines Laguna. 47. W. Inc. 31. 28. Inc.290 53.7 10. 42. 29. Jollibee Foods Citibank N.4 8. 30. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters.8 9. Inc.6 9. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1. . 34. 50.A.5 10. 14. Philip Morris Philippines. Philips Semiconductors Phils.9 14.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management.7 13. 43. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. real estate.9 7.9 7. EAC Distributors Inc. Corp.9 6. 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. 40. Amusement and Gaming Corporation Mitsubishi Motors Phils. National Steel Corporation National Food Authority Phil.6 1. 37. 45.0 12. 32.1 9. 49. corn (unmilled).0 5. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay.5 8. 36.3 8. 44.8 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. 41. 48. 46. and various company annual reports. PSE Databank.0 11. 9.5 8.2 7. Uytengsu/General Milling Group David M. 39. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment. 35. 26.3 13. 27..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.0 13. 33.000 Corporations (1997).8 6.
8 The Board of Directors As the representative of shareholders in a company. investments of corporate funds in other companies or purposes. accounting and auditing. removal of directors. Of course. issuance of stocks. issuance of corporate bonds. sale or disposition of a substantial portion of corporate assets. approval of management contracts. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. jointly and individually. . although public investors held a majority of shares. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. appointment and compensation of senior executives. The Corporation Code holds members of the board of directors liable. voluntary dissolution. and declaration of cash dividends. shareholder voting in general meetings and legal protection of their rights. such as amendments of the articles of incorporation. amendments in the bylaws. They are likewise liable if they pursue financial interests that conflict with their duty as directors. determination of compensation to board members. Vol. business groups had only minority ownership.186 Corporate Governance and Finance in East Asia. 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. these were dispersed shareholdings. and financial disclosure. corporate mergers or consolidations. Actual control of the banks was still held by the groups. the board of directors plays a crucial role in corporate governance. 3. 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. However. II publicly listed commercial banks affiliated to these groups. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. 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.3.
7 percent). in a descending order. appointing senior management. or the Government without approval by shareholder general meetings. In practice. Making day-to-day management decisions was not regarded as an important board responsibility.6 for board chairpersons and 7. the average number of years of holding office was 6. . Board chairpersons in a substantial number of responding companies did not own significant amounts of shares in their personal capacities. The ADB survey results show that a chairperson is compensated either by a fixed fee (52 percent of respondents). ensuring that a company follows legal and regulatory requirements. The majority of respondents indicated that board directors and chairpersons were elected mainly on the basis of either relationship with major shareholders (31. In a few cases. The ADB survey shows that the number of board directors ranged from six to nine among the responding companies. This can partly be explained by the fact that many family-based large shareholders control companies through holding companies in which they have majority ownership.7 percent). Such a short tenure may to some extent suggest that large shareholders want to keep their board members under close control. a fixed fee plus performance-related bonuses (30 percent). But professional expertise is also an important criterion (28. a typical chairperson owned 3 to 5 percent of outstanding shares of a company on average. with a maximum of 36 percent. or a per diem for meetings (18 percent). appointed by the Government. The average stipulated term of office of the chairperson and members of the board for most responding companies was one year. Financial compensation is another means by which shareholders can motivate boards and board members to manage companies in their interests. or percentages of shareholdings (28. protecting shareholder interests.9 percent). or representatives of creditors.5 for board members. More than half of respondents indicated that board directors were elected during the shareholder general meetings. According to the ADB survey. and determining remuneration for board directors and senior management.Chapter 3: Philippines 187 actual practices of board functions and the role of shareholders may diverge somewhat from the legal framework. But half of respondents indicated that they also had board directors directly nominated by controlling shareholders or management. The longest was 27 years for board chairpersons and 14 years for board directors. board directors were the founder of a company. Respondents of the ADB survey ranked the following as the most important responsibilities of the board: making strategic decisions.
Ninetythree percent of the respondents had one or more outside directors. the CEO 9 The three most common board subcommittees are the compensation. and reviews the findings of external audits. however.188 Corporate Governance and Finance in East Asia. and nomination committees. There was no case found in the ADB survey where a minority shareholder invoked such a provision of the Corporation Code. About half of the active committees were audit committees and the other half nomination committees. Vol. or amount of shareholding (15 percent). the parent company or company bylaws (21 percent). the chairperson of the board was also the chief executive officer (CEO). CEOs apparently cannot increase their shareholdings because family-based owners restrict the number of shares available to management. A CEO that was not the chairperson of the board was selected on the basis of professional expertise (42 percent of respondents). When the CEO was not the chairperson. The compensation committee reviews and recommends remuneration plans of key officers and employee stock option plans. Unlike in Western corporate models. negotiates the audit fees and scope of audits. It is also not clear whether the outside directors were elected before or after the financial crisis. The Corporation Code prohibits the removal of any director without cause if that act would deprive minority shareholders of representation in the board. namely. But the independence of these outside directors is often doubtful. owners brought prominent political or civic leaders into their boards with the intention of improving the visibility of the corporation rather than improving the quality of board decisions. or management (15 percent). by tenure and compensation. The nomination committee searches and reviews candidates for key management positions. only 35 percent of responding companies have set up board committees. II Compensation for the chairperson was determined either by the board (54 percent of respondents). In the ADB survey. large shareholder-dominated companies often view such committees as unnecessary formalities. This suggests that large shareholders control CEOs by means other than shareholdings. The ADB survey shows that in 41 percent of the responding companies. These committees were established only recently. . relationship with controlling shareholders (35 percent). audit. Companies may set up special board committees to strengthen due diligence procedures.9 In practice. In some companies. The audit committee selects external auditors. Senior Executives The Corporation Code does not specify the role and responsibilities of senior executives.
(ii) contracts with companies linked through interlocking directorship.2 years. Companies are not allowed to issue shares with different voting rights. of directors representing minority shareholders. or (iv) enters into a merger or consolidation with another corporate entity. . the Corporation Code allows cumulative voting for directors. i. equal to three years’ pay. the Corporation Code requires that the following types of transactions involving potential conflict of interest between shareholders and management be reviewed and approved by the board: (i) dealings of a company with directors or officers. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. and prohibits the removal. Third.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. 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. shareholders may exercise appraisal rights. Among others. shareholders enjoy a number of rights and protection. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. without cause. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. (iii) invests in another company for a purpose different from that of the corporation. Shareholder Rights and Protection Under the Corporation Code. 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.. The longest service rendered was 27 years. But about 27 percent viewed it to be ensuring steady growth of the company. Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. Second. Fifth. 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. if the CEO’s contract was preterminated. to help ensure the representation of minority interests in the board. first. The average service length of CEOs was 5. Fourth. They can vote through proxy. including electronic means.e. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. and (iii) involvement of directors in businesses that compete with the company.
Being appointees of controlling shareholders. no one has been successfully prosecuted for insider trading. But an action by the regular court on a petition by the company’s owners/officers prevented SEC from pursuing the investigation. In the case of preemptive rights. There was only one case. potential buyers are required to make a tender offer to minority shareholders at a price equal to the offer it is making to controlling shareholders. in cases of corporate takeovers. there are no requirements for disclosing such transactions to shareholders under the Corporation Code. in the Philippines.190 Corporate Governance and Finance in East Asia. In practice. there were often no real discussions of board proposals or actions. During annual general meetings where minority shareholders could exercise their rights. that of Interport Resources Corporation. it is doubtful whether this legal protection for shareholders will achieve what it intends to in practice. SEC proceedings were costly and time-consuming. because of the dominance of large controlling shareholders. Consequently. In cases of derivative suits against directors for wrongdoings or actions against insider trading. Vol. II shareholders are allowed to inspect a company’s stock and transfer books. There was little chance that a proposal from minority shareholders could ever get approved. the Corporation Code allows a company to waive this in the article of incorporation upon registration or in a subsequent amendment. a shareholder could file a derivative suit against a director to redress a wrongdoing. Regardless of the amount of shares held. The company was dissolved before indictment. Sixth. However. the Revised Securities Act has strict provisions designed to deter insider trading. An effective market for corporate control may provide some protection for minority shareholders against the expropriation of their interests by the incumbent management. Although transactions involving potential conflict of interest need to be reviewed and approved by the board. where SEC made substantial progress in investigation. Last. Few minority shareholders actually exercised their appraisal rights. Those who did were usually offered below-market values for their shares. hostile takeovers are not common because in most companies ownership is concentrated . minority shareholders were often vulnerable to the expropriation of their interests by controlling shareholders and management. 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. In the past. Dissenting minority shareholders did not necessarily have recourse to a third party for an objective appraisal of their shares.
the successful hostile takeover by First Pacific Group of PLDT.2 43.4 70.4 percent of shareholders but 58 percent of outstanding shares. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held. The ADB survey provides further evidence on shareholder rights. Table 3. representing 3. appointed either by the board or shareholders during the annual general meetings.0 36. The brokers or securities companies were the most important proxy voters.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.0 48.8 92.2 7. An average of about 4.Chapter 3: Philippines 191 in a few controlling shareholders and families.4 No 0.7 43. a company that is widely held but has a large shareholder.13 ADB Survey Results on Shareholder Rights Percentage of Respondents Shareholder Rights One Share One Vote Proxy Voting by Mail Preemptive Rights on New Share Issues Prohibition of Loans to Directors Mechanisms to Resolve Disputes with Company Independent Audit Mandatory Independent Board Committees Severe Penalty for Insider Dealings Source: ADB Survey of Philippines Publicly Listed Companies. About 93 percent of the respondents contracted .8 56.3 56.2 69.6 30. and their activism in the corporate sector. Yes 100.0 51.13 summarizes rights that the shareholders of the responding companies enjoyed. The responding companies had on average 43.900 shareholders per company did not vote during the last annual general meeting. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares. Nevertheless. followed by management and banks.0 63.8 30. protection.522 shareholders each. representing about 24 percent of outstanding shares. 1999. About 333 shareholders per company voted by proxy. Table 3. Nominees held about 45 percent of the outstanding shares.
the international accounting standard. the responding companies have been associated with their present auditors for 13 years. . the local standard (i. financial reporting standards allow room for interpretation by independent auditors. Meanwhile. and an analysis of financial statements. More than 20 percent of the respondents have been dealing with their auditors for 20 years or more. independent auditors are likely to be quite familiar with the operations and financial aspects of their clients. foreign currency-denominated liabilities. a preferred independent auditing firm either reported assets that did not exist (Victorias Milling Corp. On average. These different versions of GAAP. SEC requires all registered companies to periodically submit reports for the purpose of updating their respective registration statements filed at the agency. the information statement transmitted to every shareholder should contain the audited financial statements. with the longest being 50 years. a hostile takeover case). the US GAAP). imposing penalties on violators..192 Corporate Governance and Finance in East Asia. namely. as practiced in the Philippines). or the accounting standard of a specific developed country (for example. In two celebrated cases. investments in subsidiaries.. and consolidation policy. In practice. vary in their evaluation of some major accounts such as securities and other liquid assets. a bankruptcy case) or hid a large amount of liabilities and losses (PLDT. 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. Nevertheless. the agency also requires reports on important details about their operations and management. Most major international auditing firms operate in the Philippines. The Code grants a shareholder the right to inspect business records and minutes of board meetings. Nevertheless. The accounting profession in the Philippines is considered fairly developed and Manila is a known regional center for accounting expertise. a management discussion of the business. An auditor can choose among three alternative sets of GAAP. From publicly listed companies. although closely related.e. there are many cases of poor financial reporting by large companies. intangible assets. independent audits do not guarantee the absence of questionable accounting practices. Because of such long relationships. Vol. intra-company receivables and payables. II their annual audit to an international auditing firm. long-term leases. revaluation of fixed assets.
Even for widely held public companies. arguably. from a minority-controlled to a majority-owned subsidiary. sometimes did not penalize independent auditors for poorly prepared audited financial statements. e. marketing. the authorities. and publicly listed. they also make it easier for controlling shareholders to expropriate interests of minority shareholders. Such expropriation is due to gaps between control rights and cash flow rights that pyramiding structures of business groups centered on holding companies create.g.and medium-sized businesses did not have quality financial statements. as large shareholders had no need for financial statements to monitor their companies and management that were under their own control. which are controlled by large shareholders with public investors in a minority position.6 billion. Corporate Control by Controlling Shareholders As in many other Asian countries.Chapter 3: Philippines 193 Many small. Pure holding companies can be privately owned. Laws of many Southeast Asian countries allow the establishment of pure holding companies (with the exception of Korea up to 1999). “Selective public listing” is a strategy of many business groups for channeling funds from public investors to member companies. which are usually controlled by holding companies. accounting for 27 percent of the total stock market capitalization that year. which are closely held by large shareholders and family members. controlling shareholders in the Philippines usually exercise their corporate control through the setting up of business groups. namely SEC and the Philippine Institute of Certified Public Accountants (PICPA). When control rights exceed cash flow rights. Family-based controlling shareholders use them as vehicles for controlling business groups. However. they formed the largest group of corporate entities in the Philippine stock market in 1997. The popularity of holding companies in the Philippine corporate sector is evident: with a market capitalization of P258. and financing. Controlling shareholders usually select member companies that require large . They allow risk pooling and can achieve economies of scale in management. 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. Publicly available financial information was often of low quality.. because of the highly concentrated ownership of Philippine corporations. Holding companies enable controlling shareholders to collectively own shares of other companies in a business group and to centralize the group’s management.
and customers.2 percent. controlling shareholders of the parent company may eventually increase their shares to a majority position. It has a majority control at 71. II equity investment for public listing. namely.1 percent of Ayala Land. In cases of minority ownership. controlling shareholders of the parent company do not participate in management. and a passive minority investment at 15 percent in Honda Cars (Philippines).1). Minority-owned companies may also need access to resources of the group. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. These investments can be classified according to the role of the controlling shareholders in the management of the invested company. minority control at 42.194 Corporate Governance and Finance in East Asia. It is majority-owned by Mermac. Ayala Corporation’s majority.. . Ayala Corporation. Ayala Corporation is a publicly listed pure holding company. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. financing. especially its management. at 47. Public investors collectively hold a minority of 41 percent. an active minority share at 44. as an example (Figure 3. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. Some holding companies are not pure holding companies. Honda Cars (Philippines).4 percent of Bank of the Philippine Islands. Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. Controlling shareholders gain additional leverage in management control over minority-owed companies. In a passive minority-owned operating company. with 59 percent of shares. a family-owned pure holding company. They are operating companies but at the same time have majority or minority share ownership in other operating companies. They may have a representative in the board.6 percent of Globe Telecom.and minority-controlled operating companies are also holding companies. Depending on the performance of the company. active minority or passive minority holdings. 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. the parent company plays an active role in management. The first three companies are publicly listed while the fourth. Ayala Land fully owns Makati Development Corporation and holds a minority stake. In an active minority-owned operating company. of Cebu Holdings (a publicly listed government-owned company). is privately owned. Inc. Vol.
96%) Privately-Held Pure Holding Company Public Investors (41.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998.6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc. .44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings. (58.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44. (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. Inc. (47..Figure 3. Inc.
First Philippine Holdings Corporation. Generally.5% x 14. Simeon Djankov. The situation offers large shareholders tremendous incentive to move resources 10 For details. H. Rockwell Land.5%] [39.44%] / [25%] = 1.7 times Ibid. 1999b. Joseph P.3% x 1. defined as control by large shareholders of an operating company through minority ownership by several companies.14%] / [1.8%] 5.44%] = [42.7 times 12 .98% x 42. and Larry H. Lang.12 These examples show that even when large shareholder groups are minority shareholders.3% x 5.11 The Lopez family’s control rights over MERALCO was 5. Lang: 1999a.64% +37. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Who Owns and Controls East Asian Corporations? 11 Ibid. see the World Bank research papers by Stijn Claessens. P. Vol. Expropriation of Minority Shareholders: Evidence from East Asia. and a minority-controlled holding company. 1998. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. Fan. The control of companies through indirect corporate shareholdings. and 1999c.76%)] [39. MERALCO. See also Stijn Claessens.10 The Ayala family’s control rights over BPI was 1. and Larry H. however.5%] / [(88.64%) + (37. [control right] [cash flow right] = = = = = [sum of control rights via Benpres and First Holdings] [sum of cash flow rights via Benpres and First Holdings] [1. Simeon Djankov. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector.196 Corporate Governance and Finance in East Asia.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. companies in the Lopez Group are large and minority-controlled.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. The Separation of Ownership and Control in East Asian Corporations. 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.14%] / [6. Being in the public utilities sector. Diversification and Efficiency of Investment by East Asian Corporations. a privately owned company. Benpres Holdings. is illustrated in the Lopez Group (Figure 3.44%] / [58. P.2).
7% 62. Privately-Held Pure Holding Company 88.76% Operating Company MinorityControlled 24. .3% 11.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.Figure 3. Inc.64% MinorityControlled 14.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998.5% 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.
whether for working capital or capital expenditure. Most responding companies had dealt with their commercial bank creditors for more than five years and nonbank creditors for only about two years.3 The 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. Suspension of Payments of Debts Under PD 902-A. SEC could suspend the rights of a creditor to demand payment from a borrower in accordance with the terms of the loan . However. Vol. a publicly listed company dealt with an average of eight banks and six nonbank financial institutions.3. 3.198 Corporate Governance and Finance in East Asia. The controlling shareholders could also use the resources of minority-owned subsidiaries to engage in overexpansion and empire building investments. Sixty-one percent of respondents indicated that creditors usually asked for collateral for all types of loans. II from their subsidiaries to their majority-owned publicly listed holding company or elsewhere up the pyramid. while 80 percent reported that creditors with which they had renegotiated loans were still willing to lend to them. it was not common for creditors to take legal action against debtors or foreclose on those assets held as collateral in cases of default. and (ii) how the legal framework protects creditor interests and rights. accessed nonbank creditors for specific purposes but dealt with commercial banks on a long-term basis. Most respondents (81 percent) indicated that they had renegotiated with their creditors on loan repayment when they faced liquidity problems. Control by Creditors According to the ADB survey. The average company. the data suggest. Some 85 percent of respondents believed that creditors had no influence or only weak influence on corporate management. 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. Only a minority of respondents (18 percent) indicated that they had faced adverse creditor actions such as a collection lawsuit or foreclosure of collateral.
profitable companies from going public. For example. 3. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC.. 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. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. bank credit is the main source of corporate financing. Under such circumstances. Commercial banks hold about three fourths of the resources of the financial system. Markets for equity and debt instruments are small and there are serious structural problems that discourage large. 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. Consequently.4. the litigation process. Under this mode. wait for 14 years from the time the company petitioned for suspension of payments in 1984.4 3. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. The first mode is for simple suspension of payments.Chapter 3: Philippines 199 agreement.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. could take an indefinite period. under which. There are two modes of suspension of payments under PD 902A. including the rehabilitation of the corporation. The corporation continued to be under rehabilitation receivership as of June 1999. SEC and the court required that the creditors of BF Homes. SEC could intervene to avoid asset dissipation. There are no legal or practical limits to the time period of suspension of payments. The borrower will propose a rehabilitation plan to SEC. a real estate-based business group. In practice. Inc. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse. Publicly listed companies do not represent a cross section of the Philippine corporate .
and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. Korea and Thailand). Of the 221 companies listed in the Philippine Stock Exchange in 1997. the country experienced double-digit inflation. and convertible securities. while interest rates were at high levels and volatile. and Indonesia ($61. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods.g. The period 1993-1997 was one of lower inflation and declining lending rates. Malaysia. 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. II sector. about the size of Thailand’s. compared with other economies. The crisis affected the Philippine corporate sector. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Equity financing through IPOs was active. especially short-term debt. However. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. From the 1970s up to the early 1990s.. The stock market was depressed up to the early 1990s. the Republic of Korea (henceforth. Most publicly listed companies issue only up to 20 percent of total shares to the public. the minimum required to qualify as a public corporation. compared with Malaysia ($186 billion). this is because. The market capitalization of the Philippine stock market in August 1997. The corporate sector raised a substantial amount of . but not to the same extent as it did in other Asian economies. was one of the smallest in the region at $47. and less engaged in risky investments. Table 3. In part. only 84 had sales large enough to be placed in the top 1. is far ahead of the flock.200 Corporate Governance and Finance in East Asia. less exposed to foreign debt. Rising stock prices during the Ramos administration reflected to some extent the business optimism. They invested in only a few large companies whose shares were relatively liquid. 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. most listed companies are controlled by their five largest shareholders. Equity instruments include common stocks. preferred stocks.000 companies. Foreign portfolio investments also remained small.14 shows that the average volume of daily trading in 1997 stood at P2. companies expanded only at a moderate pace. Philippine companies were less leveraged.5 billion). inflation. Interest rates. Vol. Even in the real estate sector. The Philippine stock market is not a liquid market.7 billion.4 billion (or $59 million using the average exchange rate). As a result. however. Korea) ($143 billion).
3 — = not available.3 0.1 88.0 0.9 114.0 0.373.077.9 608.7 391.5 72.8 799.686. Source: PSE databank.7 1.121.421.14 Philippine Stock Market Performance.1 0.9 1. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.386.2 1.7 0.5 571.5 Year 369.248.5 16.2 3.1 0.2 1.9 2.251.545.8 1.2 0.4 Ratio of Market Capitalization to GDP 0.5 1.2 ($ million) — — — — 6.2 59.7 41.2 297.9 2.515.4 9.3 59.474.3 0.6 1.8 1.088.7 2.0 161.3 4.6 1.351.906.6 261.8 1.171.0 1.4 728. .5 12.7 207.445.1 0.692. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19.2 925.4 1.3 158.3 314.1 524.1 5.9 682.9 12. P billion) Gross Domestic Product (current prices.5 1.2 61.2 57.0 0. 1983-1997 Daily Trading Volume (P million) — — — — 129.8 0.2 0.0 2.5 26.Table 3.8 102.3 Market Capitalization (year end.3 2.1 0.
Under SEC regulations.2 Patterns of Corporate Financing The study looked at retained earnings. include bank credits. and debt as sources of corporate financing by using flow of funds analysis. of which 85 percent was raised from 1993 to the first half of 1997. discounting of receivables. Because existing shareholders wanted to retain their proportionate control over their companies. by volatile interest rates and the absence of a secondary market.. Debt securities include commercial papers and corporate bonds. about 127 companies went public with a total value of offerings of about P134. the rights issue was a popular way of raising equity capital. and high transaction costs. The largest buyers have been commercial banks. Few companies offer preferred stocks because the Philippine tax system does not allow tax deductibility of dividends on preferred stocks. The underwriter. which in most cases is an affiliate of the issuing company. tight regulations. and inventory financing. Only a few large companies floated commercial papers because of the limited market. sells these commercial papers through brokers. This is because only companies with strong capitalization and predictable cash flows such as public utility companies can issue bonds. II equity capital through IPOs during the stock market boom from 1993 to the first half of 1997. which buy commercial papers either for their own account or for their clients. Debt instruments include negotiated credits and debt securities. moreover.6 billion. From 1988 to 1997. Capital markets cannot provide the market discipline that corporate investors need. are in a position to provide such discipline. asset-backed credits. Corporate bonds are another type of debt securities. issuing companies had to undergo a process of review and credit rating by the Credit Information Bureau Inc. a strong regulatory system for bank supervision is imperative. which were the principal source of corporate financing in the Philippines. new equity.202 Corporate Governance and Finance in East Asia. and the dominance of large commercial banks. which ultimately influences the pricing of commercial paper issues. 3. because business groups often own large commercial banks. However. lack of competition among financial institutions.4. The measures used in the analysis are: . corporate bond issuing was even more limited. Only the commercial banks. Negotiated credits. The corporate bond market was stunted. leases. by virtue of their large stakes in the financial system. Vol. The picture of the financial system that emerges is thus one of limited capital markets. However.
On the other hand.0 0.4 1.1 0. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.5 0. By definition. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.8 0.0 0.2 0.4 0.8 0. the SFRT was low at Table 3.4 0.9 0.3 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets.9 0.5 0.15 Financing Patterns of the Corporate Sector. 1988-1997.5 0. during this period.5 0.9 0. .4 0. As shown in Table 3.3 0.6 0.3 0.8 0.1 Average 1.7 0.1 0. It measures a company’s reliance on borrowings in financing asset growth.4 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets.5 Source: SEC-BusinessWorld Annual Survey of Top 1.4 0.5 0.4 0.5 0.3 0.1 0.000 Corporations in the Philippines from 1988 to 1997.6 0.1 0.2 0. the average SFRF was high at 109 percent.3 0.5 2. It measures a company’s capacity to finance asset growth by equity capital. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.3 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.4 0. it is one minus IDFR.5 0.000 Corporations in the Philippines.6 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.5 0.1 0.2 0. It measures a company’s capacity to finance asset growth by internally generated funds.3 0.5 0.2 0.9 0.2 0.15.
1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1.1 a Excludes negative balances. Vol. the level of corporate leverage increased. except for foreignowned companies that had a negative new equity financing ratio.9 0.7 0. reflecting the capital flight caused by political instability in the early 1990s. Corporate Financing by Ownership Type As shown in Table 3. debts were the most important source of financing.16 Corporate Financing Patterns by Ownership Type. internal funds were not a significant source of financing growth in total assets.2 (0. the SFRF was higher. when it financed 45 percent of it.5 Foreign-Owned 1. . Retained earnings were the least important.3 0. and 1997.2 0. In 1997.204 Corporate Governance and Finance in East Asia. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period. with debt providing 93 percent of the financing requirements. On Table 3. privately.0) 0.000 Corporations in the Philippines. As a result. There were significant year-to-year variations.6 0.5 0.8 0. for all three types of companies—publicly listed. implying that internal funds were far from sufficient to finance growth in total assets.5 Privately-Owned 0. retained earnings declined and few new equity investments flowed into the corporate sector. Companies financed fixed assets from internal sources in hard times. Source: SEC-BusinessWorld Annual Survey of Top 1.16. except in 1991. Total assets grew by 23 percent that year. 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. 1991. In all the years. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. 1988-1997. This was mainly caused by the declining contribution from retained earnings. In periods of an economic crunch such as in 1989.and foreign-owned.3 0. II only 19 percent.3 0.3 0.
8 51.3 11. Foreign-owned companies relied more heavily on debt financing.3 48. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.9 16.7 4.9 100.0 38.2 100. significantly Table 3.0 Source: SEC-BusinessWorld Annual Survey of Top 1.9 0.Chapter 3: Philippines 205 average.8 3.4 12.6 43.17. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.0 9.4 100.4 100.5 0.6 48.3 51.7 13.4 43.1 49.8 26.4 2. The sector built up its short-term debts.1 15.4 100.0 9.0 9.3 12.7 7.7 2.4 3.9 4.2 3.8 4.5 27.8 38.8 3.4 10. especially bank loans.0 8.1 13.0 9.8 0.0 1995 1996 13.0 10.7 13. 1988-1997.9 3.0 1994 19.6 26.7 23. 1992-1996 (percent) 1992 Assets Cash and Temporary Investment Accounts Receivable Inventory Other Current Assets Total Current Assets Investment Fixed Assets Other Assets Total Assets Liabilities and Equity Accounts Payable Short-Term Loans Other Current Liabilities Total Current Liabilities Long-Term Debt Other Long-Term Debt Other Long-Term Liabilities Total Liabilities Stockholders’ Equity Total Liabilities and Stockholders’ Equity 14.4 100.3 4.6 37.5 41.9 16.2 51. publicly listed companies relied more on new equity financing than privately.1 7.2 3.9 24.2 100.8 16. It presents a composition analysis of assets and financing sources for the period 1992-1996.1 9. contributing 90 percent of growth in total assets.6 0.9 38.9 16.7 2.1 10.4 2.5 16.0 1993 14.1 50.9 12.17 Composition of Assets and Financing of the Publicly Listed Sector.3 10. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.3 13.0 12.0 100.8 17.5 12.0 53.0 10.0 6.8 100.6 48.2 12.3 12.2 42.3 12.000 Corporations in the Philippines.and foreign-owned companies.8 39.3 10.5 9.8 46. .0 13.8 0.4 41.7 100.
13 was at 1. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. Vol.206 Corporate Governance and Finance in East Asia.3 0. the easier access to external credit. Table 3. As shown in Table 3.5 0.9 0.5 0.6 Independent Company 0. indicating that many publicly listed companies were likely to be in a tight liquidity position.1 0. group companies usually financed their investment in member companies by equity rather than debt. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. the current ratio.2 0. compared with an average of 54 percent for independent companies. their inherent ability to pool risks. respectively.3 0. for independent companies.000 Corporations in the Philippines. Further. and economies of scale in fund raising. the average SFRF of business groups was higher compared with that of independent companies. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded.18 Financing Patterns by Control Structure.45 in 1996. 1988-1997. The normal standard liquid position is a current ratio of 2 or higher.3 0.18. 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. On average. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities. For these two reasons. . Group companies financed an average of 45 percent of growth in total assets by debt.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1. as opposed to 94 and 30 percent. The traditional measure of liquidity. II in 1996 and became more vulnerable to the financial crisis in 1997. Group companies were generally more profitable than independent companies.
The corresponding ratio was 0.76 for small companies and 0. These years were 1991 with 110 percent. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.6 0.1 0. with an average of 3.3 0.06.3 0.20).000 Corporations in the Philippines. On average.19 Financing Patterns by Firm Size.55 was substantially higher than the small companies’ 0. 1988-1997. Excluding .3 0.47.50 (Table 3.19). Table 3. Source: SEC-BusinessWorld Annual Survey of Top 1. and 1997 with 131 percent. With assets growing at a fast pace during this period.2 0.2 0. 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. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.8 0.5 Medium 3.6 0. Large firms consistently increased their reliance on debts from 1994 to 1997.88 for large companies (Table 3.5 Excludes negative balances. 1993 with 96 percent. There was also increased reliance on debt financing. compared with 55 percent for large companies and 47 percent for small ones.9 0.08 and SFRT of 0.4 Small 0.2 0. equity financed 42 percent of incremental asset growth.Chapter 3: Philippines 207 independent companies.5 0. medium-sized companies used more debts. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. averaging 61 percent of growth in total assets.
achieving an average SFRF of 3. Excluding 1997 when fixed assets declined.27. Since the real estate boom coincided with that of the stock market.6 0. Incremental equity financing amounted to an average of 44 percent of total asset growth. Source: SEC-BusinessWorld Annual Survey of Top 1. The situation improved beginning 1994.7 0. While this level is considered prudent. debt financed about 78 percent of asset growth in real estate. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.6 0.4 3.3 0. when debts declined. II 1991. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets.208 Corporate Governance and Finance in East Asia.4 0. Vol.5 (0. The real estate industry financed its growth by substantial equity funds. Table 3.5 0. Equity financed an average of 62 percent of total asset growth. The construction sector was a heavy user of debt financing. while SFRT averaged only 0.91.2) 0.5 0. During the crisis year.4 Construction 0. increasing to 0.32.4 0. Up to 1997. the incremental equity ratios of the industry were high.79 and in 1997 at 0. with an SFRF as low as 0.6 a Excludes negative balances.47 two years later. the total debt ratio was much higher in 1996 at 0. Total liabilities increased partly as a result of the local currency devaluation and financed all of asset growth for the year. Equity financed the rapid expansion in the industry’s assets in the period 1994 to 1997.5 Utilities and Real Estate Services and Property 0. ranging from 41 to 118 percent. the industry generated internal funds.3 0. SFRF for the sector averaged 0.6 0.3 0. 1988-1997. The effects of the crisis of 1997 were adverse.1 0. . the manufacturing industry financed 57 percent of its total asset growth by debt.4 0. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1.29.58 and SFRT of 0. In the eight years preceding the crisis.3 0. The utilities sector showed weaknesses in internal fund generation in 1989-1994.04.000 Corporations in the Philippines. many of the leading real estate companies successfully went public during that time.20 Financing Patterns by Industry. The sector had the highest leverage among all industries that year.
008 5. while if it fails. ROA.00056 1.21.14 Large shareholders may borrow excessively to undertake risky projects. Profitability. alternatively. ROA = return on assets.4. was regressed against measures of profitability and of financial leverage. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0. the degree of ownership concentration. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and. Exit.860 Leverage = the ratio of total assets to total equity. Journal of Finance 48: 831-880.004 3. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA. 1992-1996. Financial Leverage.21 Ownership Concentration.00036 2.287 0. ownership concentration = the total shareholdings of the top five shareholders.130 ROA 0. ROE. Source: Author’s estimates based on the PSE databank.769 0.Chapter 3: Philippines 209 3.009 5. and leverage. ROE. Using the PSE database. 14 See for example Michael Jensen (1993). measured by the percentage of shareholdings of the largest five shareholders. As shown in Table 3. Table 3. ROE = return on equity.00125 2. and financial leverage are all positively and significantly related to the degree of ownership concentration. more profitable. creditors bear the consequences. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. at the same time. and the Failure of Internal Control Systems.3 Ownership Concentration. as the dependent variable.421 0.230 Leverage 0. . knowing that if an investment turns out to be successful they could capture most of the gain. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. The Modern Industrial Revolution.
Historically. After a . with a narrow exporting industry base. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment). The country experienced balance of payments surpluses but these were due to transfers. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. In sum.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. foreign investments in the country have been low. but its share had been declining by 4 percent per year since 1995. Net investment inflows were $3. and intermediate goods. notably remittances of overseas workers. Because of limited local capital. which averaged 4. more than half (52 percent) of exports were semiconductors. the economy still showed vestiges of its import-dependent and substituting character.210 Corporate Governance and Finance in East Asia. industry at 34 percent. Vol. The largest contributors to GDP were services at 43 percent. Commercial and industrial activities in the country were largely oriented to domestic markets. raw materials. and agriculture at 21 percent. Garments was the second largest export sector at about 9 percent. with commodities accounting for the balance. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness. Compared to other East Asian crisis-affected countries.” that is. an overexpansion of capacities.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. Exports were growing at about 20 percent per year in the three years preceding the crisis. The costs of an economic correction brought about by the regional financial crisis were thought probably to be low due to the sound structure of the real economy and the strong position of the financial sector. Net trades in goods and services averaged a deficit of 4.5 3. their growth gathering momentum only beginning in 1992. Although much lower than those of other Asian countries.5 percent per year from 1992 to 1997. the country’s GDP growth pace indicated that it did not have a “bubble economy.5.8 percent of GDP from 1995 to 1997. II 3. In 1997.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. 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. Manufactures accounted for about 85 percent of exports. The export sector had a very narrow breadth.
a government fiscal surplus from 1994 to 1997. From 1988 to 1996. the country and the corporate sector had no access to foreign currency debts from the international financial market.5 percent. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors.3 percent. which. In the Philippines. .Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. and a relatively healthy banking system.1 percent. an average Treasury bill rate of 13. average ROE was 13. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998. The corporate sector was in a relatively stable financial condition around the time of the crisis. Total debts were only 52 percent of assets or 108 percent of equity. assets grew at a compound annual rate of about 31 percent. however. After hovering in the range of 100 to 127 percent. depended on the quality of the corporate sector’s investments. During this time. the Government sought stability and achieved this in 19921997. fueled also by successful IPOs during the stock market boom of 1993-1996. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10. a positive balance of payments from 1992 to 1996. in turn. The adverse impact of the crisis in most Asian countries was proportional to the amount of short-term foreign debts relative to net international reserves. the Government restructured its debts into longer tenors with a maximum of 25 years. Financial institutions called on their shortterm loans and shortened the maturity of existing loans.6 billion as of March 1997. Eventually. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis.8 percent. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. From 1993 to 1997. The lessons from debt restructuring became the basis for the Government’s economic policies. an average inflation rate of 7. 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. while sales grew by only 20 percent per year. Closer analysis. Profitable operations since 1992 had allowed it to build equity. unlike their counterparts in the region. resulting in stability in the short-term debt to reserves ratio. adjustments were focused on the quantity and quality of the banking system’s corporate loans. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3.
or 114 percent of net foreign direct investment (FDI). Table 3. Vol. 1998 = 41.47.101 billion or 196 percent of net FDI in 1996. . It rose to $2.609 1.” 3. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. Data for 1998 cover only January-August.485 145. precisely.101 92.749 26.718 30.303 23. In sum.0 1998 739 555 328 69.300 1. 1995-1998 Item Net Foreign Investments ($ 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 1.4 1997 762 1.212 Corporate Governance and Finance in East Asia. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3. These patterns in investment and financing are similar to those of other countries in the region.06.5. 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.71. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. the other immediate impact of the crisis was that on foreign investment flows. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region. Net foreign portfolio investment amounted to $1. Most of this leverage happened during the boom years in the region. 1997 = 29.0 1996 3. 1996 = 26. mitigated the effects of the pullout and liquidation of investments in the aftermath. but to a lesser degree. growing by about 34 percent per year from 1994 to 1997.22 Foreign Investment Flows. In 1997.22). net FDI remained stable at more than $1 billion.073 (406) 121. But portfolio investment amounting to $406 million flew out of the Philippines.074 2. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.5 billion in 1995.2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment.7 Note: Peso-dollar exchange rates used are: 1995 = 25. Sources: Bangko Sentral ng Pilipinas and SEC.650 32.22.517 1. Debts financed a large part of this expansion. It financed 26 percent of corporate capital growth.
The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. new borrowings financed asset growth.2 to 28. Companies deferred investments in new fixed assets. Loan calls. sparking a rise in interest rates on corporate loans. ranged from 11 to 13 percent from 1993 to July 1997.7 percent in January 1998.2 percent in November 1997. in varying degrees for each sector. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. Loans outstanding of commercial banks declined by the first quarter of 1998. depended on the liquidity and capital position of commercial banks. the sectors with the highest outstanding loans had reduced their credit exposures. Average bank lending rates climbed to their peak of 25. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. Net profit margins were at a 10-year low at 4. The real problem of the corporate sector during the crisis was the rise in interest rates. Because commercial banks were strongly capitalized. the commercial banking sector’s capital remained strong at 17. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. then rose to a high of 22. they were willing to restructure and renegotiate existing loans by corporate borrowers.9 percent. ROE at 6. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. By March 1988.2 percent was barely above inflation rate. With the increase in borrowings and reduced liquidity. Lending rates were well above the 20 percent level from July 1997 to March 1998. and leverage increased to 149 percent compared with 109 percent in 1996. The resources of the financial system that year totaled P3. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. albeit at current market interest rates. By October 1998. the corporate sector became vulnerable to loan calls and high interest rates. which held about 75 percent of the assets of the financial system in 1997. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. When the Treasury bill rates eased in March 1998. with commercial banks holding P2.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997.513 billion.3 percent of assets. The interest rates on Treasury bills. meanwhile. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. and the wholesale and . in turn.369 billion. Because of weak internal fund generation. lending rates also came down. Although corporate borrowers were not highly leveraged.
by 12 percent.3 percent in December 1997. 3. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. single-digit NPL ratios began only since 1989. through the Bankers’ Association of the Philippines.6 percent in June 1998. In March 1997. These peaked at 14. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998. But the Philippine banking system had gone through worse crises in the past. thereby reducing overall intermediation costs.9 percent of bank loan portfolios. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1. This allowed the Central Bank to convince the banks. set limits on overbought/oversold foreign exchange positions of banks.214 Corporate Governance and Finance in East Asia. as with its counterparts in other Asian countries. real estate loans averaged 11. including (i) a regulatory limit of 20 percent on banks’ loans to the . As for nonperforming loans (NPLs). and set up a hedging facility for borrowers with foreign currency-denominated loans. was a problem sector. the fiscal position. However. and subsequently went down to 13. The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial 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.5-6 percent. Still. 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. Vol.5. and its experience of low. the ratio increased to a high of 11.5 percent by September 1998. These figures show that adjustment problems were industry-specific and that the real estate industry.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. The Central Bank adopted other measures to strengthen the financial system. and the financial system. The move retained the liquidity position of banks but lowered their cost of reserves. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. II retail trade sector.
The policy directions and actions taken by the Government appear to have ushered in recovery. First Pacific Corporation. The real estate portfolio of commercial banks also declined and was well below the Central Bank’s regulatory ceiling by March 1998. Financially strong companies were able to survive the crisis by effecting such internal restructuring. the country’s flag carrier. (iii) fixing loan loss provisions of 2 percent of the gross amount of loan portfolio on top of individually rated bad loan accounts. The acquiring company.Chapter 3: Philippines 215 real estate sector. 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. came up with a rehabilitation plan by May 1999 that was found acceptable to all parties. bank loan rates have also come down. (v) improving disclosure requirements on the financial position of banks. (iv) increasing banks’ capital requirement by 20 percent for universal banks (banks with expanded licenses) and 40 percent for ordinary commercial banks. was known to have a policy . Responses of the Corporate Sector The corporate sector’s financial position. and giving up noncore businesses. With prudent monetary management. (PAL). its accessibility to foreign capital. the Government kept inflation below 10 percent. (ii) shortening the period for classifying unpaid loans as past due from three months to one month. changing technologies. Takeovers in the past involved cooperative negotiations between purchasers of a target company and family-based large shareholders. subcontracting and outsourcing. A 40 percent devaluation of the Philippine peso lowered the purchase price of PLDT to foreign investors. Large companies with heavy loan exposures such as Philippine Airlines Inc. Publicly listed Philippine companies could also be restructured through takeovers by local and foreign investors. the Asian crisis opened a unique opportunity for foreign investors. Average Treasury bill rates have cooled since mid-1998. consolidating business units. With its weakened financial position. The economy avoided a recession in 1998 and achieved 3. which was privatized with the Lucio Tan group gaining control and the Government retaining minority ownership. and the legal framework for reorganization and liquidation conditioned its response to the crisis. the largest telecommunications setup in the Philippines. PAL.6 percent growth in 1999. In response to calls for lower bank intermediation costs. took more action. In the case of PLDT. and (vi) issuing guidelines on duties and responsibilities of banks’ boards of directors for improved quality of bank management.
When Cojuangco took over. 3. First Pacific. When companies are highly profitable.1 Summary. Consequently. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years. The question.216 Corporate Governance and Finance in East Asia. the Cojuangcos. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. One mode was the outright purchase of shares in the open market. is whether there are sufficient safeguards to prevent controlling shareholders from . and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders. SMC is another widely-held company managed by a minority shareholder. II of investing to control companies that are dominant players in their industries. Ownership is highly concentrated and a few dominant players control major industries. however. at a premium over the market price to reflect the value of management control. 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. eventually took over PLDT and announced a restructuring plan for the entire group of companies.6. the Soriano family. Corporate governance is conditioned by the high ownership concentration of these large companies. By itself. In a legal process that ended in his takeover of management. Conclusions. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. controlling shareholders can capture these profits by excluding public investors from ownership. the stock price of PLDT was buoyant during the takeover period. using some or all of these means.6 3. concentrated ownership of companies is not equivalent to weakness in corporate governance. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. A second method was to purchase the shares of other large minority shareholders. Although considered the prime industrial company in the Philippines. Its stock price and returns to shareholders had stagnated. Vol. 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.
By size. Returns to capital exceeded inflation rates. influenced by industry characteristics. were the least profitable.Chapter 3: Philippines 217 expropriating the wealth of minority shareholders through aggressive and risky investment. Corporate governance should be viewed in the context of an increasing presence and growth of large shareholders-centered conglomerate business organizations. Financial institutions are not significant shareholders. ownership of banks by business groups. Publicly listed companies had the highest profit margins and lowest leverage among the local companies. Ownership of publicly listed companies is highly concentrated. foreign companies were the most profitable but highly leveraged. By control structure. passive independent auditing. the most numerous in the corporate sector. With large shareholders in control. to some extent. Leverage was within Asian norms but above developed country standards. This study points out weaknesses in external control mechanisms such as weak legal protection for minority shareholders. an underdeveloped capital market. By ownership structure. The five largest shareholders have majority control of an average publicly listed company. an ineffective insolvency system. Business groups occupied seven of the top 10 and 25 of the top 50 largest corporate entities in the Philippines in 1997. companies that are members of family-based conglomerates had higher returns and lower leverage than independent companies. oligopolistic market structures. This study analyzed trends in corporate performance and financing in relation to corporate governance from 1988 to 1997. The result is that corporate governance depends only on internal controls. medium companies showed higher profitability than large and small ones. Forming business groups appears to be a viable means of competing because this allows for more efficient organization and utilization of resources of large controlling shareholders. Analysis of corporate financing by ownership . The Philippine corporate sector was relatively efficient in investing and financing compared with other countries affected by the Asian crisis. with the real estate and public utilities industries standing out for their pronounced cyclical patterns. Privately-owned companies. The corporate sector consistently relied on internally generated funds and equity before resorting to borrowings. minority shareholders need to be protected by external control mechanisms. while the largest 20 shareholders control more than 75 percent of shares. Performance was. The financing pattern of the corporate sector was influenced by the tight financial conditions prevailing in the country up to 1992. and the lack of market for corporate control.
. Large companies owned or controlled by business groups tend to dominate their industries. Business groups with pyramiding structures heighten the issue of corporate governance. ROE. After controlling for industry effects. superior profitability. 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. and the extent of supervision of outside institutions such as independent auditors and SEC. Large. statistical analysis of company-level data revealed significant relationships between corporate performance and corporate governance. Such structures result in control by large shareholders through disproportionately smaller investments in equity ownership. The extent of governance problems depends on internal control policies of the controlling shareholders. Family-based business groups have focused their investments in industries where their superior financing capacities and political/social influence give them unique advantages. The difference between management control and ownership rights is usually substantial. and leverage were all positively related to the degree of ownership concentration. Internal financial markets operated by business groups allowed them to optimize their financial resources at lower external debt levels. Companies whose large shareholders have higher degree of control tend to borrow more but generate better returns. and centralized management and financing. ROA. Publicly listed companies were responsive to investors’ requirements for prudent use of debts. The positive relationship between financial leverage and ownership concentration is consistent with the hypothesis that controlling shareholders prefer to use debt financing in order to avoid ownership dilution. the bank usually accounted for a large share of each group’s net profits. Ownership concentration was positively related to both returns and leverage.218 Corporate Governance and Finance in East Asia. A commercial bank is an important part of most business groups. as typified by the Ayala Group. with the foreign-owned companies found to rely more on borrowed funds. and sustained growth. the amount of pressure from stock market investors and PSE (for publicly listed companies in the group). A business group is an effective business organizational model for achieving leadership in industries. Even in cases where the group owned only a minority share of a commercial bank. family-based shareholders gain control by such means as the setting up of holding companies. II type gave similar results. The pyramid model is useful for centrally managing smaller companies. selective public listing of companies in the group. Vol.
a strong international reserves position. As the crisis wore on in 1998. Still. 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. strong capital position built on IPOs in a buoyant stock market. SEC’s quasijudicial functions. That is. SEC officials. 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. the government budget in surplus.Chapter 3: Philippines 219 The financial crisis came when the Philippine economy was in a relatively strong financial position. mostly by highly leveraged companies and speculative investors in real estate. For example. This law is flawed in concept because it supplants a market-based credit agreement with a political process. and a market-oriented policy environment. 3. There are systemic risks involved in highly concentrated ownership.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. are to be removed and transferred to courts. Under the new Securities Regulation Code enacted in 2000. The corporate sector was also in good financial condition with rich internal cash flows accumulated from a number of profitable years. Specific actions recommended are described below. including suspension of payments. with recently restructured public debt. rather than the banks that lent millions of pesos. decisions by large sharehold- . The Central Bank imposed strict limits on real estate lending. 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. decide on the financial future of a troubled debtor. The Central Bank responded by improving the liquidity of the system and by establishing conditions for bringing down interest rates on bank loans.6. resulting in the banks’ accelerated restructuring of troubled debts in this sector. low inflation. adversely affecting companies’ operations and financial position. and sound overall creditworthiness. The crisis caused a tightening of credit to the corporate sector and a spike in interest rates. there were sharp rises in the number of bankruptcies and petitions for debt relief.
to 25 percent. SEC should strengthen disclosure requirements by issuing specific guidelines on minimum disclosures required for related party transactions. The adjustment should be made over a fixed period of time. To help ensure this. To strengthen the board. and (iii) increase the minimum required percentage of outstanding shares for public listing in the stock exchange from the present 10-20 percent. II ers often cause wide volatility in stock prices and invite reaction from creditors. Because independent directors tend to adopt the perspective of minority shareholders in board decisions. Increasing the Statutory Accountability of Directors and Strengthening the Board System The Government should clarify statutory fiduciary responsibilities of the board of directors. and self-dealing. the PSE Listing Rules require the appointment of a minimum number of independent directors in the board of publicly listed companies. Vol. inadequate disclosures. they serve to curb the powers of controlling shareholders. Clear legal accountability is a precondition for successful shareholder activism. PSE Listing Rules should specify criteria and a selection process that will help ensure that the nominees for the position are truly independent and qualified. It has suffi- . This may limit current practices of appointing prominent individuals and family members as directors. depending on the size of the company. 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. (ii) require disclosure of material changes in ownership. 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.220 Corporate Governance and Finance in East Asia. Another measure would be to impose a statutory limit on the number of directorships that one can accept. This will enable SEC to enforce prudential requirements on management of companies and enable minority shareholders to pursue grievances against their boards.
The following recommendations aim to further improve banking regulations and supervision in the Philippines: (i) limit shareholdings of nonfinancial companies in banks. reporting. Impose severe penalties for any attempt by banks to circumvent this regulation.g. For example. in areas of supervisory functions of the central bank. and related interests. and of banks in nonfinancial companies in order to avoid connected lending. Improving Financial Regulation and Strengthening Implementation The Asian crisis demonstrated the need to strengthen banking regulation. officers. It is encouraging that the newly enacted 2000 Banking Laws have introduced changes along these lines. (iii) adopt international standards of capital adequacy and ensure that banks comply with these standards. the board can easily muster the needed majority to approve the deal. fit and . and (v) closely monitor. current rules allow boards of directors to approve own-dealings or related party transactions by simple majority. in particular. the Corporation Code should be amended to impose sufficiently stiff penalties for self-dealings that patently expropriate the wealth of other shareholders. Finally. directors. They need legal empowerment such as higher majority voting requirements. The Government should improve its prudential supervision system to ensure that banks perform their role as external control agents of their corporate debtors. (iv) require banks to follow international financial accounting. raising the current two-thirds majority to a three-fourths majority. By requiring sufficient disclosure and a 75 percent majority vote on such decisions. (ii) set strict limits on lending by banks to affiliated companies. prudential measures and regulations. e. and disclosure standards.. or prohibit cross-guarantees by companies belonging to affiliated groups. Minority shareholders have failed to use traditional venues such as the annual general shareholders’ meetings to discipline controlling shareholders that expropriate their wealth. 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. limit. Because ownership is generally concentrated in five shareholders.Chapter 3: Philippines 221 cient case history that can be used as a basis for tightening its disclosure requirements.
222 Corporate Governance and Finance in East Asia. 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. The other is the addition of provisions in the Corporation Code to facilitate class action suits against corporate directors. management. Other investors benefit from the information that analysts produce for these institutional investors as information technology makes their output a public good. By supporting the establishment and operation of institutional investors. and lending to DOSRI. This way. and external auditors. One is improved transparency and disclosure on specific items that potentially involve expropriation of wealth of minority shareholders. The current law should expand class action suits to include management and . 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. Vol. SEC appears to be taking a primarily regulatory posture in the operation of investment funds. SEC and PSE can help ensure that these external control agents provide market discipline even in companies controlled by large investors. foreign ownership of banks. Promoting Shareholder Activism Promoting shareholder activism to encourage small shareholders to actively monitor management is an approach that has not been tried out in the Philippines. an active financial analyst community can begin to form. Two measures should be adopted to promote shareholder activism. institutional investors can be a driving force in providing market discipline to management. Its priority is to protect prospective fund investors from unscrupulous fund managers. II proper rule. In developed capital markets. Investment and venture capital funds meet this description. transparency. Managements find that their investment and financing decisions affect stock prices and become aware of their responsibility to create shareholder value. institutional investors lead public investors in providing market signals to companies. The absence of institutional investors indicates that the legal and regulatory basis is inadequate. Presently. Institutional investors impose market discipline by voting on strategic corporate decisions. If institutional investors are present.
compensation contracts. entry . and Credit Information Bureau that can be the starting point of this effort. Companies are likely to remain dependent on bank financing if the authorities do not strictly enforce prudential lending regulations. the Government could develop the market for future issues of corporate bonds. guarantees. Placing the means for prosecuting in the hands of minority shareholders may instill more discipline in controlling shareholders. 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 the external auditors. information disclosures. And by issuing Government Treasury securities in longer tenors.Chapter 3: Philippines 223 auditors. and dividend decisions. leadership. The present provision on class action suits is inadequate because shareholders view the process as ineffective and expensive. Philippine Government Treasury bonds should provide bellwether rates for corporate bonds in the way that they have for short-term bank debts. These groups have an incentive to gather technical expertise. Legal provisions for class action suits should cover self-dealing by directors. Promoting the corporate bond market requires that the Government develop trading systems and services of credit risk rating of corporate issuers. where the threat of class action suits alone is sufficient to encourage quality decisions and behavior from management. and broad-based political and popular support to pursue possible cases involving expropriation of minority shareholders’ wealth. their directors and management. It should develop a medium-term yield curve for the corporate debt market by strengthening the Government bond market. Promoting Competition in Product Markets The Government should pursue industrial development policies that promote competition through the elimination of subsidies. SEC should allow minority shareholders to be represented by activist groups. 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. The Government should enhance the securities markets as an alternative source of corporate financing and pursue aggressive development of the local debt securities markets. Securities market development efforts should coincide with strict regulation of the commercial banking sector. There are existing institutions such as Dun and Bradsreet.
The increase in percentage of public holdings may be gradually implemented to enable the companies to adjust. Increasing the Supply of Quality Equities in the Stock Market To promote the capital market as an external control agent in corporate governance. and provide quality basic services should also be heightened. Lack of liquidity deters institutional investors. Efforts to reduce graft and corruption. PSE and SEC need to build a liquid and efficient market. Little attention is given to the conditions that make those regulations effective in the US corporate sector but not present in the Philippines. 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. improve enforcement of the rule of law. II and exit barriers. Vol. The resulting absence of a strong investor base makes share prices vulnerable to manipulation or insider trading by large shareholders. The Government should also continue to improve infrastructure. Another problem is the orientation of external auditors to the interest of large shareholders rather than public investors.224 Corporate Governance and Finance in East Asia. Improving External Audit Standards and Information Disclosure Effective external control in corporate governance requires accurate and timely information about companies. SEC should require that a larger percentage of publicly listed companies’ shares be sold to the public. Many large companies remain privately owned. 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.and medium-scale companies can become more competitive relative to large companies. and publicly listed companies trade barely the minimum number of shares required for public listing. The Government’s competition policies should aim to facilitate the free entry and exit of domestic and foreign companies and regulation of anticompetitive practices. Audited financial statements contain basic information about a company’s financial position and performance. Current disclosure requirements of SEC are not rigorous enough for public investors. so that small. Penalties for poor conduct of auditing by independent . and various other forms of protection. there is a need to increase the supply of quality securities from top-tier local companies in the Philippine stock market.
it creates a moral hazard problem. Reorganization. Although the new Securities Regulation Code enacted in 2000 has removed some of SEC’s quasijudicial functions. SEC and PICPA need to formulate more specific disclosure standards. and transferred these to courts. PD 902-A has not accomplished any successful rehabilitation of a petitioning company since its implementation. violators were made to pay only nominal penalties. including the resolution of intracorporate disputes. The law on suspension of payments replaces a market-oriented solution with a political process. Reforming the legal framework for suspension of payments. reorganization. suspension of payments and private damage actions.Chapter 3: Philippines 225 auditors and the mechanism for imposing them are weak. and liquidation of troubled companies should be made a priority of the Government. and implement those standards and penalties rigorously. Instead. Improving the Legal Framework for Suspension of Payments. review the system of penalties on professionals involved in a company’s violation of disclosure rules. and Liquidation. the new law needs to be effectively implemented and enforced. For that matter. 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. SEC and PICPA have not publicly penalized any auditor company that violated disclosure requirements or failed to submit audited financial statements. In spite of the many well-known cases of poorly audited financial statements that resulted in losses for investors. .
Tokyo: Institute of Developing Economies. 1997. and Corporate Diversification. and Larry H. Journal of Financial Economics 25: 371-395. October. Monitoring and the Value of the Firm. Thailand’s Corporate Financing and Governance Structures: Impact on Firms’ Competitiveness. Claessens. Denis. Bangko Sentral ng Pilipinas. Vol. Harold. Key Indicators of Developing Asian and Pacific Countries 1998.226 Corporate Governance and Finance in East Asia. 1998. Journal of Finance 2 (1). 1985. Equity Ownership. Joseph P. Claessens. 1994. Stijn. H. Fan. Stijn. Michael. and Simeon Djankov. Jr. July. 693-728. Simeon Djankov. Discussion Paper. P. and Kenneth Lehn. edited by Toida Mitusuru and Daisuke Hiratsuka. P. Lang. Diversification and Efficiency of Investment by East Asian Corporations. Simeon Djankov. Institute of Southeast Asian Studies. 1997. May. M. H. 1998c. Private Benefits from Control of Public Corporations. Fan. David J. 1988. Working Paper. Pedro. 1999. Dennis. Simeon Djankov. Emilio. and Atulya Sarin. Asian Industrializing Region in 2005. Expropriation of Minority Shareholders in East Asia. Simeon Djankov. Claessens. Stijn. World Bank. and Larry H. Stijn Claessens. The Philippines: Onward to Recovery. 1999. George. Manila: Asian Development Bank. 1998a. Philippine Macroeconomic Prospects: The Next Ten Years. Joseph P. Quarterly Journal of Economics. Simeon Djankov. Journal of Political Economy 93 (6). World Bank. Alba. P. World Bank. Lang. . Agency Problems. 1989. Joseph Fan. Thailand: From Financial Crisis to Economic Renewal. H. and Larry H. P. Vol. Lang. Working Paper. Diane K. World Bank. Conference on Thailand’s Dynamic Economic Recovery and Competitiveness. Asian Development Bank. Stijn. 1998.. March. and Clifford Holderness. 1998b.. Who Owns and Controls East Asian Corporations? Discussion Paper 2054. The Structure of Corporate Ownership: Causes and Consequences. The Separation of Ownership and Control in East Asian Corporations. and Larry H. Ownership Structure and Corporate Performance in East Asia. Burkart. Demsetz. and Larry H. Stijn. Lang. World Bank. Antonio. Working Paper 2088. Dennis Gromb. Joseph P. Claessens. P. Lang. Claessens. 1999. Fan. Barclay. Large Shareholders. and Fausto Panunzi. XXIX. II References Abonyi.
Agency Costs and Ownership Structure. and the Theory of Investment. Michael. Determinants of Corporate Borrowing. Gestner. Journal of Finance 48: 831-80. 1984. 1995. 1991. Journal of Financial Economics 3: 305-360. Myers. Takeo. Stuart. Michael. The Quarterly Journal of Economics. Capital Structure and the Information Role of Debt.. Internal versus External Capital Markets. Stein. American Economic Review 76: 323-29. Corporate Finance and Takeovers. Franco. and Jeremy C. Corporate Governance: Emerging Issues and Lessons from East Asia. 1977. American Economic Review 85: 567-85. The Market for Corporate Control: A Scientific Evidence. Stephen.Chapter 3: Philippines 227 Diamond. David S. 1990. and David Gallagher (eds. Euromoney Books. 1958. Michael. Financial Intermediation and Delegated Monitoring. 1994 and Investment Guide 1997. Agency Costs of Free Cash Flow. Lufkin. Institutional Investment Patterns and Corporate Financial Behavior in the United States and Japan. Douglas. Exit. Robert H. 1993. 1983. American Economic Review 48 (3): 261297. and John Moore. Michael. Jensen. The Cost of Capital. Scharfstein. and Richard Ruback. 1995. Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management. Oliver. World Bank. 1994. and William Meckling. Prowse. Anil Kashyap. Jensen. Journal of Financial Economics 11: 5-50. The Modern Industrial Revolution. 1990. Journal of Finance 45: 321-350. Journal of Financial Economics 27: 4366. 1986. Quarterly Journal of Economics 106: 33-60. November. and the Failure of Internal Control Systems. Philippine Stock Exchange Fact Book 1997. 1990. Prowse. Corporation Finance. Joseph C. Stephen.). International Corporate Governance. and David Scharfstein. Jensen. Jensen. . Corporate Structure. Hart.. Liquidity and Investment: Evidence from Japanese Industrial Groups. Theory of the Firm: Managerial Behavior. Harris. Journal of Financial Economics 5: 147-175. and Artur Raviv. Milton. Modigliani. F. and Merton Miller. Hoshi. 1976. Review of Economic Studies 51: 393-414. 1998.
Internal Capital Markets and the Competition for Corporate Resources. and Banking Lecture 17. and Robert W. Some Conceptual Issues in Corporate Governance and Finance. Washington. . 1998. Vishny. David. Stephen. DC. 1992. Journal of Finance 91: 1121-1139. Journal of Money. 1985. IFC/WB. The Structure of Ownership in Japan. No. 1998. Shleifer. Mimeograph. World Bank. Jeremy C. Webb. Shleifer. Journal of Finance L11: 737-783. Andrei. II Prowse. Journal of Finance LII. Credit Markets and the Control of Capital. Technical paper No. How Do Large Corporations in Developing Countries Finance their Growth? Corporate Financial Structures in Developing Countries. Vishny. Stein. Vol. Joseph E. No. and Robert W. November. Large Shareholders and Corporate Control. Stiglitz. Journal of Political Economy 94: 461-88. Ajit. 1996. East Asia: The Road to Recovery. May. 1997. Washington. 1.228 Corporate Governance and Finance in East Asia. DC. 1997. March. Asian Development Bank. 2. Singh. 1. Andrei. 1991. A Survey of Corporate Governance. Credit.
Korea). As a result. heralding not only a financial crisis in the country. In the prelude to the 1997 crisis.1 Introduction In May to July 1997. but also the stalling of East Asia’s “economic miracle. poorly regulated and sheltered from competition. the Thai Government conceded and adopted a floating exchange rate regime. For the period 1994-1996. The majority of these debts were not properly hedged. both of ADB. and Philippines all depreciating significantly. coupled with financial liberalization and deregulation in the absence of an effective regulatory and supervisory system. The banking system. Thailand’s crisis exposed similar vulnerabilities in other East Asian economies. with Thai corporations overutilizing short-term foreign currency-denominated loans. Faculty of Business. . the banking system merely validated the financial risks. with the currencies of Indonesia. Thailand. David Edwards. Instead of serving as a buffer between the large inflow of foreign capital and the corporate sector. magnified the impact of these problems on the economy when the crisis hit. Republic of Korea (henceforth. The crisis in Thailand stemmed directly from unsound macroeconomic policies and imbalances. The corporate sector also contributed significantly to the crisis. short-term private debt obligations grew to about 60 percent of total private sector debts. annual short-term capital inflows to Thailand were equivalent to 7-10 percent of gross domestic product (GDP).4 Thailand Piman Limpaphayom1 4. the Stock Exchange of Thailand for its help and support in conducting company surveys. But it also laid bare weaknesses in both the financial and corporate sectors. The author wishes to thank Juzhong Zhuang. the Thai baht came under pressure from speculative attacks. It was inefficient in financial intermediation. Malaysia. The fixed exchange rate policy. Asian University of Science and Technology. and Lea Sumulong and Graham Dwyer for their editorial assistance. 1 Associate Professor. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. Thai corporations were collectively overexposed to exchange rate risks. Chonburi. had been plagued with prudential problems for a long time.” After mounting an aggressive defense of the currency.
while new industries were encouraged to reduce the need for imports.2 discusses the development of the Thai corporate sector under the National Economic and Social Development Plans.3 looks at corporate ownership patterns that resulted in inadequate protection for minority shareholders and weak corporate governance in Thailand.230 Corporate Governance and Finance in East Asia. Import tariffs on machinery and heavy equipment were removed.5 discusses how the corporate sector contributed to the financial crisis and looks at its impacts.2 4. The study then considers policy recommendations with emphasis on corporate governance improvement. Section 4. Section 4. II There is now a consensus that weak governance was partly responsible for the corporate sector’s poor financing and investment practices. its growth and financial performance. focusing mainly on the companies listed in the Stock Exchange of Thailand (SET).2. To protect domestic industries. 4. This study examines these and other factors that might have weakened corporate sector governance in Thailand. with government policy providing support but avoiding direct interference.1 Overview of the Corporate Sector Historical Development The corporate sector has long been considered the engine of Thailand’s economic growth. the Government implemented major infrastructure projects and modified its tax policy to encourage capital investment and savings. The National Economic and Social Development Board was created to plan the country’s economic and social development. the Government increased tariffs on products that could be produced locally. as well as its legal and regulatory framework. Section 4. Section 4. . Key factors that led to weak corporate governance include the ineffectiveness of the regulatory framework. The country initiated national economic development planning in 1961 when the economy was growing rapidly. and a family-based corporate ownership structure. The First and Second Plans (1961-1971) Under the first two plans. lack of transparency and adequate disclosure. Vol.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.
In the wake of lower world oil prices and the rapid growth in income from the tourism and travel industry. the current account registered a surplus in 1986.6 percent per year. The results were increased exports. averaging 1. Inflation reached 15. with the agricultural sector the major contributor. Thus. the government’s debt burden escalated.4 percent of GDP. The focus shifted to export promotion. However. however. and reduced current account deficits. especially foreign aid from the United States. resulted in increases in the current account deficit. Budget deficits also increased throughout the Fourth Plan. helped offset these deficits. and increases in world food and oil prices. remaining high until 1981. External factors. textiles. became a major problem as domestic investment declined. But the sustained importation of heavy machinery and equipment resulted in large trade deficits. To close the fiscal gap. Budget deficits remained a major problem during the Fifth Plan. leaving the Government no choice but to resort to overseas borrowings. The decline in imports was steady. the value of the baht remained stable. using tax policy to control prices of consumer goods and implementing several price control measures to curb inflation. The average budget deficit reached an all-time high of $2. processed steel. The Third. an improved trade balance. . including luxury goods. canned foods. The Government decided to embark on restructuring measures in the Fifth Plan (1982-1986) to rehabilitate the ailing economy. with the devaluation of the baht in 1984 a major step in this direction. The Government had to shift emphasis to restoration of economic stability. capital inflows. and automobile assembly) emerged. it proceeded with its development plan for the industrial sector.Chapter 4: Thailand 231 During this period. Consequently. the Government borrowed $6. lower than anticipated due to a worldwide economic recession. Fourth. Unemployment. the industrial sector grew at a faster rate than the agricultural sector.4 billion from overseas and increased taxes on numerous items.5 percent in 1973 and 24. and Fifth Plans (1972-1986) An economic downturn at the end of the Second Plan led to an adjustment in policies. however. Inflation levels were low.15 billion per year or 4. including a weakening of the dollar. Average growth for the period was 4 percent per year. chemicals. At the same time. As a result.3 percent in 1974. gross national product grew by about 7 percent per year. Industrial sector growth was also rapid and many industries (tires.
China—went to export-oriented manufacturing industries. invited a deluge of capital seeking profitable investments. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. the bulk of domestic investments went to speculative ventures such as real estate. and the stock market. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. Average annual growth in real GDP was 8 percent. United States.232 Corporate Governance and Finance in East Asia. and Hong Kong. an oversupply of housing emerged. the property sector began to collapse in 1996.8 percent.2 and 13. lower than the target of 8. compared with the 14. increasing its share in total export value from 42 to 76 percent. from only $31 billion in 1992.2 percent target. reaching an annual inflow of $2 billion in 1991. The country’s high ratings in the international capital market. The exchange rate was steady at around B25 to the dollar. property development. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. The country also attracted a large amount of foreign direct investments (FDIs). compounded by a slump in property sales. with private foreign debt reaching $92 billion by the end of 1996. while exports expanded considerably. respectively. combined with its liberal financial policies. better than the 5. By 1995. Europe. Growth of exports and imports averaged 14. On top of its predominantly “borrowed” nature. Thailand became a debtor’s market. The manufacturing sector became a dominant force in the economy.4 percent targets. Most of the FDIs—originating mainly from Japan.5 percent. compared with the 8. . Growth rates during 1987-1991 ranged from 9. From 1989. Vol. Singapore.5 to 13.6 percent target of the Seventh Plan.6 percent. Private sector investment grew at an average annual rate of 7 percent.8 percent.2 percent per year. rather than to productive activities. Inflation was 4. Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies.7 and 11. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. averaging 10. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due.
And because the Government considered the banking system vital to the development of the economy. many companies considered the Act too restrictive and a hindrance to growth. SET officially became “the Stock Exchange of Thailand” in 1991. However. a policy that held throughout the first six economic development plans.” which later became the master plan for the development of the Thai capital market. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. the capital markets didn’t play a significant role until 1975. Sidney M. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996.2. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. a former Chief Economist from the US Securities and Exchange Commission.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. its policy had always been to protect domestic banks. In 1972. Robbins.8 percent in 1995 to 1. 4. on account of an overvalued baht that weakened export competitiveness. the signs of an economy about to falter were there. In his report. which was amended in 1979 and 1985. which raised the debt service ratio. Before the capital market emerged. placing all publicly listed companies under regulation. the corporate sector’s main source of funding was the banks. Foreign banks were barred from competing directly with domestic banks. the Government amended the “Announcement of the Executive Council No. the Government passed the Public Limited Company Act. In 1969. The deficits caused the Government to rely on even more external borrowing.Chapter 4: Thailand 233 Toward the end of the Plan period. 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. Under the 1962 Commercial Banking Act. In 1978. the Bank of Thailand and . In May 1974. with growth shrinking from 23. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development. Exports went into a tailspin.3 percent in 1996. prepared a comprehensive report entitled “A Capital Market in Thailand. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975.
The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. With the liberalization of financial markets. Externally. Earlier. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. Thailand’s capital market entered a new era with improved legislation and regulation. increased financial market activities. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. to cater specifically to its . Vol. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. In the 1990s.” The Government also granted financial institutions overly generous bailouts. the financial and banking laws were generally ineffective. Laws were enacted to stimulate growth of the corporate sector. while the Securities and Exchange Act (SEA) the same year sought to improve capital market supervision. and the General Agreement on Tariffs and Trade (GATT) meeting in Uruguay had the liberalization of financial services on its agenda. While the Bank of Thailand had the regulatory power to influence business practices.234 Corporate Governance and Finance in East Asia. the World Bank had recommended such a move. Thai banks gained access to a variety of funding sources from around the world. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. However. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. the Government was under international pressure to deregulate the financial sector. 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. II the Ministry of Finance had full authority to supervise all commercial banks. Economic growth had been rapid and domestic savings could not keep up with the pace to support investments. and new financial instruments. At the end of the Sixth Plan. it usually relied on “moral suasion. The regulatory measures were inadequately designed and poorly enforced.
4.3 83.2 11. .291. the financial sector is the largest. Hunting. 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. finance.1 Public Companies Registered.0 21. and Water Construction Wholesale and Retail Trade.101. Storage.394.9 261. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4. In terms of capital. Social and Personal Service Total Note: The data for 2000 is as of October 2000. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.5 111.3 trillion have been registered with the authority (Table 4.1 trillion and paid-up capital of B1. Thailand.6 23.5 791.6 2. Worldwide. and Communication Financing.1 78. however. Gas.9 1. about 661 companies with total registered capital of B2. Forestry. Real Estate. and Business Service Community.0 110. with B1. in that order. The majority of the companies are in manufacturing.9 16.2 Type of Business Agriculture. Ministry of Commerce. The result was a corresponding growth and development in Thailand’s capital markets. Source: Department of Commercial Registration. and wholesale/ retail trade and restaurant/hotel sectors.5 50. the country became recognized as an economic development model for other emerging economies.0 19. and Restaurants and Hotel Transport. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies.0 Paid-up Capital (B billion) 1.9 34.6 1. Financial deregulation and liberalization were key to realizing that vision.2. and Fishing Mining and Quarrying Manufacturing Electricity.1 30.4 trillion in registered capital and B791 billion in paid-up capital. Insurance.6 350.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act.Chapter 4: Thailand 235 fast-growing neighbors.1).
The preeminence of the financial sector is a direct result of financial deregulation and liberalization. the capital market became instrumental in the rapid growth and development of the corporate sector. Securities and Exchange Commission of Thailand. reaching a precrisis peak in 1996 (Table 4. meanwhile.5 — — 56.8 151.5 39. The signing of Article VIII with the IMF. The 1997 crisis battered the primary market for securities.7 136.0 0.0 1994 82. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.6 39.4 34.0 20. the value of public offerings rose steadily.5 billion and B1 billion the previous year.3).7 billion in 1996.7 billion and B27. II B261 billion.6 7. These peaked at B89.1 286.7 9. The number of listed companies and securities steadily increased until 1996 (Table 4.3 1996 1997 65.7 5. Market capitalization.3 31. The development of the corporate sector closely followed the development of capital markets.6 — = not available. the year before the crisis struck. respectively. allowed Thai financial institutions and corporations to obtain funds overseas.8 — 26.6 174.1 599.9 31. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement.9 1998 1999 15.2 12.5 1. Source: Key Capital Market Statistics.2 25.5 1.7 27.1 — — — 6.3 194. reached .2 40. After the passage of the SEA of 1992.3 6.2 5. moreover.4 277.9 37.3 22. The stock market also became an invaluable source of funds for corporations.2 Public Offerings of Securities.4 51. 1992-1999 (B billion) Type of Securities Equity Debt Instrument Domestic Offering Offshore Offering Hybrid Instrument Domestic Offering Offshore Offering Total Funds Raised 1992 1993 1. Vol. Table 4.8 1995 64.6 8.4 96.8 billion.1 54. reducing the value of offerings to a little more than a quarter of the previous year’s level.8 201.7 7. While a rebound was apparent beginning in 1998.2). Domestic and offshore debt issues reached B54. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.236 Corporate Governance and Finance in East Asia. from only B20.1 2.
was the ominous deterioration in the key financial ratios of publicly listed companies.303 930 855 1. The financial leverage of all companies declined until 1994.5 at its peak in 1987. corporate profitability had been declining.268 2.683 1.301 3. While the decline in gross profit margin was not as sharp. and gross profit margin. ROA dipped from 10. The key financial ratios of all companies listed on SET bear this out (Table 4.360 1. not all public companies are listed on the SET. gross profit margin rose until 1991 before falling in 1992.133 1.281 832 373 356 482 Due to listing requirements and other reasons. 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. Side by side with this surge of financing for corporate growth. Meanwhile.565 2. Source: Securities and Exchange Commission of Thailand. pulled down by active public offering activities. had been on the rise throughout the 1980s.535 1. its high point in 1995 at B3. the companies could not generate enough net returns from their assets and equity. return on equity (ROE). Throughout the 1990s. The trend reversed in 1995. ROE similarly fell from 21.114 1. however. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . when long-term debt grew as Thai corporations began to borrow heavily to finance growth. The upward trends for ROE and ROA continued through 1989. Foreigners accounted for an increasing proportion of SET’s turnover value.4). however. By the early 1990s.610 1.3 percent in 1989 to 3. the average times interest earned (TIE) was down to 5.4 percent in 1996. as measured by return on assets (ROA). the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. resulting in their inability to fulfill debt obligations.193 2.6 trillion. their share rising from 17 percent in 1993 to 43 percent in 1997.Chapter 4: Thailand 237 Table 4.3 Statistical Highlights of the Stock Exchange of Thailand.8 percent. then stalled in 1990. From 10.1 by 1996. the averages for all three profitability ratios took a downswing all the way until 1996. in the end. Corporate profitability.560 1. But instead of shifting to a low gear.4 percent to 5.325 3.201 2.
0 125.1 60.8 151.0 7. Korea and Thailand had the highest debt-to-equity ratios.4 12.2 35.4 5.7 5.6 125. Vol.7 12.2 161.1 52.1 242.4 7. They were generally more efficient in managing their assets and . these companies opted for debt. Overall. was also distinct in the region.5 63.7 34.0 63.4 34. Severely affected by global competition throughout the decade. The downtrend in corporate profitability. A major reason for this was the rapid rise in asset prices.6 27. Thailand’s ROE.2 10.9 66. Among the crisis-hit countries.1 16.7 35.5 51.2 27. Hotels and travel showed the highest ROE of 15 percent while textiles. resulting in higher collateral values for borrowers.7 80.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.9 51.0 139.1 114.9 7.2 49. and footwear had the lowest at 11 percent. the textiles.9 8.3 10. which was particularly significant in the two years preceding the crisis.6 36.4 3.7 27.0 29.4 7.0 145.5 15.9 27.1 9.5 30.1 120.3 8.4 119.8 5.1 16.6 138.8 5.8 88.4 44.1 44.8 51.6 168. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.7 12. Despite the availability of the equity market.4 9.9 39.3 12.4 51.8 8.6 12.9 140. clothing.3 4.8 14.7 20.4 139.2 27.6 7.7 5.4 28.9 14. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.7 12. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. II Table 4.4 12.0 117.0 3.4 4.5 52.9 77.7 5.4 18.2 64.7 4.3 91. clothing. practice of heavy borrowing.7 54.8 25. US.6 41. which fell from 16 percent in 1991 to just under 6 percent in 1996.8 11.9 144.7 21. 1985-1996 LongTotal Term Total Return Return Gross Debt Debt Debt on on Profit Times to to to Assets Equity Margin Interest Equity Equity Assets (%) (%) (%) Earned (%) (%) (%) 3.2 10.5 50.9 7.7 59.5).238 Corporate Governance and Finance in East Asia.8 54.2 215.7 15.2 6.6 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. was felt across industries.7 27.4 24.4 26.5 38. and footwear industries also experienced losses.2 10.7 12.4 47.4 Key Financial Ratios of Publicly Listed Companies.5 9.
3 15.4 8. by the 1990s. capital despite the higher gross margins of small companies. the law disallowed cumulative voting. However.3 176.3 52.7 10.2.2 121. .2 10.6 30. Although stable in the 1980s. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.5 7. weaknesses became evident.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.2 12.4 Legal and Regulatory Framework Before 1992.6 7. measured by total asset turnover.6 30.3 23.1 6.0 83.8 142.8 47.5 Average Key Financial Ratios by Company Size. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.1 29.8 62.5 6. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales.6 31.9 13.1 5. which would be disruptive to company management.2 18.4 116. the overall activities of listed companies.8 6.1 25.6 12.8 26.1 13.3 43.Chapter 4: Thailand 239 Table 4. They also tended to use more financial leverage than small companies as their total DERs show. In sum.6 5.6 10.3 164.6 6.6 61.3 88.3 49. For instance. US. it was thought.7 6.5 87. could lead to a high turnover in the board.9 20. total asset turnover declined after 1989. also deteriorated.0 48. 1985-1996 Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6. During the 1990s.0 20.2 134.8 6. 4.8 10. Cumulative voting. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.1 Small Medium Large 5. although the performance of listed companies in the late 1980s was strong.3 135.3 49.3 25. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.4 52.5 94.7 14.
The law prohibited the largest shareholders. the limit on shareholdings by the largest shareholders was increased from 50 to 70 percent of total outstanding shares. As the succeeding sections point out. The protection of minority shareholders was inadequate under the Public Company Act of 1992. for instance.5.240 Corporate Governance and Finance in East Asia. The original company owners welcomed the changes and the number of publicly listed companies subsequently rose to more than 600. The Public Company Act of 1992.3 Corporate Ownership and Control Ownership and control of corporations in Thailand are highly concentrated. 2 ADB survey questionnaires were sent to all Thai listed companies in early 1999. coupled with weak corporate governance.2 The market for corporate control was not active and did not give managers strong incentives to perform efficiently. Vol. and the punishment for management misconduct was also lightened considerably. 4. played an important role in bringing about the financial crisis. adopted to promote the development of publicly listed companies. Cumulative voting was made optional. However. from holding more than 50 percent of total outstanding shares and other shareholders from holding more than 10 percent of outstanding shares individually. a feature that is believed to have impaired the effectiveness of existing regulatory mechanisms in the corporate sector. relaxed the contentious provisions of the 1978 Public Limited Company Act. that creditors had generally little influence on the management of corporations. but not all questions were answered. The legal and regulatory framework for the corporate sector also includes provisions related to insolvency. An Asian Development Bank (ADB) survey conducted for this study shows. As it turned out. the exit of these provisions appears to have contributed to the 1997 financial crisis. The provision discouraged original family owners from registering their companies. concentrated ownership. Fortysix companies responded. II Another issue was the proportion of shareholding by top shareholders. as a group. . the new legislation removed a number of incentives that would have kept public companies prudent and diligent in their operations. This will be discussed in Section 4. and external monitoring and control of corporations were also weak.
4 26. China firms have the highest single shareholder ownership concentration at 35. creditors.1 percent of control rights.9 52. In contrast.0 7. Indonesian.4 percent of outstanding shares.3 percent.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.9 52.6 4. Table 4. But with their increased reliance on new varieties of equity and debt instruments.3 5.0 5.1 3.7 12. Thai.0 53.Chapter 4: Thailand 241 4.6). In the past. there were only slight variations in the pattern.1 5.8 32. 56. Stock Exchange of Thailand.3.1 7. Across industries.0 7. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings. Ownership Concentration Between 1990 and 1998.4 4. 33.9 55.4 26.1 5. with the top three shareholders accounting for almost 50 percent (Table 4.9 11. 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.9 percent of shares of a company.9 6.2 4.4 26. Most large Thai corporations listed on SET started out as family businesses.0 3.4 10.7 6. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28.3 7.4 6. respectively.9 3. the top five shareholders of each of publicly listed Thai companies held.9 3.6 57.3 11. on average.8 11.9 52.5 28.9 4.4 6.0 56.8 5. and Hong Kong.5 Average for 1990-1998 period.7 7.7 percent.1 4.2 56. these companies obtained funding solely from banks or from their own retained earnings.9 26.1 12. Ownership was most concentrated in the packaging. one would expect the public.6 27.3 7. this was not the case.2 11.2 4. .7 11.9 54.3 16.1 5.4 5.5 9.3 percent and 18. and 28.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.0 3.6 68.1 11. and minority shareholders to stake their claim in the control and regulation of these companies.China have the least concentrated ownership. Unfortunately.2 4.6 28. with the largest shareholder on average controlling 10. Source: Comprehensive Listed Company Information Database.3 28.
and building and furnishing industries.7 Statistical Relationships between Corporate Profitability.058* ROE (0. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.001) 0. Through these holding companies.029 3. *** at the 1 percent level. Vol. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries.8). Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. On the other hand. as measured by debt-to-equity and debt-to-asset ratios.116) Debt-to-Equity (1.003 0.800 0. Company size is significantly related to ROE and leverage. with a top-five ownership concentration of at least 60 percent. owning 26. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies.080 6.005** 0. ** at the 5 percent level. including those that are publicly listed . Leverage. II agribusiness. there is no statistically significant relationship between ownership concentration (measured by percentage of shares owned by the top five shareholders) and profitability of Thai publicly listed companies (Table 4.072) (0.001 0. Based on a regression analysis. * Denotes significance at the 10 percent level. 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. US. results show a significant positive relationship between ownership concentration and financial leverage. Ownership Concentration. year.7).115 9.242 Corporate Governance and Finance in East Asia. founding families maintain effective control of entire groups. and ownership types.037 0. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.090 0.169*** 0.647 Note: The regression included dummy variables for industry.7 percent of outstanding shares on average (Table 4.022*** 0.031 3.001*** 0. Table 4.034*** 0.533)*** Debt-to-Assets (0.
with 29.6 28.1 4.9 7. . The largest shareholder is Central Holdings Company.5 Individuals 13.8 23. in SET.8 0. one of the founding members.1 1.5 1. operates five of the most successful shopping malls in Thailand. Stock Exchange of Thailand.3 0.8 1. Although holding companies set up affiliate firms.3 27.5 5. a NBFIs denotes nonbank financial institutions.5 Government Other 0.4 20.8 28.5 1. the affiliate firms rarely hold shares of their parent companies.7 Bank 2.5 0.9 18. In addition. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.6 1.0 3.2 1.4 1.9 19.4 1. Established in 1980 with a registered capital of B300 million.3 — = not available. including finance and investment companies.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.5 0.2 1.7 — 1.3 1. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.3 1. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. In 1994.3 27.3 20.Chapter 4: Thailand 243 Table 4.6 1.6 5.0 19.6 1. Individual family members also hold a significant amount of outstanding shares.4 22.2 18. the company increased its registered capital and became a public company listed in SET. These individuals usually hold important management positions in concerned companies.7 5.6 25.5 2.3 1.0 18.5 0.2 7. This practice is illustrated by Central Pattana. the company.4 1.5 percent. Typically.9 0.1 0.7 1. a company listed in the real estate sector of SET. The top 10 shareholders include a holding company owned by the Tejapaibul family. The ADB survey indicated that listed companies held shares in an average of 11 companies.6 percent of outstanding shares.9 6.9 15.3 27. owned by the Chirathivat family.3 percent of outstanding shares. unlike in Japan where crossshareholding is common.7 0.0 17. individual members of the Chirathivat family aggregately hold 25. averaging about 18. Source: Comprehensive Listed Company Information Database. a joint venture among three families.5 NBFIsa 6.2 5.1 1.5 26.
5 percent of total outstanding shares of listed companies. There was a trend of rising government shareholdings throughout the period 1990 to 1998. where the top three shareholders are the Ministry of Finance.. Although the list of top shareholders of publicly listed companies includes financial institutions. they account for 80 percent of total outstanding shares. the predominance of individual family members and holding companies in the top shareholder list remains valid. 4. Except in the hotel and travel service sector. Thai Airways International Plc. However. on average. Nonbank financial institutions hold an aggregate 5. with the envisioned privatization master plan. the top 10 shareholders consist predominantly of members of founding families and their holding companies. II another of the company’s founding members. By owning 62 percent of voting shares. only one tenth of listed companies have commercial banks on their top-five shareholder list.1 percent of total outstanding shares of listed companies. these shareholders are able to control the company. 1.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. Moreover. has the Ministry of Finance as its only large shareholder with 92. Together. roles. the Government’s role in public companies is expected to decline. and responsibilities of directors of public companies. In effect. duties.5 percent of total outstanding shares.3. and a state bank. 3 Discussions in this section are based on results of company surveys by SET and ADB. Another example is Bangchak Petroleum Plc. both conducted in 1999. commercial banks account for only 1.244 Corporate Governance and Finance in East Asia. The Government holds. the Petroleum Authority of Thailand. . Across industries. About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. they exercise limited influence in operations because of the restricted size of their shareholdings. In such cases. Only a handful of companies have the Government among their large shareholders. Vol. the Government owns the majority of the shares. On average.9 percent of outstanding shares. qualification. For example.
In five other companies. Generally. . Although 28 percent of the chairpersons came from the ranks of independent outside directors. an executive board consists of senior management and some main board members. The appointment of the chief executive officer (CEO) needed approval during the AGSM in 11 of the responding companies. the ADB survey found that 31 companies (out of 46 responding) required outside directors to be present at all board meetings. Some companies (36 percent) had five to six main board members holding seats in their executive boards. Most companies (83 percent) satisfied SET’s requirement of having two independent board members. directors shall be elected at the annual general shareholders’ meetings (AGSMs). and to comply with the laws and articles of association. If found in violation of these provisions. Almost all companies (98 percent) exceeded the minimum required five members in their Board of Directors. while 30 percent of respondent companies held board meetings monthly. In their business conduct. but not in 22 others. meanwhile. the majority (71 percent) had board chairs who were also members of top management teams. directors are required to act with care and honesty for the company’s best interest. 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. Many companies have a formal policy on corporate governance and business ethics. directors may be imprisoned or fined. A survey by SET found that the majority (58 percent) of the 202 responding companies held their board meetings every quarter. Nineteen companies stated that selection was based on professional qualifications. Unless stipulated in public companies’ articles of association.Chapter 4: Thailand 245 Directors are required to meet minimum qualifications specified under the SEA of 1992 and the Listing Rules issued by SET. The ADB survey indicated. Meanwhile. Three companies indicated that the CEO and the chair were close relatives. directors could be compelled to compensate the company for damages arising from their misconduct. selection was based on relationships with controlling shareholders. In addition. while 15 percent of respondents went beyond the requirement. that only in two of the 46 responding companies were the chair of the boards elected based on the extent of their shareholdings.
Half of the companies in the SET survey had a separate remuneration committee. In one company. All respondents confirmed the use of external auditors. the majority of the companies (77 percent) did not have outside directors as members of their remuneration committees. Directors with managerial responsibility or those related to major shareholders cannot be members of such audit committees. In 25 companies. These committees were mainly responsible for determining compensation for senior and regular staff. SET’s attempts to bring accounting practices to international standards have included requiring listed companies to consolidate all liabilities— including those on off-balance sheets—in their financial statements beginning June 1998. however. Vol. the remuneration packages had to be approved during AGSMs. II Compensation of Directors. Audit Committees and Accounting Standards Since January 1999. Fourteen other companies had profit-related incentive schemes in addition to fixed fees. with 41 firms admitting the use of services of international auditing firms. while 19 companies observed only some of them. Twenty-five of the 46 respondents to the ADB survey declared adherence to all relevant international standards. not an independent assignment. The SET survey found that the majority of listed companies (81 percent) still have no separate audit committee. and CEO The majority of company respondents to the SET survey provided similar compensation packages to internal and external directors. Where different. the work of this committee was often considered part of the executive board’s responsibilities. Companies already with audit committees did not have independent outside directors as audit committee members. The ADB survey indicated that 18 of the 46 responding companies compensated their chairpersons using a fixed-fee schedule. Also. However.246 Corporate Governance and Finance in East Asia. all listed companies have been instructed to establish audit committees to be responsible for examining the quality and reliability of company financial statements. Three companies allowed their management to determine the chair’s compensation package. these were attributed to variations in the extent of duties and responsibilities assumed by those directors. the auditor is not . Chair. 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.
as well as the registration and holding of shares. SET. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. The Act. stipulates the proper conduct of shareholder meetings. shareholders have access to reliable information at no cost. According to the ADB survey. and executive committees. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. there are also significant gaps in the system of shareholder protection. most responding companies have rules and regulations intended to protect shareholders. likewise.Chapter 4: Thailand 247 independent from the company. (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. with 13 companies allowing proxy voting through mail. (iii) Because the chair is frequently also part of the top management team. Relationships between firms and external auditors are generally long-term. or other financial instruments. (i) No standards are enforced in the content and timing of notices for shareholder meetings. remuneration. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. For instance. The Act also holds directors liable for any damage to shareholders. While safeguards are in place. Forty-four companies indicated that they had proxy voting in place. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. debentures. shareholders can claim compensation in cases of negligence or dishonesty by management. As a result. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. In the majority of these companies (38 out of 46 respondents). SET’s rules and regulations closely follow this Act. SEC. However. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. there is the danger that top management may be capable of unduly influencing the board’s decisions. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. 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. and the Bank of Thailand— are not clearly defined. although recently. At least 28 responding companies had the following .
On paper. While stimulating the growth of the sector. and call an extraordinary session. 66 percent of total outstanding shares. representing only about 28 percent of shareholdings. they comprised only 8 percent of total shareholders. Banks would be obvious candidates to implement these mechanisms. Vol. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. takeover of the company. it would be difficult for minority shareholders to gather the shares needed to take action. Almost 82 percent of shareholders. Although the attendees held. and insider trading.248 Corporate Governance and Finance in East Asia. however. In effect. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. given their importance in providing finance and their stake in companies. In practice. . did not vote in previous AGSMs. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. But with the ownership concentration of Thai companies.3 External Control Control by Creditors The fact that insider control in Thai companies is very strong should compel a search for alternative external control and monitoring mechanisms. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. such protection has been insufficient. But the exercise of these rights requires even higher shareholding levels. on average. minority shareholders are assured adequate legal protection. In theory. 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. Only a small number of shareholders attended the latest AGSMs. and mandatory disclosure of related interests and significant shareholders’ transactions. 4. the only group of shareholders that can exercise rights is the top five shareholders. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results.3. 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.
Debtors had many handles to stall the bankruptcy process. Seven of the companies responding to the ADB survey indicated that all their creditors required collateral. to solve debt repayment problems. while loans for fixed investment were also more likely to be supported by collateral. Only three companies thought otherwise. the majority believed that creditors had little influence on company management and decision making. Actual bankruptcy proceedings took more than five years on average. Thailand has relied on commercial banks and finance companies to channel funds to private enterprises. The impact of the financial crisis on credit eligibility and supervision requirements has been significant. In the end. as the ADB survey confirmed. Leverage allows the assets and operations of the company to grow without diluting corporate control. they resort to borrowing. 11 experienced rejection after the crisis started. The presence of collateral usually diminishes banks’ incentives for screening project feasibility and monitoring project implementation. There were many options. when insiders want to expand their company’s operations without losing control. other than losing control. However. 17 indicated that only some of their creditors had such a requirement. while 18 said none of their creditors required collateral. a company’s reputation and its long-term relationship with creditors sufficed in many instances. Most companies reported that banks were more likely to require collateral. which could cause a delay by at least a year. One tempering mechanism that could inhibit the excessive use of borrowing is the threat of losing control in the event of bankruptcy. Among 16 companies in the ADB survey whose loan applications in the last three years were rejected. For 20 of the 46 responding companies. Under a weak bankruptcy system. including procedural disputes. such as that seen in Thailand before the crisis. creditors do not always require project feasibility studies or business plans in granting loans. Eleven companies stated that creditors usually exercised whatever influence they had on management through covenants regarding the use of loans. borrowers seldom lose control to creditors even when they default and become insolvent. The old bankruptcy law in Thailand also made it difficult for creditors to obtain payment against bankrupt borrowers. Fifteen of the 20 companies that had to renegotiate loan repayment with creditors in the last five years did so after the crisis. Only 28 of the responding companies in the ADB survey indicated that their creditors required such feasibility studies. Normally. creditors’ collateral requirements were tightened after the crisis. Apparently. however. .Chapter 4: Thailand 249 Historically.
and (iii) tender offers will be effective 30 days after the report has been filed with the SEC. with a total tender offer value of B42. According to the SEA of 1992. Although merger and acquisi- . and failed to provide managers with strong incentives to perform efficiently. (ii) an advertisement regarding the tender offer must be placed in major newspapers for at least three consecutive days. There are detailed requirements regarding such notification. The company has 21 days to evaluate the tender offer and submit a report to SEC and all shareholders. which is a general offer made to shareholders of a company to acquire at least 25 percent of outstanding shares. of shareholders: (i) all shareholders must receive tender offers. Since the introduction of the Public Limited Company Act of 1978.3 billion. before the extent to which the bankruptcy framework has been strengthened becomes clear. In 1994 and 1995. whether directly or indirectly. there were only six tender offers. with a significantly lower total tender offer value of B8. The situation remained sluggish in 1997 at nine tender offers and a further decline in total offered value. a person who acquires more than 5 percent of issued shares must file a report with SEC one day after the date of acquisition. It will take years.9). SEC has no authority to either approve or reject tender offers.3 billion (Table 4. its main role is to ensure transparency and fairness. there are two categories of merger and acquisition activities with associated regulatory measures. II The financial crisis has presented a unique opportunity for reinventing the framework for corporate bankruptcy and for creating regulatory and judicial precedents. SEC was later made responsible for regulating corporate takeovers. The first category is the acquisition of shares in the open market. only a limited number of successful mergers of public companies have taken place. In this case. Such efforts would serve to strengthen external discipline on controlling owners. there were 41 cases of tender offers. In 1996. however. The Market for Corporate Control The SEA of 1992 was the first legislation that stipulated rules and regulations regarding the market for corporate control. The market for corporate control has not been active in Thailand. The second category is the tender offer. Recently. the minimum tender offer was reduced to 10 percent and some procedural modifications have also been introduced. 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. if the purchase of shares implies a change in the directors or business activities. Vol.250 Corporate Governance and Finance in East Asia.
Provident funds for government workers and workers in public enterprises have been established only recently. But instead of opting for an active role in the market for corporate control. if any. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5. but employees have never been represented in the board of directors since their shareholdings are minimal.0 B billion 4.1 58. Eleven of the 46 responding companies in the ADB survey offer ESOPs.9 3.2 6. Few companies offer employee stock option plans (ESOPs). Twenty-nine firms indicated that employees held shares of their companies.2 7. most of these were forced mergers or related to rescue packages.3 60.3 11.2 6.5 6.2 8. Because of the current crisis.7 Purchase Value Number of % of Tender Offer Value Companies 84. Source: Securities and Exchange Commission of Thailand. employees regard the plans as monetary incentives. it remains small.1 75.Chapter 4: Thailand 251 Table 4. they have mostly been concerned with short-term gains.3 6. . tion activities increased after 1997. Employee Participation in Corporate Governance There has been little.9 Merger and Acquisition Activities. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. trading by mutual funds in SET represented less than 10 percent of total trading. employee participation in corporate governance in Thailand.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value.0 55. but the average shareholding is smaller than 1 percent of total outstanding shares.8 81.4 23. While the Thai mutual fund industry compares well to those in other developing countries in the region. not with a view to becoming involved in actual management.1 19. employees are even less willing to accept common shares as a form of compensation or benefit. Even when companies offer ESOPs. Pension funds are perhaps even weaker in Thailand. Since 1994.1 84.6 17.7 11.
5 5.161.4 1. 15 of which were domestic banks.3 546.4 519.5 trillion. In 1996.2 262.171.10 Size and Composition of the Thai Financial Sector.10) shows that Thailand is a highly bank-dependent economy.5 4.775.559.372.230. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2. The share of domestic banks in the banking system’s total assets was 80 percent.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.268.564.390. there were 29 commercial banks.3 5.2 2. accounted for 28 percent of the banking sector’s total assets. the banking sector was highly concentrated.669.0 424. and Bank of Thailand. II 4. .4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.0 339.979.0 3.906.1 6.300.4 4. the next four largest banks accounted for 63 percent.663. Thai Bond Dealing Centre.1 5.037.0 SET Market Capitalization 1.5 6. Bangkok Bank Ltd. The country’s largest bank.477.5 4.6 1. total assets of commercial banks amounted to B5.5 Outstanding Loans from Commercial Banks 2.8 941. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET. although its role increased in the wake of the crisis.1 7. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market.4 3.1 Domestic Debt Securities Outstanding 215.4 4.9 2.325. The bond market played only a marginal role in corporate financing.430.133.0 8.360.3 1.6 6.825.8 3. Vol.6 2. The Banking System Until recently.4..252 Corporate Governance and Finance in East Asia.1 3.193.1 3.119.485.912. Competition from foreign banks was limited as they were not allowed to engage in full branch operations. Table 4.
Because borrowers carried the exchange rate risk. SET was not very active. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency. and almost all capital account transactions were deregulated. Easy access to commercial bank loans by family business groups. SET is organized into 32 major industries. an over-the-counter market. finance. The lack of supply of quality shares was a big problem for SET at that time. The Government removed controls on capital and dividend repatriation in 1991.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. Some 347 companies were listed in the same year with a total market capitalization of B3. Many company founders did not want to release even a small portion of corporate ownership and refused to go public. The number of listed companies also quadrupled between 1981 and 1993.2 trillion.8 in 1998. In 1993. also made it unattractive to raise capital from the equity market. was set up by 74 members with an initial capital of B500 million. In 1995. BIBF banks also enjoyed tax incentives on their operations and profits. BSDC is a nonprofit. Benefiting from rapid economic and industrial growth. the stock market entered its first boom period in 1986. banking. self-regulatory organization under the . Despite the worldwide market crash in 1987. due to their close ties. Licenses were granted to 15 Thai banks. Through the years.3 trillion. Banking activity peaked in the mid-1990s. the SET index declined. and 20 new foreign banks. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. 12 existing foreign banks. SET immediately recovered due to the strength of the Thai economy. In the following years. After that. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. the Bangkok Stock Dealing Center (BSDC). Turnover value reached B2. and property have accounted for the bulk of trading volumes. In contrast. The Equity Market During the first few years of its operations. reaching 355. owning 70 percent of the country’s second largest bank. the market rose steadily and reached a record high in the fourth quarter of 1993.
In 1998. and pro forma balance sheet and income statements. which consist of SET and BSDC. among other functions approved by SEC. also acts as a clearinghouse. A company wishing to qualify for listing in SET must file an information booklet (prospectus) with SEC and SET. however. SET established new requirements for initial public offerings. SET. but dropped the following year to B122 million. stock trading can commence within five days. The listing application should be submitted concurrently to SEC and SET. After initial public offerings. the two classifications were merged. 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. In July 1990. to assist in the public offering process. Vol. Listed companies were those that had (i) paid-up capital of at least B20 million. each holding no more than 0. II jurisdiction of SEC. Only one security was listed in BSDC in 1995 and two more in 1996. approved by SET. lottery drawing must be used to ensure fairness. The primary market is supervised by SEC. turnover value was negligible and the BSDC Index remained flat throughout 19961998. It separated the primary and secondary markets to promote more flexible and effective supervision of both. The SEA of 1992 installed the legal and regulatory framework for Thai capital markets. . there were two kinds of companies in SET—“listed” and “authorized” companies. Turnover value was B1. The company should then appoint a financial adviser.8 billion in 1996. The allocation procedure is nondiscretionary. Before 1993. If approved by SEC and the SET Board of Governors. According to the SEA of 1992. Company applicants must have an established history of operating under substantially the same management. If the issue is oversubscribed. and securities registrar.5 percent and collectively owning at least 30 percent of paidup capital. and (ii) a minimum of 300 shareholders. the BSDC was dissolved in 1999. so now only listed companies are traded in SET.254 Corporate Governance and Finance in East Asia. financial projections. Consequently. Authorized companies were those with a minimum of 200 shareholders owning collectively at least 25 percent of paid-up capital. Proposed changes in capital must be submitted for approval to SET accompanied by a detailed memorandum outlining the use of proceeds. securities can be traded in the secondary markets. securities deposit center. In 1996. with each facing different listing requirements. which has a legal mandate to examine a company’s financial status and operations before allowing it to issue securities to the public. Its main role is to serve as a secondary market for unlisted companies trying to raise capital.
it represented only 9 percent of GDP.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. The Thai Rating Information Services. compared to 110 percent in the US and 74 percent in Japan in the same year. The recent financial crisis. A turning point of the corporate debt market was the enactment of the SEA of 1992. In 1996. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. the Bank of Thailand assumed responsibility for regulating the bond market. it accounted for a small share of the entire financial sector. Beginning 1961. The proportion of domestic convertible debt instruments increased until 1995. Investors had limited knowledge of debt instruments. however. The budget surpluses of the 1990s eliminated the need for new bond issuance. which encouraged limited companies and public companies to issue debt instruments. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. Four years after the passage of the SEA. the Government issued more bonds to finance industrial development projects and perennial deficits. the market for these bonds has been slow owing to the change in the Government’s original policy of requiring the use of state-guaranteed bonds as legal reserves. while secured debt instruments accounted for just above 10 percent. in 1994. the first bond rating agency in Thailand. However. To gain some perspective of the size of the bond market in Thailand.11). Upon its founding in 1942. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. the size of the corporate debt market rose to B132. The bond market in Thailand started in 1933. . led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. and the Government did not issue new bonds during 1990-1997.9 billion. was also instrumental to the growth of the corporate debt market. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent. The corporate sector played a limited role in the bond market in the early years because of the complicated rules and regulations in effect at that time. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization.
Vol.3 29.1 141. .1 59.7 0.9 5.9 329. the year the crisis unraveled and the baht was floated.0 — 26.8 31.7 0.7 95.2 89.7 — — — — — 4.4 57.8 167.1 10.5 — 0.7 5.8 55.9 30.0 26. However.7 — — — — — — — 77.0 33. a surge attributed to capital inflows encouraged by high returns on Thai bonds.0 — 5.2 43. The following year.6 19. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996. total offshore debt offerings had plunged by 68 percent to a mere B28.1 41.5 — — — 3.5 — 39.2 — — 50.1 315.1 289.4 7.4 — — — 1.6 billion.6 — — 0. Total offshore debt offerings peaked in the run-up to the financial crisis.9 40.3 8.3 — 14.3 — — 3.2 2. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts. II Table 4.0 60. 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 6. By 1995.4 49.11 Offerings of Debt Securities.0 333.8 191.256 Corporate Governance and Finance in East Asia.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.1 107.5 43.0 0.0 5. by the end of 1997.7 538.3 140.0 281.3 46.5 37.1 8.9 0.2 28.5 10.4 110.5 138.0 — 5. turnover value had reached B51.2 39.4 billion.7 — — 40.0 27.4 — 26. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.0 7.1 — — — 29.5 — — — — 1.5 5.7 28.1 12. then declined substantially in 1996 and 1997.9 20.5 55.7 90.7 7.8 2. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992.5 billion.7 132.3 50.9 37.7 821.3 22.1 121.3 6.4 — 9.0 86.1 61.3 46.6 — 0.7 5.1 — — 6.3 13.2 57.8 47.1 55.1 21.3 3.5 — — 32.2 45.9 37. this had climbed to B200. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs.0 17.
In 1997. while for the property development industry. judging by their relatively low levels of retained earnings. In any case. cash balances.4. For the construction industry.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. these accounted for 33 percent of total liabilities. turnover value plummeted to B106. with equity levels remaining high despite an increase in debt.12). Construction and property development industries tended to have high proportions of long-term loans and debentures. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. From 1990 to 1996. steadily easing up between 1990 and 1996.2 billion as a result of the default of debentures due to the Asian crisis.1 billion in 1998. 4. Longterm loans accounted for about 20 percent of total liabilities. a trend most apparent in the leap between 1991 and 1992. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. short-term loans accounted for more than 40 percent of total liabilities. At lower than 5 percent of total liabilities. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. The proportion of accounts receivable also declined steadily. Retained earnings accounted for about 30 percent of total equity financing. these comprised 31 percent. Turnover fell further to B72. Equity financing remains an important part of listed companies’ long-term financing.Chapter 4: Thailand 257 compared with investment in equities. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996. Companies in construction and property development seemed unable to generate internal funds. In the same year. In addition. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. significant variations can be noted. The average for all industries was only 22 percent. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. There was also little change in the trend in retained earnings within the seven-year period. and marketable securities holdings. Across industries. they also had a relatively small proportion of equity and .
8 14.8 1.4 6.2 15.9 17.5 1.2 1.2 1.7 9. medium.2 43.8 25.258 Corporate Governance and Finance in East Asia.1 36.2 12.6 15.9 17.0 100.0 100.4 48.2 35.9 20.0 100.8 3.1 2.8 9.9 49.9 43. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.6 50.9 12.0 100.0 100.3 21.3 48.6 18.7 1.9 14.0 100.4 2.3 1.7 14.2 2.6 38.8 17.6 22.3 1.5 43.6 36.4 21.8 9.6 2. were highly leveraged.6 13.7 0.8 35.6 0.3 12.8 46.9 38.0 10.9 10.3 6.6 8.6 0.2 17.5 37. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4. US.0 10.3 18.4 17.4 17.8 10.8 6.5 0.1 18.2 3. compared with the 44 percent general average.2 2.9 14.1 7.8 20.6 100.5 9.9 40.0 6.0 100.8 34.3 18.0 7.9 14.9 6.8 8.0 51.9 14.2 16. Printing and publishing companies had lower financial leverage than companies in other industries.4 7.5 11.7 7.12 Common-Size Statements for Companies Listed in SET.0 100.4 49.2 42.3 14.8 37.7 50.8 37.9 50.9 2.6 11.6 14.7 36.0 12.6 0.2 17.2 45.5 9. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.3 49.3 38.7 15.9 6.3 50.2 22.5 14.5 1.2 43.4 8.4 43.0 100.0 100.0 100.0 100.2 1.0 15.7 16.3 34. Vol.0 48.6 51.6 100. The level of total liabilities for the group characterized by high ownership concentration .9 18.2 2.2 2.1 13.0 13.1 5.7 16.1 17.4 14.8 21.6 6.8 19.9 16.1 50.0 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.5 1.9 14.2 17.3 34.7 52.0 2.6 0.2 34.7 17.9 3.1 49.8 7.6 21.13).3 17.9 15.2 17.9 0.0 100. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.0 100.3 2. II Table 4.2 16.0 1.6 12.3 14.3 25.0 14.4 49.6 10.7 18.
8 13. For the high ownership concentration group.7 percent for medium ownership concentration companies and 49.4 37. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.6 22.Chapter 4: Thailand 259 Table 4.4 50.8 13. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.0 16.4 3.0 100.13 Common-Size Statements of Public Companies by Ownership Concentration.6 14.4 35.6 9.0 7.9 7.0 100.3 16.8 37.7 19.5 18.6 15.2 45.8 12.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 13. was 53 percent of total assets compared with 49.4 1.0 19.9 50. US.5 100.1 49.5 11.7 17.3 1.0 Low 1.3 35.0 6.0 14.9 2.6 47.5 percent for low ownership concentration companies.1 36.3 1.2 22. . 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 49.5 21.2 0.1 53.4 7.5 13.6 0.9 0.2 8.7 12.4 18.9 21.1 18. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.3 8.9 100.0 6.0 41.6 100.3 100.1 44.2 14.2 11.9 16.9 36.0 Medium 2.6 2.
1 31.9 14.6 125. While further detailed investigations are necessary. After the crisis. Short-term debt accounted for most of the increase.14).15.7 34. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.8 percent in 1990 to 52.6 41.9 7. US.1 16.7 percent in 1996.0 50.5 38.1 44. and maintenance of the existing ownership structure.7 in 1994 to 5.8 65. Such deterioration of financial positions during the period was a common feature of listed companies. bond issues.1 144.8 5.0 25.6 7. Vol. 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 8.8 51. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.0 145.1 31.7 66. More important. Generally. these firms more easily increased their leverage.7 12.7 34.4 12. Public companies relied more on short-term debt financing in the period before the financial crisis.4 7.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.2 49. Table 4.4 139.2 35.7 5.1 16. followed by bank loans.3 31.8 151. minimization of transaction and interest costs. As a result.3 61. however.9 51. especially from 1994 to 1996.4 51.1 23. and rights issues.6 138. 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 4.14 Financial Ratios of All Listed Firms.9 140.9 63.1 52.4 5.7 11. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing. was the headlong deterioration of firms’ ability to meet their interest payment obligations.1 in 1996.4 44. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. however.260 Corporate Governance and Finance in East Asia.1 64.7 28. The ratio of total debt to total assets increased from 50.0 28. thus rendering them more vulnerable.7 12.2 68. bond issues overtook loans from commercial banks as the second preference.5 52. . The TIE ratio declined from its peak of 7.8 65. the choice of financing is determined by the company’s liquidity considerations.
6 30. The corporate sector contributed significantly to the crisis because of its rising levels of leverage. The proportion of external debt as a percentage of GDP consequently increased from 42.5 34.8 14.4 63.Chapter 4: Thailand 261 Table 4.9 percent in 1997.4 27.5 148.1 High 6. The proportion of nondebt-creating capital flows.6 11. From only 34 percent in 1986. 4. debt-creating capital inflows rose to 65 percent in 1990. . Nonbank private debt increased from 27. and a preponderance of short-term debt liabilities. unhedged foreign exchange liabilities. 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. however.8 66. such as direct equity and portfolio investment.5 126.2 49.5. the proportion of short-term debt increased from 15. continued to slide from 1985 to 1997.8 Medium 7. on the other hand.2 124.16).5 percent of external debt in 1996 (Table 4.5 percent between 1985 and 1990 to 8. is even more telling.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.15 Financial Ratios of Listed Companies by Ownership Concentration.8 49. Additionally.8 28.4 13. The composition and term-structure of this debt.0 64.8 29. by a remarkable growth in the proportion of debt-creating capital inflows in the wake of the development of the debt market and the establishment of the BIBF.5 4. private debt accounted for 84.4 52. From 45 percent of total net capital movements in 1985.8 percent in 1986 to 52 percent in 1995.2 percent in 1986 to 251. US. peaking in 1994 at 84 percent.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.7 percent from 1991 to 1996. Their average annual growth rate declined from 28.4 percent to 46 percent during the same period. This decline was accompanied.3 42.
3 7.5 12.1 Source: Bank of Thailand.3 10.9 1.9 6.9 13. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.5 12.4 — — — — — — — 1.9 3.6 7.9 10.1 5.5 4.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.8 13.3 0.9 7.1 0.3 0.2 32.9 0.3 3.0 11.6 — 0.9 43.4 5. .9 4.5 1.2 2.1 95.3 2.1 0.8 3.4 18.9 10.7 10.0 8.9 1.0 3.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.3 0.Table 4.7 2.7 13.2 15.3 — — — — — — — 6.3 0.0 4.1 23.9 35.3 37.16 External Debt.9 100.8 12.9 5.6 52.0 0.2 0.9 6.0 6.5 16.1 0.0 13.5 4.3 0.1 0.2 0.9 29.2 2.8 108.9 31.4 10.1 2.4 3.6 18.2 10.0 11.7 24.3 0.3 16.3 20.7 109.7 0.5 19.6 1.8 10.1 22.3 3.1 34.4 2.3 12.5 14.7 23.9 3.0 21.3 0.8 31.2 14.8 0.2 0.7 20.7 1.1 64.8 3.1 12.9 11.4 15.3 0.2 2.3 105.6 Total 18.1 30.
6 in December 1996. the index declined to 1. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4. Trading volume has since been thin. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. 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. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. banks would be recording more of such NPLs. Most of these foreign debts were not properly hedged. Meanwhile. The effects of the crisis were felt across all industry sectors. foreign currency-denominated debts constituted 55 percent of their total debt portfolio.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. and (iii) bankruptcies. trading activity at SET had been on the downturn. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. Aside from the problem of NPLs. It hit a 10-year low in the second quarter of 1998. from its peak in 1995. large Thai companies had actively borrowed at low interest rates from foreign financial institutions.6 billion from the 1996 level of B201 billion.281 in December 1995 and to 831. Due in part to liquidity problems on the one hand. exposing the companies to disaster when the baht started tumbling on 2 July 1997. reaching 45 percent of total outstanding credit in December. On average. Foreign investors retreated from the market. Similarly. If lending rates remained high. outstanding credit also declined throughout the second half of 1998. . The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. Even before the crisis. the liquidity problems faced by the corporate sector are likely to continue for some time.17). and poor business confidence on the other. leaving domestic investors with large capital losses. suggesting that serious investors have not returned to the market. the SET Index stood at 1. closures. At the end of 1994. After that. and drastic decline in the number and capital of newly registered companies. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. the number of newly registered companies dropped to a 10-year low in 1998. according to the Bank of Thailand. The value of public offerings sank in 1997 to B56. based on the three-month past due definition. With easy access to foreign funds.360.
052 36.904 20. II Table 4.334 4. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package.925 12.407 28.933 25. Vol.080 9. It also explains the higher dividend yield ratio.134 31.695 3.066 19. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10. The IMF financial package was a credit facility of $17. Ministry of Commerce.264 Corporate Governance and Finance in East Asia.201 24.409 6.2 billion for balance of payments support and buildup of the country’s reserves.2 Responses to the Crisis Initially.17 Number of Newly Registered and Bankrupted/Closed Companies.5 at the end of 1994 to 12 in 1996 and further to 6. The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.307 4.096 22. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.410 5.112 9.224 4.977 Source: Department of Commercial Registration. the Government was left with no choice.792 7.095 14. 4. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies. . A steady price decline over the past few years has dragged down the ratio of market price to book value. As part of the assistance package.797 4.902 3.410 37.288 35.677 Bankrupted/Closed 2.5.915 37.105 4.218 3.312 25. But when assistance from other sources did not materialize. Thailand.777 11.6 in 1997. The price-to-earnings (P/E) ratio deteriorated from 19.
The assets of the other companies were liquidated by auctions. and restore solvency. Securities. and did not recognize debtor-initiated bankruptcy declarations. As it turned out. and Credit Foncier Businesses. and if necessary. They could seek civil action through the courts and could also use criminal sanctions to enforce debt repayments. loan provisioning. and worked on revisions to the Secured Transaction Law. For example. While no definition for “insolvency” could be found in the bankruptcy law. There were many options for solving debt repayment problems. These include repeal of the Commercial Bank Act.” Creditors thus bore the burden of proving a debtor’s insolvency before the courts. secured creditors had to obtain the court’s approval before starting proceedings . creditors seldom succeeded in obtaining payment against bankrupt borrowers. The Government also passed the Bankruptcy Act and Foreclosure Act Amendments. it was widely interpreted as “having debts more than assets. the Civil and Commercial Code. In early 1998. The Financial Sector Restructuring Authority was established in October 1997 to address the problems of 58 finance companies that were suspended in 1997. Several changes in the banking and financial policy environment have been effected in line with the restructuring program. The core of the IMF conditionalities was the restructuring of the banking and financial sector to regain investor confidence. By invoking procedural loopholes. follow through with a civil or bankruptcy suit. The Government required all remaining financial institutions to recapitalize and instituted closer monitoring measures to ensure full compliance with this requirement. also aimed at institutionalizing legal and regulatory reforms. Strict loan classifications.Chapter 4: Thailand 265 The terms of the agreement required the Government to maintain tight monetary and fiscal policies. Many believed that the process was inefficient. debtors could drag out the process for many years. Regulatory Response by the Government The IMF program. IMF relaxed these key conditions. and income recognition were implemented. The Bank of Thailand also improved banking standards. increase profitability. The old law allowed only creditors to file bankruptcy suits. and the Act Regulating the Finance. drawn up with World Bank and ADB assistance. only two companies emerged intact from the suspension. however. Under the old bankruptcy laws. Creditors could negotiate to reschedule debt repayments.
Under the old Bankruptcy Act. any new loan to a company extended after the creditor discovered the insolvency would not be eligible for repayment. the judges and court officers have yet to learn and master the new bankruptcy procedure. The reorganization process is successful if (i) the debts shall have been discharged. There are other potential problems. and (iv) the debts shall have been settled within a five-year period. Enforcement of the new law is bound to be ponderous and lengthy. If the process fails to revive the business. which means that a debtor could continue in business while the reorganization program was being implemented. it covers only the court-supervised reorganization of distressed companies. 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. time consuming. (iii) shareholders regain their legal rights. the amended law limits the rights of secured creditors. 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. thereby allowing court-supervised corporate restructuring. In Thailand. Vol. The amendment added reorganization provisions to the Bankruptcy Act of 1940. For one. and expensive process. In 1999. The amended legislation also includes voluntary bankruptcy as a new feature.266 Corporate Governance and Finance in East Asia. creditors always had to contend with the threat of disruptions in a delinquent borrower’s business. But more important. 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. but it is a complicated. Chapter 11 is the main tool in restructuring bankrupted companies in the US. (ii) management of the company reverts to the borrower. the National Assembly passed an amended Bankruptcy Act and approved the establishment of special bankruptcy courts. the company shall be declared bankrupt and liquidation of assets shall follow. The amended law also introduced the concept of automatic stay. II for the recovery of debt through the realization of any collateral. Chapter 11 cases account for only 5 percent of bankruptcy suits in the US but consume 90 percent of the courts’ time. Companies need . The model for Thailand’s amended bankruptcy law was the US Chapter 11. Foreign secured creditors had to go through the motions of establishing that their country of domicile granted Thai creditors similar rights. In effect. To make matters worse for creditors. The original Bankruptcy Act dealt only with liquidation and composition.
In case the board of directors does not comply.” The Foreclosure Act Amendment was likewise passed in 2000. The minimum shareholding requirement is too high for any individuals or groups of minority shareholders to take action against controlling shareholders. Most important. Under the new law. In the past. has not been satisfactory. however. The proposed new law seeks to expand the type of assets that a borrower can use as collateral. The amendment seeks to revise old rules and procedures that tended to delay foreclosure proceedings. . Minority shareholders also have to absorb the costs related to their actions because the 1992 Act does not allow them to be reimbursed by the company. the test for insolvency still uses the balance sheet criterion. SEC also examined the possibility of an amendment to the Public Company Act of 1992. The new foreclosure law cuts short the procedures required under the Civil and Commercial Code for petty or simple cases dealing with mortgage defaults: (i) submission by the drafting committee of a default judgment bill within a week. There have been proposals to lower the minimum shareholdings required for a minority group to request the board of directors to call an extraordinary general meeting at any time. minority shareholders’ rights are not adequately protected. The amendment also remedies the slow process of executing or disposing of assets in a public auction. The proposed amendment also includes a provision for the company to reimburse minority shareholders for expenses related to calling such a meeting. Consequently. the 1992 Act relaxed some of the original restrictive rules and regulations to encourage public company registration. which aims to increase liquidity in the domestic economy by allowing businesses to use both tangible and intangible assets in securing credit. corporate governance) that caused the bankruptcy in the first place. namely “liabilities exceed assets.. Without the necessary corporate restructuring. The result.” as opposed to the more appropriate criterion of “ability to pay when the debt falls due. Replacing the Public Limited Company Act of 1978. Still pending Parliament approval is the amendment to the Secured Transaction Law. questions have been raised regarding the appropriateness of the 1992 Act. only tangible assets were the norm. the Bankruptcy Amendment will just prolong the problems of nonviable borrowers. Procedural delays give borrowers an advantage because they can refuse to pay back their loans even though they can meet their obligations. after determining the legitimacy of the request.g. shall have the power to call the extraordinary general meeting.Chapter 4: Thailand 267 to solve the problems (e. the court. and (ii) processing of default cases within four to six months of filing of a court claim.
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. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. claiming that it creates fragmentation in the board of directors. Where equity will come forward. the main problem is overlooked.e. i. which. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. This may be true in countries where publicly traded companies are widely held. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. The proposal clearly delineates duties of care and loyalty for directors of public companies. Most companies decide against cumulative voting. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. In the absence of such a stock market boom now. 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. Because of high ownership concentration. the dominance of controlling shareholders. vis-a-vis the minority shareholders. it permits directors.268 Corporate Governance and Finance in East Asia. subject only to approval by the board of directors.. this is not so in publicly traded companies in Thailand. the controlling shareholders have the exclusive domain to appoint or exercise management. Otherwise. But as demonstrated. who are also the managers. But because this is the assumption embedded in the regulation. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. minority shareholders have no chance of being represented in the board. in turn. The proposal for the amendment of the Public . The regulators are drafting a proposal to amend the provisions on related transactions. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. However. with the approval of the board. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. without cumulative voting. disrupts the company’s management and decision making. they face the prospect of being unable to compete for the scarce funds available in the equities market. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. and determine voting results on virtually any matter. 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. Consequently. Vol. In addition.
and manufacturing sectors. methods. CDRAC’s target debtors comprised 10. Within three months.1 trillion in outstanding credit. In particular. Commercial banks initiated 74 percent of these cases. the number of cases has abated. accounting for B1. In response. This point is crucial because compared with .1 trillion of outstanding credit. with the majority of the debtors coming from the commerce. as well as those that did not cooperate with CDRAC’s restructuring process. Equally important is the contribution of effective and reliable bankruptcy procedures for improved corporate governance. the court had more than 80 cases for disposition. 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.767 cases involving outstanding credit of B2.147 cases (B1. However. The Bank of Thailand issued guidelines in 1998 encouraging financial institutions to specify their own policies. In addition. Another 5 percent of cases (B70 billion) are undergoing restructuring negotiations. only 7. will be settled by the courts. contributing to the unprecedented rise in the corporate sector’s bad debt. personal consumption.764 debt restructuring cases involving B1. Some 82 percent of these cases have been successfully restructured. Another 77.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. Considerable progress has been achieved on this front. The first bankruptcy court in Thailand opened on 18 June 1999.068 cases involving B475 billion are undergoing restructuring. where bankruptcy procedures are swift and effective.6 trillion) have agreed to cooperate with CDRAC’s restructuring process. By October 2000. the Government introduced debt restructuring-related measures to help resolve bad debts. and procedures for debt restructuring.8 trillion had been completed. 322. Corporate Debt Restructuring and Bankruptcy The 1997 crisis led to a severe liquidity problem in the economy. The reason is that bankruptcy law amendments appear to facilitate settlements outside the court. accounting for B1. As of November 2000. the mere threat of external control alters the incentives faced by managers and controlling shareholders significantly. Reforms in bankruptcy procedures should be seen not only in the context of crisis resolution. Cases for which negotiations were unsuccessful. although since then.6 trillion.
and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand. 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. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. behavior. The study covers the period 1985 to 1996. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. 4. The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. and performance during this period helps understand the causes of the crisis. For this reason. Philippines. Such improvements in disclosure standards are part of the efforts of SET and SEC. Examination of corporate ownership. II Malaysia.270 Corporate Governance and Finance in East Asia.1 Summary. Financial information from listed companies will also soon be required to conform to International Accounting Standards. In the next three decades. It required listed companies to establish their own audit committees by the end of 1999. and promoted key industries through incentives. to push companies to harmonize their accounting with international standards. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. despite the weakness of their disciplinary powers. 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. and even Indonesia. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations. Conclusions. Vol. the Government protected certain corporate sectors through tariffs and regulation.6 4.6. The . 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.
000 from the previous year’s level. reaching its peak in 1996. the Public Company Act of 1992 and the SEA of 1992. Profitability increased throughout the 1980s but began to decline in the first half of the 1990s. Consequently. Subsequently. Because most of these debts were not hedged. at a time when most of them were already experiencing declining profits and high leverage. In 1995 and 1996. Financial liberalization apparently encouraged companies to borrow overseas to finance investments that were not productively employed. Nonbank private corporations accounted for most of the increase. foreign debt in the Thai corporate sector increased continuously. the numbers of bankruptcy cases and company closures reached alltime highs. Meanwhile. The financial performance of the corporate sector remained satisfactory up to the years before the outbreak of the financial crisis. The impact of the crisis was felt across all industries. Minority shareholders. even after the development of capital markets. The study examined the impact of ownership structure on corporate governance and financing patterns. the overall corporate sector was seriously affected. the top five largest shareholders hold about 56 percent of total outstanding shares.Chapter 4: Thailand 271 importance of bank financing continued throughout the 1990s. the number of listed companies in SET fell from 454 in 1996 to 392 in 1999. the increase in long-term debt more than compensated for the drop. 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 SEA of 1992 also marked the beginning of an active bond market in Thailand. Although there are some variations across industries. the corporate sector entered a new era with the enactment of two major pieces of legislation. One of the major findings is the high ownership concentration among Thai companies listed on SET. the overall pattern of ownership concentration seems to have been stable for the past 10 years. The number of newly registered companies in 1997 dropped by almost 10. . One of the principal causes of the crisis was the excessive use of foreign debt by the corporate sector. Thai companies were vulnerable to exchange rate risks. In 1992. the devaluation of the baht that began on 2 July 1997 affected the financial condition of Thai corporations. During 1992-1997. the number and value of public offerings of securities accelerated. After 1992. Although there was a decline in short-term foreign debt. At the onset of the 1997 financial crisis. there was a marked increase in the number of public corporations. At the same time. On average. the profitability of publicly listed companies abruptly declined and their financial leverage increased.
Vol. Thus. publicly listed and unlisted companies in Thailand are equally subject to the consequences of the risk-taking behavior of controlling owners. In the past. The rules in both Acts governing . along with a highly concentrated ownership structure. II although larger in number. contribute to the lack of external controls on the corporate sector through the capital markets. foreign and domestic. are not active. Most foreign institutional investors invest only on a short-term basis and aim for short-term trading profits. the government pension fund was the only major institutional investor. they have little influence over management decision making and control. commercial banks hold only about 2 percent of total outstanding shares while nonbank financial institutions hold about 6 percent. Institutional investors in Thailand. there is a clear lack of outside monitors for these publicly listed but family-controlled companies. The highly concentrated ownership structure weakens the protection of minority shareholder rights. It remains to be seen how reforms in bankruptcy procedures—including the increased threat of creditor control—could shift the incentives of controlling shareholders toward greater acceptance of equity finance and its consequent accession of control to new shareholders. The key laws. Financial institutions hold a very small proportion.272 Corporate Governance and Finance in East Asia. With financial institutions playing limited roles in the capital market. Recently. the existing legal and regulatory framework suggests otherwise. averaging 46 percent. The Government holds about 1 percent of total outstanding shares but these holdings represent majority shares of a few companies. An analysis of the corporate ownership structure in Thailand suggests that founders and management continue to own and control publicly listed Thai companies. through the use of holding and affiliated companies. holding companies and affiliated corporations hold the largest proportion at 27 percent of total outstanding shares. The absence of external market controls on the management of publicly listed corporations is dangerous. These laws stipulate rules and regulations concerning the activities of all public companies. All these. Individuals and insiders hold the second largest proportion at about 19 percent. Nominally. Consequently. hold only a small portion of total outstanding shares. the Public Company Act of 1992 and the SEA of 1992. protect the interests of all shareholders of public companies. The investing public holds the rest of the outstanding shares. The implications of ownership structures that are concentrated to such a high degree are serious. the mutual fund industry has entered the picture but with limited roles and activities. Among the five largest shareholders of Thai companies listed on SET.
The Government has been moving to amend the Public Company Act of 1992 to increase minority shareholders’ protection in this regard.Chapter 4: Thailand 273 minority shareholders’ participation in decision making and in initiatives against management conform to international standards. moreover. The third issue involves creating external market controls through better regulation and development of the capital markets. laws did not provide minority shareholders sufficient safeguards in cases of transactions involving companies where the controlling shareholders had related interests. For example.2 Policy Recommendations There are three major policy issues and recommendations that could improve corporate governance in Thailand. an aim that can be achieved mostly through legal reforms. 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. The ownership structure of Thai listed companies also significantly affects company behavior. these companies tend to become overleveraged. because there are shared interests between the controlling shareholders and key management personnel. . the Public Company Act of 1992 allows shareholders to act only when they hold a minimum proportion of shareholdings. In view of this. but is significantly related to financing patterns. a requirement impossible to meet due to the concentrated shareholdings of founding family members and management. the main challenge is not how the board can control management to maximize shareholder value. It appears that founding family members use debt extensively to finance investments because they want to preserve control of their firms. making them vulnerable to economic shocks. Certain provisions. key reforms that will strengthen the regulation of financial institutions. because there is no separation between ownership and management. The first issue involves the development of a comprehensive supervisory framework and the strengthening of the capacity of supervisory agencies. 4. the main challenge is in protecting minority shareholders from the possibility of expropriation by the majority. The second issue involves the protection of shareholder rights. before the crisis. Specifically. For instance. Consequently. In this third area. the high ownership concentration of many listed Thai companies inhibits the effectiveness of these provisions. However.6. posed formidable barriers in the minority shareholders’ exercise of their rights. Rather.
There is also supposed to be separation of ownership and control. the Ministry of Commerce had the sole supervisory responsibility. the supervisory agencies also need to be empowered to enforce the laws. If this were the situation. The Government must develop an overall framework for corporate sector supervision and redefine the regulatory jurisdiction of each agency along functional lines. As in other crisis economies in the region. and after the enactment of the SEA in 1992. Development of a Comprehensive Supervisory Framework There is a need for the Government to establish a comprehensive supervisory framework for the corporate sector. . Only then will these agencies be able to act promptly and effectively. with control delegated to professional managers. Once the roles and responsibilities are clearly defined. the supervisory system is fragmented and not as effective as it should be. SET. unified supervisory agency or a permanent regulatory division consisting of supervisory units from the three agencies. II encourage market competition. in 1975. three major government organizations (the Ministry of Commerce. Protection of Shareholder Rights The common assumption is that publicly traded corporations are widely dispersed in terms of ownership. In reality. and increase the participation of institutional investors are imperative. activate the market for corporate control. It is important that the roles and responsibilities of each agency are clearly defined to the public. SEC was established as another supervisory agency. the principal shareholder typically plays a key role in management and often serves as the chief executive officer. he/she often has the decisive vote. voting only on major decisions. the key issue in corporate governance is how to prevent insiders from expropriating assets of minority shareholders. the key issue in corporate governance would then be to ensure that managers act in the best interests of the shareholders. Consequently. The owners of a firm rely on a board of directors to supervise the managers. If the principal shareholder is in fact chair of the board. in most of Thailand’s publicly traded firms. The best approach may entail establishing a single. SET was mandated to supervise listed companies. and SEC) are involved in corporate supervision.274 Corporate Governance and Finance in East Asia. Vol. this is a problem in Thailand. Under the current system. The board therefore plays a pivotal role. In this setting. This is due to the historical development of the Thai corporate sector: before 1975.
there has been much progress in this area. This includes prescribing ways to empower minority shareholders without disrupting the company’s operations. requiring cumulative voting for the election of directors. The second recommendation is to dilute ownership concentration through the use of regulatory power. Because these holding companies control a number of large public companies in Thailand. and . This move is expected to be unpopular among founding family members and original owners. Some of the legal reforms under consideration concern settling conflictof-interest situations with significant effects on minority shareholders. Both SET and SEC are taking an active stance in improving the transparency and efficiency of Thai capital markets. The situation prompts two specific recommendations. 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. Current laws allow a high degree of ownership concentration and provide inadequate safeguards against possible conflict-of-interest transactions and their impact on minority shareholders. the Government can change the shareholding limit for controlling shareholders. The first recommendation involves the repeal of current legislation to allow minority shareholders to have greater influence over management decision making. The Ministry of Commerce is conducting a study on proposed amendments to the Public Company Act of 1992. transparency. increasing penalties for directors engaged in misconduct.Chapter 4: Thailand 275 There is a need to recognize the unique ownership structure in Thailand and its effects on corporate investment and financing behavior. The current ownership structure leads to ineffective corporate governance and inadequate protection of minority shareholders. The slow improvement in the legal framework has likewise obstructed progress in this area. and a prohibition of connected transactions by directors or management. they should be monitored and regulated. accountability. regulators must increase transparency and step up enforcement. SEC has been trying to lay the foundations of good corporate governance by espousing fairness. To ensure a level playing field. 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 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. Through an amendment in the Public Company Act. Since the Asian financial crisis.
This may not be possible without reforms in the banking sector itself. in turn. for instance. there is a need to increase market disciplinary power through market competition. The Bank of Thailand’s enforcement of prudent lending practices among Thai financial institutions. 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. a well-developed secondary market will pave the way for market disciplinary forces to act against poorly managed companies. it is important to explore reforms that can lead to the enhanced role of banks in monitoring enterprises. the power of the capital market to discipline inefficient management is almost nonexistent. Accounting standards have also been under review. Thailand should develop a strong public debt market to supplement the banking system in financing corporate investments. The variety of debt instruments available to the corporate sector and investors should be increased and longer-term sources of bond finance actively promoted. . especially in the area of connected lending. II responsibility among companies. Further. will lead to the emergence of a reference yield curve. Because the financing of Thailand’s corporate sector is predominantly bank-based and will remain so for a long while yet. Without a strong and efficient capital market. which. A well-developed domestic debt market will provide corporations with an alternative to bank financing. the SEC’s disposition toward a largely voluntary approach for adoption of these characteristics has resulted in uneven compliance among public companies. In an environment of highly concentrated ownership. aimed at ensuring that banks finance only creditworthy projects. while a strong domestic debt market will also offer protection from foreign exchange risk. The first step is to establish an active secondary Government bond market. will incidentally close off easy sources of finance for companies that have been practicing regulatory arbitrage. Capital Market Development and Regulation Another important issue concerns the development of capital markets. Vol. The promotion of active roles for domestic institutional investors should also improve corporate governance in Thailand. There will be no incentive for companies to raise capital in the equities market if they can obtain funds at a lower cost elsewhere. However. In the stock market. it will be difficult to improve corporate governance in Thailand. The same goes for improvements in the bankruptcy system.276 Corporate Governance and Finance in East Asia.
The University of Rhode Island. Bank of Thailand Quarterly Bulletin. Ministry of Commerce. Thai Accounting Standards. The Securities and Exchange Commission of Thailand. 1997. 1995-1999. Bank of Thailand Monthly Bulletin. Bond Market Development in Thailand.Chapter 4: Thailand 277 References Annual Report. The Stock Exchange of Thailand. Pacific-Basin Capital Markets Research Center. Fact Book. Key Capital Market Statistics. The Stock Exchange of Thailand. 1998. The Stock Exchange of Thailand. The Stock Market in Thailand. 1995. Bank of Thailand. 1995-1999. . Kingston. 1997-1999. PACAP-Thailand Database. 1995-1999. US. 1997. Thailand. The Thai Bond Dealing Centre. Bank of Thailand. Department of Commercial Registration Database. The Securities and Exchange Commission of Thailand.
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