Corporate Governance and Finance in East Asia

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

Country Studies

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

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


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

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

53 53 55 55 60 62 65

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

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

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

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

17 DER of Listed Companies by Degree of Ownership Concentration Table 1. 1996-1998 Table 1.15 V alue of Stocks Issued and Stock Market Capitalization. 1992-1999 Table 1.16 FinancingPatternsofPubliclyListedNonfinancial Companies. 1992-1998 Table 2.12 CharacteristicsoftheBoardofDirectors Table 1. 1992-1997 Table 1.14 Banking Sector Outstanding Loans.1 Listed Firms with Positive Economic V alueAdded. 1992-1995 Table 1. 1990-1997 Table 1.13 Presence of Board Committees in Listed Companies Table 1.18 GDP Growth by Sector.8 OwnershipConcentrationofPubliclyListedCompanies. 1988-1996 Table 1. Republic of Korea 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 . 1996-1999 Table 1.7 Growth Performance of the Top 300 Conglomerates.9 OwnershipConcentrationofPubliclyListedCompanies by Sector.3 Subsidiaries of the 30 Largest Chaebols Table 2.11 CharacteristicsoftheBoardofCommissioners Table 1. 1996-1998 2. 1986-1996 Table 1. 1990-1998 Table 1.1 Growth of the Banking Sector.5 Financial Performance of Publicly Listed Companies by Sector.10 Anatomy of the Top 300 Indonesian Conglomerates. 1993-1997 Table 1. 1992-1997 Table 1. Indonesia Table 1.20 ROE of the Banking Sector. 1992-1997 Table 1.6 GrowthandFinancialPerformanceofState-Owned Companies. 1992-1997 Table 1.21 Nonperforming Loans by Type of Bank.4 Development of the Stock Market.3 GrowthandFinancialPerformanceofPubliclyListed Companies. 1992-1999 Table 1.4 Growth Performance of Publicly Listed Companies by Sector.19 DER and ROE of Publicly Listed Companies by Sector.2 Foreign Capital Flows.2 KeyMacroeconomicIndicators Table List of Tables 1. 1997 Table 1. 1993-1999 Table 1.

22 Table 2. 1995-1997 Ownership Composition of Listed Companies. 1988-1997 Features of the 30 Largest Chaebols GrowthandFinancialPerformanceofthe30Largest Chaebols.25 Table 2.14 Table 2. 1985-1997 GrowthandFinancialPerformanceofListedCompanies by Size. 1988-1997 Ownership Composition of Listed Nonfinancial Firms by Industry. 1993-1997 The Top 30 Chaebols’ Debt-to-Equity Ratio. 1992-1997 OwnershipConcentrationofListedNonfinancialFirms. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSectorby Industry Financing Patterns of Listed Companies.vii Table 2.17 Table 2. 1997 OwnershipConcentrationofListedNonfinancialFirms by Firm Size. 1997 Ownership Concentration ofAll Listed Firms. 1985-1998 GrowthandFinancialPerformanceoftheNonfinancial Corporate Sector. 1990 and 1997 Ownership Composition of Listed Nonfinancial Firms by Size.19 Table 2.23 Table 2.5 Table 2.9 Table 2. 1997 Ownership Composition of Listed Firms in Selected Countries. 1987-1997 FlowofFundsoftheNonfinancialCorporateSector.8 Table 2. 1988-1997 Ownership Concentration of the Survey Sample of 81 Listed Firms.26 Table 2. 1994-1997 Cross-Payment Guarantees of the Top 30Chaebols.7 Table 2.15 Table 2.11 Table 2.6 Table 2.29 Table 2.24 Table 2.16 Table 2. 1994-1998 Financing Patterns of the Top 30 Chaebols.21 Table 2.18 Table 2.20 Table 2.12 Table 2.28 Table 2.10 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 . 1999 InternalShareholdingsofthe30Largest Chaebols. 1988-1997 FinancingPatternsoftheNonfinancialCorporateSector.30 Private Capital Flows to Korea.13 Table 2. 1990-1997 InternationalComparisonofRatiosofOrdinaryIncome toSalesinManufacturing GrowthandFinancialPerformanceofSelectedIndustries GrowthandFinancialPerformanceofListedCompanies. 1997 Ownership Composition of Listed Nonfinancial Firms by Control Type. 1988-1997 OwnershipConcentrationofListedNonfinancialFirms by Industry.27 Table 2.

1988-1997 Table 3.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector. 1988-1997 Table 3.33 Net Profit Margins of Chaebols.8 Ownership Composition of Philippine Publicly Listed Companies by Sector. 1997 Table 3.1989-1997 Table 3. 1997 Table 3. Thailand Table 4.31 Table 2. 1988-1997 Table 3. 1985-1997 Number of Firms with Dishonored Checks. 1992-1999 .1 Public Companies Registered.32 Table 2. 1988-1997 Table 3. 1989-1997 Table 3.20 Financing Patterns by Industry.2 Public Offerings of Securities. 1988-1997 Table 3.13 ADB Survey Results on Shareholder Rights Table 3.SectorOrientation. 1989-1997 Table 3. 1997 Table 3. The Philippines Table 3. 1988-1997 Table 3.17 Composition ofAssets and Financing of the Publicly Listed Sector.viii Table 2.21 OwnershipConcentration.22 Foreign Investment Flows.12 Control Structure of the Top 50 Corporate Entities.2 Growth and Financial Performance of the Top 1. 1990-1999 Table 3.9 OwnershipConcentrationatCriticalLevelsofControl Over Publicly Listed Companies. 1978-2000 Table 4.11 TotalandPerCompanySales.1 GDP Growth of SoutheastAsian Countries. 1997 Table 3. 1986-1998 Nonperforming Loans of General Banks. 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. 1983-1997 Table 3. 1997 Table 3.4 GrowthandFinancialPerformanceoftheCorporateSector by Ownership Type. Flagship Company. 1992-1996 Table 3.15 Financing Patterns of the Corporate Sector.000 Companies.5 GrowthandFinancialPerformanceoftheCorporateSector by Control Structure.6 GrowthandFinancialPerformanceoftheCorporateSector by Firm Size.18 Financing Patterns by Control Structure.19 Financing Patterns by Firm Size. andAffiliated Banks of Selected Business Groups.7 GrowthandFinancialPerformanceoftheCorporateSector by Industry.Profitability andFinancial . Leverage Table 3.16 CorporateFinancing PatternsbyOwnershipType.14 Philippine Stock Market Performance. 1989-1997 Table 3. 1995-1998 4. 1989-1997 Table 3.3 TheCorporateSectorandGrossDomesticProduct.

2 TheSuhartoGroup TypicalInternalOrganizationalStructureofaPublicly Listed Company in Indonesia CorporateControlStructure:TheCaseofAyalaCorporation CorporateControlStructure:theCaseofLopezGroup 24 25 195 197 . 1990-1996 Financial Ratios of Listed Companies by Ownership Concentration.8 Table 4. Ownership Concentration.4 Table 4.13 Table 4.1 Figure 1.1 Figure 3. 1993-1999 Size and Composition of the Thai Financial Sector.16 Table 4. 1990-1996 Financial Ratios of All Listed Firms. 1990-1996 Common-Size Statements of Public Companies by Ownership Concentration. 1985-1996 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand. 1986-1999 NumberofNewlyRegisteredandBankrupted/Closed Companies.7 Table 4.6 Table 4.10 Table 4. and Company Size Top-Five Shareholder Composition of Publicly Listed Companies in Thailand.2 Figure 3.14 Table 4. 1990-1998 StatisticalRelationshipsbetweenCorporateProfitability.17 StatisticalHighlightsoftheStockExchangeofThailand.ix Table 4. 1990-1996 External Debt. 1985-1999 237 238 239 241 242 243 251 252 256 258 259 260 261 262 264 List of Figures Figure 1. 1992-1999 Offerings of Debt Securities. 1993-1999 Key Financial Ratios of Publicly Listed Companies. 1985-1996 Average Key Financial Ratios by Company Size.12 Table 4.5 Table 4.11 Table 4.3 Table 4. 1990-1998 Merger and Acquisition Activities.15 Table 4.9 Table 4. Leverage. 1992-1999 Common-Size Statements for Companies Listed in SET.


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

Arvind Panagariya ChiefEconomist


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


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

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

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

1 Indonesia
Saud Husnan1



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

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

placed a high premium on these political connections in assessing the chances of being repaid. and responses to the financial crisis. When the crisis hit the country. and analyzes their importance to the corporate sector in Indonesia. these controlling families had political connections that allowed their companies to enjoy special privileges. Foreign debt reached more than $100 billion. The study also identifies family-based companies and corporate groups. regulatory framework. In this setup. followed by finance (-26. In many instances.2 Corporate Governance and Finance in East Asia. short-term loans were used to finance long-term investments. It analyzes the weaknesses of corporate governance in Indonesia. To facilitate even easier access to credit. or Thailand.2 presents an overview of the Indonesian corporate sector. patterns of financing. contracting by 36.5 percent. 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. On the other hand. Economic growth reached more than 7 percent per year and the inflation rate was kept at single digit levels. no doubt. The scale of the financial crisis exposed weaknesses of the country’s corporate sector. These banks were allowed to operate even if they violated minimum capital adequacy requirements. The construction sector was the worst hit. except utilities. However. Section 1. II rate reached 58. patterns of ownership and control. This study reviews the Indonesian corporate sector’s historical development. Malaysia. this left the Indonesian economy extremely vulnerable. posted negative growth. Foreign creditors. and . and how it contributed to the crisis. Vol. particularly those with large foreign loans. highly leveraged companies. the Indonesian economy seemed to be in generally good shape. how it has affected corporate financial performance and financing. 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 controlling families of corporate groups often established banks to provide funds to affiliated nonfinancial companies. 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. Section 1. the currency composition and term structure of corporate foreign indebtedness were causes for concern. prior to the financial crisis. were the ones most affected.6 percent) and trade (-18 percent).5 percent. These were already contributing to high levels of nonperforming loans (NPLs) in the Indonesian banking sector several years before the 1997 crisis erupted. All sectors.3 looks at patterns of corporate ownership and control.

2. In the early 1970s. It also examines the statistical relationship between corporate performance and corporate governance characteristics. while Chinese and indigenous entrepreneurs ran some large businesses in trading. a gradual shift in public investment away from manufacturing took place. 1. 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. Up until the mid-1960s. This section reports the results of an Asian Development Bank (ADB) survey on corporate management and control practices in Indonesian publicly listed companies. With the relatively liberal laws governing foreign and domestic private investments introduced by the New Order Government in 1967 and 1968. Despite the oil revenues. Section 1.and large-scale companies were dominated by state-run industrial concerns. 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). The industries that emerged were highly import-dependent and reliant on tariff protection. and its response. in the course of the fight for nationhood from 1942 to 1950. and tobacco industries. The Government became directly involved in industry as a result of the nationalization of Dutchowned shipping firms and oil companies.5 examines the corporate sector during the financial crisis in terms of its role.2 1.6 summarizes the major findings of the study and suggests recommendations to improve governance in the Indonesian corporate sector. Subsequently. . how it was affected by the crisis. medium. substantial volumes of private investment entered the scene.4 analyzes corporate financing patterns. However. Section 1. 2 Survey questionnaires were sent to 280 companies listed in the Jakarta Stock Exchange.Chapter 1: Indonesia 3 profiles the corporate sector’s governance characteristics.2 Section 1. textiles.

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

The initial banking sector reform was introduced in 1983. the capital market played an increasing role in raising long-term funds needed by the corporate sector. with a total value of more than Rp8 trillion.2. private domestic banks dominated the sector in terms of number and total assets. . However. companies could no longer enjoy low-interest credit from state banks. The Government also allowed foreign investors to buy up to 49 percent of listed shares. Interest rate regulations on state banks and credit ceilings in general were removed.3 The Banking Sector Despite the development of the stock market. more significant reforms were introduced. During this period.Chapter 1: Indonesia 5 At the end of 1988. However. Conglomerates carried out 210 out of 257 IPOs. six SOCs had issued equities in the market. The Government also abolished the practice of setting prices for IPOs and removed restrictions on price movements in the secondary market.5 trillion. the controlling shareholder of these SOCs is still the State. the banking sector has been and still is the major source of credit for the corporate sector. 1.1 shows that from 1994 to 1998. Thus. The development of the Indonesian stock market also provided a vehicle for the privatization of state-owned companies (SOCs). the liberalization of the banking industry allowed banks to determine lending rates for nonpriority loans. Since 1977. from 24 in 1988 to more than 300 in 1997. The dominance of state banks started to erode. In 1988. Table 1. However. state-owned banks were still among the biggest. priority credits still enjoyed subsidized interest rates and funding from the Central Bank. began to face competition. to date. Through the years. and increased access of domestic banks to international financial markets. These included the opening of the banking industry to new entrants. which up to then was channeling oil revenues to priority sectors. Partly as a result of these reforms. Further reforms along the same direction and affecting state-controlled banks came in the 1990s. reduced restrictions on foreign exchange transactions. the number of private domestic banks increased. The banking sector. But in terms of assets per bank. the legal infrastructure that was supposed to guide the evolution of the banking sector was not backed by effective enforcement. the number of listed companies in the stock exchange increased substantially. with a total value of Rp16. Consequently. which were previously constrained to 4 percent per day. the banking sector has undergone many reforms.

6 34 14.9 762.8 391.9 304.0 234 1994 104. . Both BCA and BUN have shareholders linked to the former President Suharto. The other banks among the top 10 were state banks.5 7 7 7 5 15.3 30 7. banks could earn profits even when they did not gather and process information about risk. Vol.4 10 35. II Table 1.9 291.7 351.5 165 308.6 7 7.5 27 66. Of these.9 248.9 31 9. while BUN has been closed down by the Government. But the banking system proved incapable of performing its intermediation function.8 10 37. 1993-1999 Type of Bank State-Owned Banks Assets (Rp trillion) Number of Banks Foreign Banks Assets (Rp trillion) Number of Banks Joint Venture Banks Assets (Rp trillion) Number of Banks Regional Government Banks Assets (Rp trillion) Number of Banks Private National Banks Assets (Rp trillion) Number of Banks Total Assets (Rp trillion) Number of Banks Source: Bank Indonesia.8 27 200.9 10 11.6 Corporate Governance and Finance in East Asia.8 10 19.4 34 12.5 528.3 27 51.9 39 18. and Bank International Indonesia (ranked 9th).3 201.2 10 14.8 29 6.8 27 147. BCA. Bank Danamon (ranked 7th). In terms of assets. and Bank Umum Nasional (BUN) have failed and the first two are now under management of the Indonesian Bank Restructuring Agency (IBRA).5 27 88.5 7 9.4 789.6 240 1996 1997 1998 1999 141. Among private domestic banks.7 27 37.2 161 214. private domestic banks among the top 10 in 1997 included Bank Central Asia (BCA) (ranked first and linked to the Salim group).9 27 113.1 Growth of the Banking Sector.8 31 10.3 10 17.6 164 144 130 92 387.4 239 222 208 173 Assets and liabilities were concentrated in the top 10 banks.8 166 248. 1993 100.1 10 47. Because regulation was weak. the 10 largest were all affiliated with major business groups. Bank Danamon.6 7 12.1 240 1995 122. 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.

Most FDIs came in through joint ventures with business groups having strong political connections.09 1.15) — = not available.87 7.2.78 2. Although these inflows were not nearly as large as those received by Thailand (10 percent of GDP) and Malaysia (9 percent of GDP).33 (13. the Government allowed foreign investors to own 100 percent of an Indonesian company.88) — — — — — — 8. Indonesia received capital inflows averaging about 4 percent of GDP.09) (0. In effect. Successive policy deregulation facilitated FDIs in various light manufacturing industries. 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). Increasingly.50 (0.11 3.81 3. Until the onset of the crisis. especially through bank loans.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. such as metal goods. textiles. Table 1. there was an explosion of credit for which the probability of repayment was based on little but blind faith in the sustainability of rapid growth and on the presumption that political connections were as good as government guarantees against bankruptcy of borrowers. as shown in Table 1. Joint BIS-IMF-OECD-World Bank Statistics on External Debt. Between 1990 and 1996. and footwear. FDI flows were strong.01) (0. But FDIs were only one form of foreign capital inflows to Indonesia. they still amounted to a large sum for the economy to absorb.74 5.59 billion in 1996.88 4.01 (2. In the 1990s. when the financial crisis hit Indonesia. September 2000.00 2. 1. there was a phenomenal growth in direct borrowings by Indonesian corporations. except in certain strategic sectors. Net FDI flows increased to $5.2.10 5.63) (1. In 1994. 1990-1998 ($ billion) Type of Flows Net FDI Net Portfolio Investment Foreign Bank Loans 1990 1991 1992 1993 1994 1995 1996 1997 1998 1. foreign creditors were eager to provide financing to Indonesia. From the mid-1980s until July 1997. November 2000. foreign investment also had a strong presence in the services and infrastructure sectors.59 4.09) 1.48 1. Source: IFS CD-ROM.40) (0. IMF.2 Foreign Capital Flows. .

of which two thirds were rupiah-denominated. Capital account liberalization permitted the inflow of foreign capital that fueled the credit boom in the country.8 Corporate Governance and Finance in East Asia. and conglomerates. the average foreign ownership of listed companies was 21 percent. In the 1990s. allowing foreign investors to buy up to 49 percent of stocks of a publicly listed company. This increased to 30 percent by the end of 1993. From 1987 to 1996. state-owned companies (SOCs). Between 1989 and 1992. . the average borrowing rate for dollar loans was 9 percent. In November 1998. participation in the Indonesian stock market was exclusive to domestic investors. foreign investors began to dominate daily trading. Consequently. The following section looks at the growth and financial performance of the corporate sector. 1. In September 1997. the analysis focuses only on publicly listed companies. Vol. but declined to an average of 25 percent during 19951997. This is lower than the average borrowing rate of 18 percent for loans in domestic currency. The excessive dollar borrowings made the corporate sector vulnerable to sudden currency fluctuations.5 Growth and Financial Performance While it was obvious that the term structure and currency composition of debt suggested problems in the run-up to the crisis. The external corporate debt owed to foreign commercial banks was $67 billion. 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. The Government relaxed this restriction in 1988.4 trillion in 1997. with the onset of the Asian crisis. Domestic corporate debt was about $50 billion equivalent. an interesting question is whether standard measures of corporate profitability and performance also indicated the same.2. 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. Due to data constraints. total corporate debt reached nearly $118 billion. II Up until the late 1980s. Private borrowers preferred foreign loans since these were relatively cheaper. especially the short-term ones. By the end of 1997. foreign banks became a significant source of financing for the corporate sector. increasing the total trading value from Rp8 trillion in 1992 to Rp120. 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. plus 4 percent for the depreciation of the rupiah.

8 percent between 1992 and 1996.4 1997 7. while total assets grew at 43 percent.0 12. b Asset turnover is defined as sales over assets.1 percent in 1997 when the crisis began to buffet Indonesia.5 37. Average return on equity (ROE) of listed firms was 11.5 3.0 12. Despite such rapid growth. total sales of listed companies grew at an annual average rate of 31 percent. The debt-to-equity ratio (DER) was high compared to those of listed companies in Malaysia and the Philippines.0 12. In 1997.3 shows the growth and financial performance of Indonesian publicly listed companies.6 percent in 1997. 1992-1997 (percent) Item Growth Indicators Sales Growth Share of Value Added in GDPa Asset Growth Financial Indicators Debt-to-Equity Ratio Return on Equity Return on Assets Asset Turnoverb 1992 — 3.9 37.4 31.0 1. Source: JSX Monthly (several publications).1 0.6 1994 50. Note: The number of firms is not identical for each year. publicly listed companies as a group contributed less than 10 percent to GDP. 250 firms.7 3. a Value added was assumed to be 30 percent of total sales.Chapter 1: Indonesia 9 Publicly Listed Companies Table 1.0 11. Table 1.4 percent.7 percent in 1997. 248 firms. Net profits grew at an annual rate of more than 20 percent from 1992 to 1996.6 3. 1994.5 240.5 34.4 1996 18. but declined to 0. The growth of listed companies was sustained by continuing investments.1 4.0 3.3 6. 246 firms. During 1992-1997. 1996.0 64.0 10.4 38. although the contribution increased over time.8 6.7 — 250.6 24. but fell to 24. Asset turnover was above 30 percent until 1996.1 220. Return on assets (ROA) was also relatively stable during 1992-1996.4 1993 45. ranging from 220 to 250 percent between 1992 and 1996. but dropped to 1. 1995.7 — = not available. the average DER increased to 310 percent from 230 percent the .3 3.9 310. 1993.2 1995 37.3 Growth and Financial Performance of Publicly Listed Companies. and 1992. When the crisis battered Indonesia in 1997.2 30. there were 204 firms.0 6. averaging 3.5 34.6 48.8 230. but turned negative in 1997.0 33. 174 firms. 226 firms.8 220.2 7.

meanwhile. miscellaneous industry. miscellaneous industry. the mining sector had the highest ROE. and services. From 1995. still posting a positive but lower ROE. In terms of share of value added to GDP. Most companies in the sector that had unhedged dollar-denominated loans suffered exchange rate losses when the rupiah weakened. consumer goods. it appeared that the performance of listed companies was quite satisfactory prior to the crisis. when the property sector was booming during 1993-1997. averaging 21. and building construction sectors had the highest DERs because companies in these sectors found it easy to obtain credit from banks. trade. due mainly to the domination of the International Nickel Company of Canada. property. only two sectors (mining and finance) showed a consistently increasing trend from 1992.3 percent between 1992 and 1996. However. which operated in nickel and copper mining in 1992 and 1993. the property sector was severely affected by the crisis.5 presents the financial performance of listed companies by sector. and property.64 percent in 1997. in terms of growth of sales and assets. Overall. the dominant sector was the finance sector.4). and services. When interest rates increased. The same applied to the trade sector. real estate. the mining sector had the lowest DER. The ROE levels suggest that high leverage enabled listed companies to achieve high returns on equity. ROE fell drastically because the sector had one of the highest DERs. Meanwhile. the fluctuation in nickel and copper prices contributed to the oscillation of ROE. property. The finance. This sector was less affected by the crisis. investment. Table 1. Vol.10 Corporate Governance and Finance in East Asia. The consumer goods sector ranked second in terms of ROE. During those years. and trade. For instance. followed by agriculture (Table 1. The finance sector’s contribution to GDP. indicating its reliance on equity to support growth.2 in 1997. mining. basic industry and chemicals. But the sector’s ROE fluctuated a lot. Before the crisis. and trade) even posted . infrastructure. real estate. finance. The Jakarta Stock Exchange (JSX) classified listed companies into nine sectors: agriculture. Four sectors (basic industry and chemicals. with ROE falling to -11.73 percent in 1992 to 1. II previous year. the mining sector ranked first. increased from 0. Also. although asset turnover was slow. the companies in the sector did not operate with a high leverage. investment. This indicates that a substantial part of corporate debt was denominated in dollars and unhedged. ROA of all sectors dropped in 1997.7 percent during 1992-1996. averaging 17. In terms of sales and asset levels in 1997. the banks eagerly provided credit to property development companies. and building construction. helped in part by the relatively strong demand for consumer goods.

6 0.3 0. and Services Asset Growth Agriculture Mining Basic Industry and Chemicals Misc.9 8.4 (149.5 0.1 0.0 18.0 31.0 16.5 61.5 45.7 54.7 — — 11..6 1994 (75.4 64.6 133.2 0. Source: JSX Monthly (several publications).5 13. and Bldg.3 (203.6 22.8) (12.7 17.1 1. and Bldg.3 0.3 340.6 51.6 (0.6 28.1 1.Table 1. Investment.5 1.8 51.8 1.9 54. Investment.9 0.3 0.7 90.0 0. Industry Consumer Goods Industry Prop.0 0.9 .4 43.4 Growth Performance of Publicly Listed Companies by Sector.6 24.0 0.7 62.8 (76.5 1.8 27.4) 8.0 0.3) 53.6) 25.1 (11.7 21.1 0.9 31.9 123.0 1.3) 39. Real Estate.5 53.7) 26.9 1.0 (28.9 64.5 28.5 (8.2 35.0 1996 1997 58.1 35. and Services Share of Value Added in GDP Agriculture Mining Basic Industry and Chemicals Misc.9 (7.0) 46.7) (27. and Services Net Profit Growth Agriculture Mining Basic Industry and Chemicals Misc..1 (41.2) 0. Constn.5) 49.5) 13. Infrastructure Finance Trade.8 1.7 — 36.7 1995 51.6 135. Real Estate.2 14.4 38. Infrastructure Finance Trade.4) 6.1 71.7 0.6 83.1 0. Constn.9 25.7 (82.7) (113. Investment.0 64.8 24. 1992 — — — — — — — — — — — — — — — — — — — — — — — — — — — 0.8 28.2 5.0 (192.7 43.1 — 39.1 23.7 40.3 92.1 1.1 42.8 62.9 36..7 112.4 30.7 28.4 0.1 67.1 28. Infrastructure Finance Trade.7 133.8) 0.5 23.1 0.6 0. Investment.4 21.5 68.6 0. Industry Consumer Goods Industry Prop.6) 119.2 41.5 92.8 66..3 51.4 44.2 59. Infrastructure Finance Trade.6 15.1 0.5 1.1 0. 1992-1997 (percent) Indicator/Sector Sales Growth Agriculture Mining Basic Industry and Chemicals Misc.6 1.4 31.1 32.6 (41. Constn.4 170.4 1993 155. Industry Consumer Goods Industry Prop.7 24. and Bldg.9 14. and Services — = not available.6) 19.6 26.4 30.9 59.3 0.1 1.2 13.9 54. Constn.4 1. Industry Consumer Goods Industry Prop.5 0. Real Estate.2 0.8 32.6 85.3 0. and Bldg.9 0.3 31.0 24.8 0.5 95.4 1.3 17.8 29.0 (20.0 0.0 0.5 (11.1 0.7) 17. Real Estate.5) 6.0 68.6 0.3 1.7 34.9 53.0 22.4 103.2 41.1 1.7 0.4 1.4 77.2 11.8 50.1 0.1 0.3 31.1 0.1 16.0 43.5 9.

8 67.1 (5.4 1. Real Estate..3) 5.7 10.5 56.1 9.0 210.4 5.0 100.4 13. and Services Return on Assets Agriculture Mining Basic Industry and Chemicals Misc.4 ..5 7.2 39.7 9.2) 15. 1992 20.1 13. Investment. Investment.5 1995 80.5 19.7 12. 1992-1997 (percent) Indicator/Sector Debt-to-Equity Agriculture Mining Basic Industry and Chemicals Misc.0 180.4 4.8 8.1 63.2 30.9 7.3 7.4 13.7 4.2 15.0 150.9 41.4 20.1 8.3 13.7 4..3 5.6 (2.7 1.2 6.5 Financial Performance of Publicly Listed Companies by Sector. Infrastructure Finance Trade.9 10.0 69.0 110.3 17. and Services Source: JSX Monthly (several publications).0 12.0 560.0 130.6 8.0 14.2 (4.5 17.1 3.7 1.0 190.6 19.4 46.4 6.3 7.1 2.1 11.0 140.7 61. and Bldg.9 17.7 4.0) 7.7 12.7 26.0 80.0 50.0 160.9 38.0 70.6 23.0 120.0 19. Industry Consumer Goods Industry Prop.0 680.2 3.0 180. Constn.0 3.7 10.2 8.4 6.1 6. Real Estate. Industry Consumer Goods Industry Prop.0 39.0 8.8 9.0 650.7 71. Real Estate.1 1996 100.8 11.6 8.3 18.6 (11.2 23.6 74.9 40.8 44.5 5.5 14.0 70.0 160.4) (1.1 65.0 140.0 90. Investment.0 60.1 1994 80.1 4.0 100.0 110.8 382.6 13.1 10..1 4.8 11. Real Estate.2 7.0 150. and Bldg.2 111.0 190.9 38.1 9.0 11.6) 18.6) 36.3 33.6 18.3 17. Constn.1 (3.7 (3.4 17.2 3.4 71.2 53.1 89.9 42.7 46. and Services Return on Equity Agriculture Mining Basic Industry and Chemicals Misc.7 13.0 110.7 8. Industry Consumer Goods Industry Prop.2 7.0 46.4 79.3 0.0 8.0 180.0 110.6 14. Infrastructure Finance Trade.5 4.0 9.0 66. Constn. Constn.0 700.0 220.9 4.8 81.8 479.2 1993 130.1 10.3 1.0 70.8 25. and Services Asset Turnover Agriculture Mining Basic Industry and Chemicals Misc.4 46.9 87.5 4.0 1997 230.3 38.7 5.7 12.0 86.0 (0.1 10.5 11.0 380.0 120. Infrastructure Finance Trade.0 110.0 17. and Bldg. Infrastructure Finance Trade.0 120.0 100.6 13. and Bldg.5 43.7 10.9 29. Investment.4 35.0 15.2) 7.2 13.0 150.3 64.8 20.9 14.1 4.0 190.0 120.6 1.8) 8.8 168.0 160.0 170. Industry Consumer Goods Industry Prop.1 1.8 5.0 80.2 11.0 100.0 650.3 73.8 16.0 110.7 8.4 35.Table 1.0 630.1 7.5 13.8 3.7 5.0 3.0 110.0 80.

3 percent in 1995.4 percent the following year. The Department of Mining and Energy ranked first in terms of sales of SOCs under its control. This was due to large sales by the National Oil Company (Pertamina). increasing from 21. but dropped dramatically to 4. The sectoral distribution of 165 SOCs is as follows: nonfinancial (143 companies). and basic industry and chemicals sectors had relatively stable ROA before the crisis. Asset turnover rates were lower relative to those of publicly listed companies.7 percent. insurance (11 companies). This was relatively high compared to the 3. much lower than that of companies listed in the stock exchange. SOCs’ sales growth fluctuated during 1990-1996. Taken together. Only the agriculture sector showed an increase in ROA in the couple of years before 1997. State-Owned Companies At the end of 1995. Six SOCs were listed in the Jakarta Stock Exchange. Trade had the highest ROA of 39.3 trillion. Assuming a fixed ratio of value added to sales. For instance. the subsidiaries and affiliates number 459 with total assets of Rp343. Similarly. ROA had been at high levels from 1992 to 1995. respectively. SOCs actively operated in various sectors4 under the supervision of “technical” departments. These growth rates were low compared to those for listed companies during the same period.6). which collectively had the largest assets. and finance company (four companies). However. Just like private companies. the SOCs’ value added as a percentage of GDP ranged from 6 to 8.1 percent in 1992 to 28. By 1995. indicating SOCs’ declining contribution to GDP.7 to 7 percent for publicly listed companies.7 percent in 1990 to 6 percent in 1996. there were 58 SOCs with subsidiaries and affiliates. While asset turnover rates of publicly listed 3 4 SOCs are those in which the State has at least a 51 percent equity interest.8 percent between 1992 and 1995 (Table 1. registering an average annual rate of 10 percent. SOCs diversified into many businesses. the Department of Finance supervised 30 SOCs. growth of net profits and assets was erratic. averaging 24 and 31 percent. but it continuously declined from 370 percent in 1992 to 250 percent in 1995. The DER was slightly higher than for listed companies. banks (seven companies). SOCs’ ROE ranged from 6. The finance and miscellaneous industry.Chapter 1: Indonesia 13 negative ROA. there were 165 state-owned companies (SOCs)3 in Indonesia. the ratio decreased from 8.1 percent in 1993.6 to 8. . between 1993 and 1995.

2 percent in 1997 (Table 1.2 23. these conglomerates owned 9.3 12.4 7.1 12.8 11. Source: Indonesian Data Business Center. b Asset turnover is defined as sales over assets.14 Corporate Governance and Finance in East Asia.0 8.7 (2.6 1995 25.3 250.0 12.3 30. but dropped to 11. II companies consistently declined over time.2 18.1 310.4 1993 16.4 13. Their total sales increased from Rp90.7 13. SOCs’ asset turnover rates showed a downward trend from 32.7 16.6 28.6 28.0 28. mostly private companies.0 6.4 13.5 percent in 1995. but climbed to 30. Source: Indonesian Data Business Center. 1992 — 7. a Value added was assumed to be 30 percent of total sales.2 — = not available. Table 1. In 1997.7 1994 (9.4 percent in 1994.4 13.1 32.2 — 370.6 percent in 1994.6) 260.8 percent in 1990 to 13.0 24.4 percent in 1992 to 28.8 21.8 12.1 19.7). 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. Vol. Assuming a constant ratio of value added to sales.5 3.1 6.0 17.1 trillion in 1990 to Rp234 trillion in 1997. 1990-1997 (percent) Item Sales Growth Share of Value Added in GDPa 1990 1991 1992 1993 1994 1995 1996 1997 — 17.1 30.766 business units.7 Growth Performance of the Top 300 Conglomerates. .0 7. Table 1.0 8.6 Growth and Financial Performance of State-Owned Companies. the contribution of conglomerates to GDP increased from 12. a Value added was assumed to be 30 percent of total sales.1) 5.4 16.5 Conglomerates This study used available data on the top 300 conglomerates in Indonesia.

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

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

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

9 shows that ownership by the largest shareholder in 1997 was more concentrated in the agriculture.5 72. the founder usually continues to own the majority of shares through a . On average.2 67.2 1.9.8 68.8 Ownership Concentration of Publicly Listed Companies.0 67. Table 1. and basic industry and chemicals sectors than in others.0 0.5 12.6 13.1 0. 3. The pattern of ownership concentration changed little over this period.5 Average 48. 1993-1997 (percent) Shareholder Rank First Largest Second Largest Third Largest Fourth Largest Fifth Largest Total 1993 50.6.9 14. about two thirds of publicly listed companies’ outstanding shares were owned by corporations that were directly or indirectly controlled by families.8 shows average proportions of shares owned by the five largest shareholders of publicly listed companies during 1993-1997. Vol.7 1994 48.5 1997 48. Rig Tenders Indonesia (shipping services) issued 51.4 2. the five largest shareholders owned 68. Data from the Indonesian Capital Market Directory (various publications) show that between 1993 and 1997.2 11. 13.1 1. for instance. This preserves the pro rata share of existing shareholders. and 0.7 1996 48.0 1.5 percent. When a company goes public.6 3. This is because a few companies in the transportation sector issued high proportions of shares to the public.1 4.6. The percentage owned by each of the five largest shareholders was 48.8.0 4.9 percent of total outstanding shares.6 4.0 0. the controlling shareholders usually act as standby buyers.0 2. respectively.8 68.1 13. and Berlian Laju Tankers (liquid bulk maritime transportation services) issued 48.3 1995 47.6 percent.6 68.6 3.5 16.9 2. consumer goods. 2. Zebra Nusantara (taxi services). mining. issued 93.4 percent.9 2. ownership widely held by the general public is highest in the infrastructure and transportation sector (not shown in the table). When a company makes a rights issue. Meanwhile. Table 1.9 0. This is partly due to the prevailing practice of raising equity through rights issues in Indonesia.8 1. II Publicly Listed Companies Table 1.9 Source: The Indonesian Capital Market Directory.18 Corporate Governance and Finance in East Asia.7 3.

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. and only 0.Chapter 1: Indonesia 19 fully-owned limited liability company (Perseroan Terbatas).4 54. Util.5 4. 1997 (percent) Sector Agriculture Mining Basic Industry and Chemicals Misc.1 11. In fact.4 11.9 44. on the other.9 Ownership Concentration of Publicly Listed Companies by Sector. Real Estate.0 5.8 14.9 0.1 1.2 10.6 9.9 3.2 15. First Second Third Fourth Fifth Biggest Biggest Biggest Biggest Biggest 54.6 percent of total market capitalization while the top 15 families control 61.1 2.3 14. Claessens et al.3 2.2 0.6 1.4 4.7 6. and Bldg.1 percent) of Indonesian publicly listed companies were in family hands.9 50.1 2.. which shows that in 1996.6 8. that the correlation between the share of the largest 15 families in total market capitalization.9 1.1 2.1 1.4 6.3 0.3 36. in a cross-country study. two thirds (67.3 48. the rule of law. is strong. on the one hand.1 1.2 2. Indonesia has the largest number of companies controlled by a single family.6 percent were widely held.7 13.6 2. the top family controls 16.1 1.6 0. (1999).1 13.1 0. Table 1.5 1. (1999) also found.4 1. and Transportation Finance Trade.7 percent of the market. Industry Consumer Goods Industry Prop. Legal and regulatory developments may have been impeded by the concentration of corporate wealth in .3 0. Thus the founder keeps the proportion of shares necessary to retain control over management of the listed firm. In terms of capitalization. Infrastructure. Investment.5 58. Most of the five largest owners of Indonesian publicly listed companies are limited liability companies rather than individuals.4 44.2 This is confirmed in Claessens et al.2 46. and the efficiency of the judicial system. and Services Average Source: The Indonesian Capital Market Directory. and corruption..9 44.7 9. These figures suggest that ultimate control of the corporate sector rests in the hands of a small number of families.7 1.7 4. as well as the existence of corruption. Constn.1 0.

In 1993. Indian. their number increased to 5 In 1997. Family control is said to have positive effects in that it allows group members in conglomerates to make strategic decisions quicker.55 percent in August to 25.42 percent in December. numbering 162 in 1988 and 170 in 1996. During 1988-1996.20 Corporate Governance and Finance in East Asia. the legal system is less likely to evolve in a manner that protects minority shareholders. most were established during the New Order Government. nonindigenous groups owned a larger proportion of the top 300 Indonesian conglomerates. and family origin. The nonindigenous businesspeople are usually Chinese. But these benefits are few and often dubious compared to the high costs of concentration. or other ethnic groups. accounting for 64 percent of total conglomerate sales in 1988-1996. Coordination is easier because informal communication channels exist. When the Government allowed foreign investors to buy up to 49 percent of listed shares in 1988. but later declined and steadied at around 25 percent. was able to create a favorable environment for business development. the proportion of foreign ownership declined from 27. resulting instead in a decline in the proportion of foreign investor ownership. In Indonesia. Batak. it rose to 30 percent. the onset of the crisis negated this development. Sundanese. conglomerates established before 1969 dominated in terms of sales.10 shows the anatomy of the top 300 conglomerates in terms of year of establishment. there is a dichotomy between corporations owned by indigenous and nonindigenous businesspeople. This may indicate that the New Order Government. II the small number of families and the tight links between companies and the Government. From 193 in 1988. 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 corruption and regulatory problems generated by high ownership concentration by families in Indonesia are likely to overwhelm its benefits. . In September 1997. and Padang.5 Conglomerates Table 1. Vol. foreign ownership increased to 21 percent. However. with all its regulations. ethnicity. Indigenous businesspeople include the Javanese. However. the Government allowed foreign investors to buy up to 100 percent of listed shares. political affiliation. Among the top 300 conglomerates.

Conglomeration Indonesia 1997.1 33.9 billion.4 37.8 Source: Indonesian Business Data Centre.2 30.7 89.0 18.1 42.8 36. more than five times its 1988 level.1 21.1 25.7 40.9 13. While they supplied 20.0 31.4 31.7 24. 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 9.9 35.5 120.6 95.9 14.7 49.4 81.6 34.1 179.2 12.4 59.4 16.2 48. the number of mixed groups declined from 86 in 1988 to 68 in 1996.6 77.7 28. Their total sales also increased from Rp38.2 23.0 28. 204 in 1996.4 22.4 48.7 95.8 30.9 47.9 73.0 58.8 12.8 25.6 trillion in 1988 to Rp137.1 percent of total .3 101.4 trillion in 1996.9 137.3 20.2 76.0 44.0 15.5 22.1 46.4 52.6 17.9 77.3 43.10 Anatomy of the Top 300 Indonesian Conglomerates.6 114. its sales reached Rp1.5 106. due to their “go public” activities.4 19.1 46.8 68.1 52.0 116.1 41.6 54.3 134.4 59.4 57.5 21.0 58.2 33.9 42.8 38.4 32.8 57.4 69. sales of the Bakrie group before it went public in 1990 were only Rp369.4 15.3 36.6 12.2 29. In 1996.4 68.1 103.4 31.2 159.9 trillion.4 18. Meanwhile.7 106. For instance.1 58.1 87.4 86.Chapter 1: Indonesia 21 Table 1.8 28.7 64.3 80.8 49.3 120.

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

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

World Bank. Simeon Djankov. Who Controls East Asian Corporations? Financial Economics Unit. . P. Lang. and Larry H.Figure 1. (Feb. 1999). Financial Sector Practice Department.1 The Suharto Group Usaha Mulia Group (cousin Hasim) Cemen Cibinong Hanurata Group Suharto Family Citra Lamoro Group (daughter Mbak Tutut) Bank Yama Bob Hasan Group (Mohamad Hasan) Gatari 22 firms with control over 20% Citra Marga Persda Tollroad Trias Sentosa Bank Central Indomobil Mercu Buana Group (step brother Probo) 11 firms with control over 20% Kedaung Indah 14 firms with control over 20% Kedaung Group (Agus Nursalim) 18 firms with control over 20% Tirtamas 21 firms with control over 20% 262 firms with control over 20% Salim Group (friend Soedono) Sempati Air Humpuss Group Bank Utamar 17 firms with control over 20% Bimantara Group (son Bambang) TPI Andromed Tripolita 8 firms with control over 20% Kabelindro Kiani Murmi Sakti Source: Stijn Claessens.

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


Corporate Governance and Finance in East Asia, Vol. II

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

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

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

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

Chapter 1: Indonesia


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

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

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

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


Corporate Governance and Finance in East Asia, Vol. II

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

BOD 5 5 5 23 38

BOC 1 1 3 35 40

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

Chapter 1: Indonesia


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


Corporate Governance and Finance in East Asia, Vol. II


External Control

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

Control by the Government Government control could be in the form of state ownership. which was acquired by Yopie Wijaya in 1995. except for publicly listed SOCs. restrictions on market entry. the owner of Tirtamas group. The BOD and BOC of PT Sari Husada were allowed to complete their terms before they were replaced. In April 1999. the bank was liquidated. Wijaya and his friends bought shares of the bank on several occasions until they gained control.6 In this case. the takeover brought significant losses to Djojohadikusumo when share prices plunged7 during the crisis. The bank was reported to have high NPLs and had broken the legal lending limit. the Government took over NPLs and put them under IBRA management. For instance. to Hashim Djojohadikusumo. . This used to be a common practice in companies associated with the Suharto regime. However. a state-owned insurance company may invest its funds in a private firm. The Government is thus able to appoint some officials to be members of the private firm’s BOD or BOC. Most Indonesian state companies are 100 percent owned by the Government. Another case was the takeover of Bank Niaga in 1997 by Djojohadikusumo. 6 7 Later in March 1999. Bank Niaga was under a recapitalization program. with the minister’s approval. it was common for the Government to invest in certain private companies.Chapter 1: Indonesia 31 external acquisitions. They then replaced the BOD and later sold the bank. State ownership for listed SOCs ranges from 25 to 35 percent. IBRA found itself tasked with managing large amounts of assets in the private sector. A more recent case was the acquisition by Nutricia (the fourth largest baby food firm in the world) of PT Sari Husada (another baby food firm) in 1998. the acquiring interest was apparently seeking economic profits. Since the NPLs reached up to Rp300 trillion. Before the financial crisis. A study by Connie Tjandra (1993) shows that internal acquisitions were often initiated for tax shelter purposes. The Government appoints the BOD and BOC of these firms. In the massive restructuring of the banking sector that commenced after the crisis. at a large profit. the acquiring parties were trying to obtain operating synergies because they had companies in the same industry. One famous takeover was Bank Papan Sejahtera. appointment of management. In these two latter cases. who was acquiring his second commercial bank. or direct subsidies.

bank loans were the only instruments available to the corporate sector for short term (working capital) or long term (investment) financing.4 1. equities became available to the corporate sector. and others offered by nonbank financial institutions or finance companies. including bonds. Private national banks and state-owned banks were the biggest domestic creditors.32 Corporate Governance and Finance in East Asia.6 48.6 4. From 34. because of the restrictions discussed below.14 Banking Sector Outstanding Loans. remain the major financing instrument for the corporate sector.7 112. 1992-1999 (Rp trillion) Type of Bank State-Owned Banks Foreign Banks Regional Govt Banks Private National Banks Total Source: Bank Indonesia.3 9. Bank loans. stocks.0 3.2 27.0 168. II 1.7 18.5 80.8 193.3 66. companies considered alternatives to bank loans. the share of private national banks in outstanding total loans increased to 44.0 487. Data from Bank Indonesia show that from 1994 to 1997.6 150. However.3 60. .3 14.9 234. 1992 1993 1994 1995 1996 1997 1998 1999 68.6 6.9 150.3 111.2 6.1 Corporate Financing Financial Market Instruments Prior to 1977. Vol. when the Government reactivated the stock exchange. Table 1. Since then. jointly providing almost 90 percent of loans until 1997.1 220. When the Government liberalized the banking industry at the end of 1988 (which allowed for higher interest rates).4 24.2 5.0 6.0 93.4 225.4 trillion in 1998.9 trillion in 1992 to Rp487.14.7 122.5 7. this market was not well developed. new instruments have been introduced to the corporate sector.5 108.9 378. Bank Credit As shown in Table 1.7 50.4 percent in 1992.6 292. however.4. private national banks overtook state banks as the dominant credit source.5 42.3 188.6 percent in 1997.4 86.4 56.6 3. bank credit surged from Rp122.9 153.2 71.1 Equities In 1977.

6 301.2 16. The ratio reached 8.1 17. and net open position). Overall.4 1996 1997 1998 50.0 206. shooting up to 18. the activities of finance companies were not covered by regulations on prudential practices in the banking sector (e.6 91.3 percent in 1990 when the stock market was liberalized and foreign investors were allowed to purchase up to 49 percent of listed firms’ shares. finance companies were increasingly used as channels for the inflow of foreign loans. but dropped to 8 percent in 1991 when the Government tried to stabilize an overheating economy. funds raised in the stock market were less than 5 percent of the credit disbursed by the banking sector.e.. In 1988.g.4 207. the Government issued regulations to supervise and promote prudential practices in finance companies. . Prior to 1995. 1992-1999 (Rp trillion) Item Stocks Issued Outstanding (As % of Outstanding Bank Credit) Market Capitalization Source: Bank Indonesia. 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 1996.7 15.8 48. i.6 859. allowed to accept deposit accounts from the public. credit cards.7 percent in 1997. the stock market has gained a bigger role in corporate sector financing (Table 1.15). limiting loans to a maximum of 15 times equity and foreign loans to five times the equity. factoring. capital adequacy ratio.6 123. In 1995..1 1994 26.1 18. thus increasing the role of the capital market in raising long-term funds.5 1995 35. legal lending limit. Most banks therefore set up subsidiary finance companies to circumvent banking regulations. During the 1990s.0 15.7 9.15 Value of Stocks Issued and Stock Market Capitalization. Table 1.Chapter 1: Indonesia 33 Some companies went public.5 333. They were not.6 310. offering services such as leasing.9 406.1 10. when foreign investors were not yet allowed to purchase listed shares. 1992 1993 11.7 14.0 70.9 1999 76. however. It gradually increased again starting in 1991.5 Financing by Finance Companies Finance companies first emerged at the end of 1980. and consumer credit.

have been popular in Indonesia since 1990. which are unsecured negotiable promissory notes with a maximum maturity of 270 days. Source: Author’s estimates based on the Pacific-Basin Capital Markets (PACAP) Databases.0 — = not available. publicly listed nonfinancial companies had high proportions of equity and internal finance (retained earnings).0 1986-1996 17. While banks had some exposure to these instruments.2 Patterns of Corporate Financing Table 1. PACAP Research Center.3 (0. 1986-1996 (percent) Financing Source Internal Borrowings Short-Term Long-Term Debentures/Equity Debentures Equity Trade Credit Others Total 1986-1990 36.6 12. .8 7.1) 23.4 13.4 23.5 21.4 8.4.0 39. averaging 26.1) 23. Table 1.6 100. This is in contrast to the lower share of borrowings during the same period.16 Financing Patterns of Publicly Listed Nonfinancial Companies.5 11. Vol.16 shows financing sources of Indonesian publicly listed nonfinancial companies estimated by using flow-of-funds analysis.6 8. Thus in November 1995. Bank Indonesia prohibited banks from underwriting issues of commercial papers but allowed them to act as paying agents. at 81 percent of total borrowings.5 — 26.0 100.3 14. short-term borrowings were greater than long-term debts.3 37.9 16. In terms of composition. they were not rated by a rating agency.6 23.5 percent and 36.3 16. respectively.5 (0.0 1991-1996 16.6 100.7 22. 1. 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). 1996.34 Corporate Governance and Finance in East Asia.8 17.2 26. In the second half of the 1980s. otherwise it would be classified as a loss in the banks’ books.0 3.8 percent. II Commercial Papers Commercial papers.

reaching Rp229. 1. Table 1.3 Corporate Financing and Ownership Concentration It has been suggested. that ownership concentration may be associated with heightened risk-taking by companies. Two telecommunications companies.4. except Semen Gresik (an SOC). The high share of equity financing was due to the surge in capital market activity following the 1988 reforms.6 trillion and Rp1.1 trillion.3 percent during 1991-1996. . Corporate debts grew over time. also suffered from foreign exchange losses but managed to post profits of Rp0. For instance.17 compares the DER of listed firms by degree of ownership concentration. These liabilities grew significantly because corporate expansion was largely financed by debt.2 trillion (mostly foreign exchange losses).9 trillion in 1996. This amount doubled in 1997.Chapter 1: Indonesia 35 In the 1990s.9 trillion. The corporate sector invested heavily from 1991 to 1993 and slowed down its investment spending a few years before the 1997 crisis. Bank loans also surged when the banking sector was liberalized in 1988. with longterm debts increasing rapidly. as evidenced by an average DER of 230 percent during 1992-1996 that rose to 310 percent in 1997. corporate debts accounted for 39. respectively. The results indicate that firms with higher ownership concentration tend to have a higher DER. Note that the corporate sector’s high leverage existed side by side with sizable equity capital raised from the capital market. All companies in the cement industry suffered from 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. Hence. Many companies suffered big losses in 1997 due to their high exposure to dollar loans. Most corporate charters require commissioners to approve debt issues or sign debt agreements.4 trillion in 1993 to Rp112. the corporate sector’s high leverage. rising from Rp54.2 trillion. the pattern changed. which managed to post significant profits due to low exposure to dollar-denominated loans. which was masked by the rapid growth in investments. was due largely to a rapid rise in long-term debts. while Semen Cibinong’s losses reached Rp2. in the context of Indonesia and some other countries. They also do not want to dilute corporate control and are more likely to finance growth with debt. Of the various financing sources. Indofood registered losses of almost Rp1. Indosat and Telekom.

and high ownership concentration among families with political affiliation.56 significant at the 10 percent level. since commissioners represent the controlling party. the free capital flow system allowed private companies to borrow dollars offshore without any restriction. the borrowings swelled.36 Corporate Governance and Finance in East Asia.0 Notes: Firms with high ownership concentration have more than 50 percent of shares owned by the top five shareholders. aided . The test of the difference between the two means found the t-value of 1. 1. Inadequate Financial Regulatory Framework Liberalization of financial markets increased the corporate sector’s access to domestic and foreign private capital. the private sector borrowed heavily in unhedged dollars.358. The low cost of foreign loans and the relatively stable exchange rate created a false sense of security for corporations. ultimately. Table 1. Vol. In addition.0 351. As a result. to maintain control of the company. 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. heavy reliance of companies on bank credits to finance investments.0 1.0 386. Source: Author’s estimates. II However.17 DER of Listed Companies by Degree of Ownership Concentration (percent) Item Mean Standard Deviation DER of Firms with High DER of Firms with Low Ownership Concentration Ownership Concentration 699.5.5 1. decisions on debt are made with the implicit endorsement of owners.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. Between 1987 and 1996. 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.

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

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

1) (26. Forestry.52 trillion. and Fisheries Mining and Quarrying Manufacturing Electricity.8 1997 1.8) (13.8 8. The JSX Monthly reported that total losses of 214 listed companies amounted to Rp39. 53 companies reported negative equity of Rp6.8 7.7 1998 (0.18 shows that growth in most sectors significantly fell in 1997. and Water Supply Construction Trade. when all sectors.8 0.18 GDP Growth by Sector.4) (0.4 7.4 5. except utilities.58 trillion (meaning their losses were greater than the paid-up capital).19. The consumer goods industry reported the lowest ROE.8) (11.9 3.6 4. Only 86 companies reported profits.5) (18. 1996-1999 (percent) Sector Agriculture.0 2.1 6. Real Estate. Most sectors showed significant increases in leverage.7 6.3 Source: Central Bureau of Statistics (Biro Pusat Statistik.6 8. Using the financial statements as of 30 June 1998 of 161 publicly listed companies.0 3. as shown in Table 1. and 128 companies reported a total loss of Rp46.2 (1.370 percent. and Restaurants Transport and Communications Financial.6 (36.2 Impact of the Financial Crisis on the Corporate and Banking Sectors Impact on the Corporate Sector Table 1.6) (3. real estate.4 7.7) 2. The average DER was found to be 1. posted negative growth rates. much higher than the 307 percent registered in December 1997.1) 1. BPS).0) 1999 2.0) (15.6) (0.6 13. Sectors with lower ROE generally had higher DER.6 12. The construction sector was the worst hit.7) (8. Table 1.24 trillion for the first six months of 1998. DER and ROE were calculated per sector.7) (2. Hotels. and building construction. This continued in 1998.3 12.1 (1. indicating a rapid rise in .1 5. and Business Services Other Services GDP 1996 3. Gas.0 5.5. followed by the finance and trade sectors.3 11.4) 2. followed by property. Livestock.2 8.Chapter 1: Indonesia 39 1.

5 percent in April 1998.0 12.0 307. This figure further increased to 47.1 30. II Table 1.0 864.21.0 105.370. The table also reveals that although private national banks dominated the banking sector in terms of assets and credits.1) 7. Source: JSX Monthly.0 635.0 65. The huge losses suffered by most companies were caused by three factors. as shown in Table 1.0 2.0 163.0 92.395.0 1.0 2.0 193.3 7.1 (124.9 12.0 108.6 (11.0 a ROE 1996 1997 1998a 14. a Actual data for 1st semester only.2 23.0 1.0 631.2 13.6) (115.097.2 (4.6) 15.0 111.4) 8. As the rupiah weakened and interest rates increased. First.0) (78. several publications. Third.1 1.0 205. from only 8.1 (3.4 (6.7 percent in July 1998.5 8.4) 18.8 (373.8 percent in 1996.0) 10. 1996-1998 (percent) DER Sector Agriculture Mining Basic Industry Miscellaneous Industry Consumer Goods Industry Property Infrastructure Finance Trade/Services Average 1996 104. Mostly suffering from a liquidity squeeze. private banks posted negative ROEs in the same year.7) 6. foreign exchange losses came about with the use of unhedged foreign debt.8 17.19 DER and ROE of Publicly Listed Companies by Sector.625. Second.40 Corporate Governance and Finance in East Asia. and would have kept on increasing if interest rates had not declined. Vol.0 97.8) 36.20 reveals that the banking sector’s ROE decreased significantly in 1997. rupiah values of dollar-denominated debts due to the weakening of the local currency and the rapid decline in equity because of losses.0 191.0 697. small foreign banks enjoyed the highest profits.7 1.0 158.0 229.0 177. losses in operation were due to declines in sales and increases in the cost of imported inputs. the NPL ratio had reached more than 60 percent.1) Note: DERs were calculated for only 161 companies (out of 214) that had positive equity.0 1997 234.0 219. Impact on the Banking Sector Table 1.271.1 (5. interest expenses rose as credit rates increased from 20 percent in early 1998 to 40 percent in mid-1999.0 1.0 72. .0 1998 186. the NPL ratio rose to 25.0 177.2) (264.0 108.4 5. but annualized to approximate full year values. Financial and banking analysts estimate that by September 1998.1 (92.

81 13.9 Regional Foreign and Development Joint Venture Banks Banks — 9.20) Table 1.7 — 1. In July 1998. coupled with negative spreads (deposit rate was higher than the credit rate).5 57.1 1. 1992 7. Source: The National Banking Association.6 — 4.1 198.0 622.3 Private National Banks — 179.07 13.5 2. 1992-1997 (percent) Type of Bank State-Owned Banks Foreign Banks Joint Venture Banks Regional Development Banks Private National Banks Total — = not available.2 8.6 — 13.2 37.5 128.89 27.91 21.7 106.Chapter 1: Indonesia 41 Table 1.38) 11.12 15.09 (11. put pressure on the banking sector.34 16.2 48.15 20.73 30.09 11.9 11.5 34.6 6.3 22.8 11.2 47.1 13. State-owned banks initially had the highest NPL ratio.21 Nonperforming Loans by Type of Bank. 1996-1998 (Rp trillion) State-Owned Banks — 140.0 — 4.69 14.30 5.2 1.06 20.3 445.45 21.70 1995 7. 230/1998.44 15.24 15. .2 10.7 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 331.25 22.9 — 11.2 — 19.0 — 32.2 8.68 1996 1997 8. July No.3 361. 227/1998 and October No.2 — 8.8 14.20 ROE of the Banking Sector. The high and increasing NPLs.7 29.28 5.45 — 1993 15.84 27.1 30.9 percent.72 16.1 274.37 19.7 4.86 11.8 187. private national banks overtook State-owned banks when their NPL ratio jumped to 57.4 7.8 3.24 (4.07 1994 14.7 — = not available. however.1 47.5 31.8 8.50 9. Source: Infobank.9 297.6 — 1.5 222.47 20.67 8.39 13.43 10.0 129.

have been subject to restructuring deals under the initiative. The scheme encourages negotiation between creditors and debtors.5.7 billion of foreign exchange debt.7 percent ($64. Since September 1998. Unfortunately. companies were not servicing their debts. However. By end-November. only a . Vol. Semen Cibinong (cement industry) became the first Indonesian company to resume paying part (25 percent) of the interest on its $1. the committee launched the Jakarta Initiative. assembling the legal and policy framework to facilitate corporate restructuring. few companies were in a position to resume interest payments. The scheme offered a hedging facility against rupiah devaluations for restructuring agreements. the Government and private sector formed a committee to help corporates deal with the crisis. and Ciputra (property business). about 80 percent of which was private. such as Garuda (a national flag carrier). In June 1998. by mid-September 1998. IBRA was formed to offer Mexican-style resolution for private sector foreign debt. particularly in terms of debt resolution.42 Corporate Governance and Finance in East Asia. none of the 2.000 eligible firms had signed up for the scheme. Aside from being described as overly complicated.000/$1) in debt from domestic commercial banks. Astra International (automotive). 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. One premise of the initiative was that creditors should agree to a standstill for a certain period (creditors would desist from exercising their claims on a distressed company’s assets) to allow debtors to operate normally after obtaining fresh financing. the corporate sector had more than Rp600 trillion ($75 billion at Rp8. the Jakarta Initiative Task Force had conducted negotiations for 52 companies with Rp2.4 trillion of domestic debt and $6. On 9 September 1998. Thus. the scheme failed.2 billion debt. Corporate debt accounted for 46. Total amortization payments due on foreign debt in 1998 were placed at $32 billion (before restructuring).6 billion) of Indonesia’s total external debt in March 1998. The committee was tasked to ascertain the level of private corporate sector debts and arrange negotiations between debtors and creditors. Another option that companies could take under the Jakarta Initiative was debt restructuring via debt-to-equity swaps. a number of prominent companies. In November. a more comprehensive scheme to tackle domestic and foreign corporate debt. In addition. II 1. While the process of restructuring was in progress.3 Responses to the Crisis Corporate Restructuring Measures At the end of 1997.

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

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

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

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

The Government and the private sector responded with measures to mitigate the negative effects.21 trillion in 1996. DER increased to 307 percent in 1997 and further surged to 1. the Government initiated corporate debt restructuring measures (Mexican-style foreign debt resolution and the Jakarta Initiative). On the other hand.Chapter 1: Indonesia 47 without diluting their control.1 percent in 1997 to -124. The Government introduced reforms to improve bankruptcy procedures. were the most adversely affected.1 percent in 1998. Sales of conglomerates as well as those of publicly listed companies were increasing. although at a declining rate. it also reflects the failure of the financial sector to channel funds to the corporate sector efficiently due to weak prudential regulation and supervision. Bank Indonesia extended emergency loans to many banks. The financial crisis led to the closure of several dozen banks.370 percent in 1998. The problem was in the maturity structure of its dollar-denominated debt and high debt-to-equity ratios in some sectors. ROE dropped from 1. financed by issuing nearly $80 billion worth of bank restructuring bonds. As the rupiah weakened and interest rates increased. 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. Net profits of publicly listed companies had consistently been growing at an average rate of 20 percent each year. followed by the property sector. and the rapid decline in equity due to losses. the highly leveraged companies. the consumer goods industry was the worst hit. the high domestic interest rates that prevailed from 1998. At the height of the crisis. When the crisis hit Indonesia.24 trillion in the first half of 1998. Impact of the Financial Crisis Prior to the crisis. Responses to the Crisis The impact of the financial crisis on the corporate sector was serious. particularly those with large short-term foreign loans. NPLs rose and capital adequacy ratios fell.1 trillion in 1997 from Rp13. Meanwhile. To restructure the corporate sector. and registered a net loss of Rp39. and strengthen prudential regulations and supervision of the financial sector. the corporate sector was in quite good shape in terms of growth and profitability. Total profits of publicly listed companies dropped to Rp3. corporate-initiated debt restructuring .

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

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

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

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

Chung and Yen Kyun Wang1 2.1). Business managers and controlling shareholders were maximizing firm size at the expense of profits. and David Webb of the London School of Economics for their guidance and supervision in conducting the study. . a practice that was not checked by creditors. The extent of inefficient investment can be seen from the fact that more than 70 percent of listed firms had negative economic value added (EVA) before the crisis while those with positive EVA declined (Table 2. internal control mechanisms. timely exit of poor performers from the market. 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. As the Korean currency. 1 Professors. David Edwards. both of ADB. Seoul. The country’s winners would then emerge based only on economic efficiency. the Government and business sector had good reason to reflect on the causes of the crisis. This has been the crux of the corporate governance problem in Korea. Inefficient investment coupled with excessive financial leverage was found to be at the root of the economic crisis at the corporate level.2 Republic of Korea Kwang S. and curtailing of morally hazardous behavior that has been prevalent among economic decision makers. A national consensus is emerging that a democratic system based on free market principles should be firmly established to promote more intense competition in every sector of the economy. The authors wish to thank Juzhong Zhuang. Further. Poor corporate governance and political and government intervention in the business and financial sectors are widely viewed as contributory factors. Korea) in November of that year. or capital market discipline. and Graham Dwyer for his editorial assistance.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. and corporates were sent reeling. Chung-Ang University. the Republic of Korea. Department of Economics. markets. It had been the norm in Korea to conduct business based on political and administrative favoritism rather than on competitive merits.

Vol. which distributed and collected the questionnaire. and improvement of bankruptcy procedures. II Table 2. This study also reviews the legal and 2 The survey was conducted mainly through the Korea Stock Exchange.54 Corporate Governance and Finance in East Asia. especially chaebols.5 Note: The EVAs are calculated as: EVA = NOPAT – WACC. 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. Restructuring efforts have focused on reduction in the degree of business diversification and in the financial leverage of large-sized firms.1 1996 561 163 29. aiming to identify the areas in need of further reform and to provide policy recommendations for improved corporate governance. Copeland. T. accountability of controlling shareholders and boards of directors. and individual companies.1 1997 518 104 20.9 1994 531 165 31. A survey was conducted for the nonfinancial listed companies using a questionnaire developed by the Asian Development Bank (ADB)2 to supplement official data. Dividend payments were at less than 2 percent annually as opposed to the double-digit interest rates in the past decades. This study collects and analyzes data on the Korean economy. Source: Korea Stock Exchange.1 Listed Firms with Positive Economic Value Added. capital market discipline. Inefficient investment undermined the competitiveness of Korean firms in the global marketplace. and J Murrin (1995).4 1993 513 174 33. This broad perspective can help clarify the ongoing reform efforts of businesses and the Government. .1 1995 560 163 29. The total number of respondents was 81 out of about 550 nonfinancial firms listed on the Exchange. 1992-1998 Item Total Number of Firms Firms with Positive EVA Percentage of Firms with Positive EVA 1992 508 180 35. the corporate sector. The EVAs are the same as the economic profit as explained in T. June 1999. Many firms left some questions unanswered. Koller. Weaknesses in the overall corporate governance system in Korea had many ramifications. Government reform goals for the corporate sector include enhancement of corporate transparency.1 1998 490 164 33. where NOPAT is the net operating profit after taxes and WACC is the weighted average cost of capital multiplied by invested capital.

It traces the country’s economic development.2 2. the board of directors system. clothing. Section 2. . and Yim (1998). In the period 19481961. and naturally adopted an import substitution policy.3 identifies characteristics of corporate governance by analyzing the ownership structures and control patterns of listed companies and the largest chaebols. The evolution of the modern Korean economy can be divided into four periods.2.2 presents an overview of the corporate sector. Yang. Import Substitution: 1948-1961 The Korean War (1950-1953) devastated Korea’s industrial capacity. and employees and their role in shaping corporate governance practices.Chapter 2: Korea 55 regulatory framework for the corporate sector and reform measures taken after the crisis. 3 The review of historical development of the Korean economy draws substantially from the book by Sohn. Section 2. creditors.1 Overview of the Corporate Sector Historical Development3 The development of the Korean corporate sector is closely related to the progress of the economy. and other necessities domestically. The Government tried to produce food. which account for a substantial portion of the Korean economy.4 contains analyses of corporate financing and its relationship to performance. Section 2.5 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. Section 2. This chapter is composed of six sections. reviewing government policies responsible for the development of the modern corporate sector. corporate control by the Government. It reviews such elements as shareholders’ rights. the import liberalization rate was below 7 percent and the average tariff rate was in the range of 25 to 30 percent.2. Major economic indicators for some of these periods are shown in Table 2. From 1948 to 1961. Section 2.6 discusses responses of the Government and the business sector and explains in detail their reform and restructuring efforts. 2. the Government relied heavily on aid from the United States (US) and United Nations to alleviate poverty and high inflation. It then presents recommendations for further reform in corporate governance and financing.

2 314. a Refers to 1971.56 Corporate Governance and Finance in East Asia.4 24. and implementing new budget and tax measures. the Government called for an unprecedented average annual economic growth rate of 7.9 — — 21.1 15.1 9.7 14.7 30.8 12.0 41.265.2 452.2 6.4 (1.2 Key Macroeconomic Indicators Annual Average (percent. Export Drive: 1962-1971 Between 1962 and 1971. This goal required very high savings and investment rates. The Government tried .9b 15.5) 8.5) (1.2 31.8 15.447. and inconsistent economic policies. Economic Statistics Yearbook.8 (724.4 29.855.1 — = not available.9) (7. the Government redirected the policy focus away from import substitution to an export-led manufacturing-based economy.2 757. modernizing the industrial structure. lack of strong drive.2 1980-1989 8. d Refers to 1997.949.1a 21. c Refers to 1989.0) (297. In 1961 it devalued the won from W65 to W130/dollar and announced its first Five-Year Economic Development Plan (1962-1966).7c 11.2 1.0) 492. International Financial Statistics. Vol. In the Plan.9) 1.102. and large current account deficits.0 27. IMF.8 (8. Source: Bank of Korea.4 10.753.2 30.6 11.7 37. e For maturities of one year or more. largely because of political instability.1 35. high unemployment and inflation.4 29.8 24.5 250.3 8.1 29.2 32. 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. 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.1 percent with moderate rates of inflation and introduced a series of reform packages aimed at developing key industries.332. b Refers to 1979.5 38. the Government was not successful in solving the problems of slow growth. However. II Table 2.9 794.4 1990-1997 7.1d 9.

The Government abolished temporary direct subsidy measures and introduced a new comprehensive export promotion system. In 1971. and maximizing mobilization of domestic savings on the other. 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.3 percent to 60. but the average growth rate for 1965-1969 shot up to 10 percent. Korea normalized political and economic relations with Japan to encourage inflows of Japanese capital that could finance big development projects. Bank deposits increased rapidly.Chapter 2: Korea 57 to meet its targets by borrowing large amounts of foreign capital on the one hand. Also.5 percent. channeling funds from curb markets into the banking sector. However. In 1965 the interest rate on one-year deposits doubled from 15 to 30 percent. the growth of gross domestic product (GDP) raised domestic savings.4 percent. The average growth rate of the economy from 1960 to 1964 was 5. which laid a solid foundation for a steady growth path. the import liberalization rate was 55 percent. This change raised the import liberalization rate from 9. But the liberalization trend turned out to be short lived as current account deficits continued. the Government tried to provide exporting firms with a free trade environment. the Government undertook important economic reforms in two areas: the foreign exchange rate and the interest rate. Exports increased sharply from $41 million in 1961 to $2. imports of consumer goods and luxury items were highly restricted. In 1964. The well-educated. In 1963-1964. During this period. 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. boosting internal investment resources. and almost doubled the foreign exchange rate from W130/dollar to W256/dollar to enhance the international competitiveness of exports. abundant. due to continuous current account deficits.2 billion in 1972. a modest improvement over the 4. up from 30 percent in the late 1950s.3 percent average between 1954 and 1959. but tariff rates were raised to 40 percent in the 1960s. resulting in high real interest rates. . During the first five-year plan period. the Government changed the multiple and fixed exchange rate system to a unitary floating exchange rate system. while the average tariff rate was 39 percent. 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.

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

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

with the 30 largest in the total economy in 1997 standing as follows: value-added. In 1993.3 percent. while continuous and large current account surpluses saved Korea from the foreign debt problem. total sales. The Government tried to adjust economic policies and regulations to meet global standards. and low oil prices. The most important element characterizing chaebols is the concentration of ownership. 13. Korea began participating in many multilateral trade negotiations during the Uruguay Round. Vol.9 percent.60 Corporate Governance and Finance in East Asia. the import liberalization ratio reached 98. In 1988. The low value of the dollar led to a low won and high yen.1 percent and average tariff rates 8. and acceded to the World Trade Organization (WTO) in 1994.1 percent. total debts. Korea adopted a market average exchange rate system.9 percent. whose business activities are controlled by an identical person. By joining the Organisation for Economic Co-operation and Development (OECD) in December 1996. II world interest rates. joined the Asia Pacific Economic Cooperation (APEC) Group in 1993. Korea abolished remaining direct subsidy systems for export activities as well as some traditionally managed trade systems. 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).2. Meanwhile. but it chose to liberalize gradually. The official rate fluctuated within a band.” A large-scale business group is called a chaebol. the importance of chaebols was increasing. .2 Rise of the Large Business Groups (Chaebols)4 The Korean Fair Trade Act defines a business group as “a group of companies. in which the official rate for the day would be based on the interbank transaction volume-weighted average of rates of the previous business day. In 1990. and total workforce. 45. where particular individuals and their family have de facto control of the management of all subsidiary companies of groups. 4.2 percent. 2. the Government committed itself to further liberalization of the goods and capital markets. 47. total assets. 46. which gradually widened. Industrial and trade policies were modified to be consistent with WTO. Korea became a signatory country to the International Monetary Fund (IMF) Article VIII.9 percent. further increasing its pace of import liberalization. and declaring that it would follow Article XI of GATT. giving up its foreign exchange controls related to the current account.

the number of subsidiaries declined drastically due to corporate restructuring. the Korean Government has set the national goals of economic development and offered all kinds of support and incentives to achieve them. and tax breaks to key industries to promote exports and industrial upgrading. Table 2. chaebols that maintained a close relationship with the political authorities were able to grow fast. after the financial crisis. Since the 1960s. Since the Government controlled most business activities. In the mid-1970s. This galvanized the fast growth of chaebols. Subsidiary companies of chaebols are subject to “fleet-type management” in that they are controlled by the overall managerial system of chaebols.Chapter 2: Korea 61 War II.3 shows that the number of subsidiaries of the 30 largest chaebols increased considerably since 1993. it was more effective to deal with a small number of companies to secure tangible outcomes. of Subsidiaries 604 616 623 669 Average No. The Government provided financial and fiscal incentives to chaebols and trading companies with relatively abundant financial resources. One reason for this controlling power is inter-company shareholding among subsidiaries. Important managerial decisions are made primarily by owners. 1993-1996 Year 1993 1994 1995 1996 No. Chaebols have a history of substantial concentration of ownership. reaching 669 in 1996.1 20.8 22. However. Chaebols are also excessively diversified. Large-scale companies owned by the Japanese were sold to individuals under preferential terms and later enjoyed a relatively favorable position for accumulating capital.3 Subsidiaries of the 30 Largest Chaebols. large-scale businesses and chaebols were thought to be appropriate actors because they could meet the huge investment requirements of these industries.5 20. In this sense. The Government provided subsidies. of Subsidiaries per Chaebol 20. financial assistance.when the Government put a great deal of emphasis on development of the HCIs. Table 2. and they are aided and supported by one another. the ownership and management of a chaebol’s subsidiaries are not separate. .3 Source: The Fair Trade Commission. This policy contributed greatly to the expansion of chaebols. From the standpoint of the Government.

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

First.370 70. a country fund. Inc.1 16. the Government announced the gradual opening of the capital market to foreign investors in January 1981. . 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).9 833. The policy to expand the size of the stock market.5 406. however.1 Market Capitalization (W billion) 6.7 934.798 Market Capitalization as a Ratio to GDP (%) 8.4 654.476 79.6 747. As shown in Table 2..989 137. mainly by increasing the supply of shares by initial public offerings (IPOs) and seasoned issues.0 49. Also that year.Chapter 2: Korea 63 During the 1980s and 1990s. Second.151 117. the Government announced measures to increase the demand for shares by providing tax and financial incentives to individual investors.4 Development of the Stock Market. of Listed Firms 342 626 669 699 721 760 776 748 Stock Price Index 138. the stock market grew rapidly during the 1980s. The Korea Fund. In this regard. 1985-1998 No. Beginning 1990.020 151. was established to invest in domestic shares beginning in September 1985.217 141.9 918.4. Because of government policies and the booming economy.6 Year 1985 1989 1990 1994 1995 1996 1997 1998 Source: Monthly Review (Securities Supervisory Board) and the Financial Supervisory Service. Third. the Government attempted to stabilize the stock market by limiting IPOs and share issues by listed companies. This reversal in policy reflected declining stock prices and was generally maintained until the outbreak of the economic crisis in 1997. continued until 1989.1 30. The aggregate Table 2. in 1986 the Government imposed limits to bond issues on firms that were recommended to go public but refused.0 79. several important policy measures were implemented to promote the development of the stock market.9 34.4 40. especially those paying small or no dividends. 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.0 965.2 44.570 95.

868 (518) (418) 63 1. Bank of Korea. The growth in the number of listed firms also slowed in the 1990s.59 percent in 1998 and to more than 50 percent in the early months of 1999.352 471 3.296) (6.650 (1. Other investments include loans.008) (3.658) (3.264) (3.534) 1. 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 1986-1989.414) 5.239 19.553 8.642 21.742 (3. The reasons for the decline include increases in bankruptcies and mergers involving listed companies since the outbreak of the economic crisis.338 4. The aggregate market value of listed shares bottomed at 16.714 1. 1985-1998 ($ million) Year Net FDIa Portfolio Investments Other Investmentsb Of Which Loans Trade Credits 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total a b 313 (9) 696 809 147 (808) (115) (311) (832) (2. and stayed at the 30-40 percent level up to 1996.126 (1.924 (1. but rose again to 34.944) 8.942) 42.141 4.433) (9.150 5.413) 56. Table 2.382 Permit basis. .953 10.339) (9.017) 1.64 Corporate Governance and Finance in East Asia. Vol.817 16. II market value of all listed firms represented only 8 percent of GDP in 1985. However.183 12. The number shrank for the first time in 1998 to 748 firms from 776 the previous year.910) 2.255 2.326 1. and 1993. and other liabilities.5 shows net FDI—inward investments by foreigners less outward investments by Koreans—in the period 1985-1998.5 Private Capital Flows to Korea.450 24. trade credits.870) (1.453 (2.085 2.571 2.86 percent of GDP in 1997.500 7. Table 2.347 3.858 4.542) (1.583 25 10.694) 2.001 4.546 (2.2 percent by 1989. currency and deposits.800 (7.149 13.852) (2. but increased sharply to 79.287 (340) 73. The relative size of the stock market diminished to 44 percent in 1990. foreign direct investment (FDI) has been very small relative to GDP and compared to other East Asian countries.737 (333) (297) (607) (2) 218 2.875 21.440 1.455) 13.785 (1. Source: Balance of Payments. due to declining stock prices.123 3.

7 billion and loans $42. and US. This would lay the foundation for evaluating the effect of corporate governance on performance. Korea had substantial current account surpluses and experienced net private capital outflow. other net private capital inflows amounted to $130 billion during 1985-1998. The Aggregate Corporate Sector The aggregate corporate sector in this study excludes the financial sector.6). (ii) listed firms. excluding FDI.China and the US. The same categories will be analyzed in later sections. Net private capital inflow. This indicates that a substantial proportion of debt was denominated in dollars. The growth rates of total assets.6 percent in 1997. Of this. and high production costs were the main reasons for low FDI in Korea. The debt-to-equity ratio (DER) averaged 311 percent for the period 1990-1996 and peaked at 424. Return on equity (ROE) and return on assets (ROA) showed similar patterns. Corporate sector net proft margins increased from 1993 to 1995. increasing to 76 percent in 1997. Profit rates of Korean firms were relatively low compared to those of Taipei. but dropped in 1996 and were negative by 1997.2. The dismal performance of the Korean corporate sector compared to the . 2.5).2 percent in 1987. The contribution of the corporate sector to GDP was 73. In addition to FDI. Japan’s was consistently higher. and sales of the aggregate sector during this period were very high (Table 2. portfolio investments amounted to $73. However. but between 1988 and 1993.Chapter 2: Korea 65 Complicated government regulations. equity.9 billion. The ratio is generally in the same range for Japan and Korea. Between 1986 and 1989. Table 2.China. and (iii) chaebols. following the sharp depreciation of the won.4 Growth and Financial Performance This section looks at the performance of (i) the aggregate corporate sector. Taipei. the growth rates of equity and sales dropped sharply in 1996 and 1997. increased substantially in 1994-1996 due to accelerated liberalization of capital movements (Table 2. Large amounts of outward investment by Koreans in the mid-1990s arose out of increased liberalization of foreign exchange regulations.7 compares the ratio of ordinary income to sales of Korea’s manufacturing sector with those of Japan. weak incentives for attracting FDI.

0 6.6 (4.3 — 3. .0 305.9 2.4 2.2) (0.3 312.5 1.1 — — — = not available.5 7.9 4.6 2.5 4.0 10.9 2.8 22.9 3. ROA = return on assets (ratio of net income to total assets).9 16.2 9.0 (0.2 13.9 3.3) 5.5 1.9 18.3 17.7 4.3 14.5 2. 1990-1997 (percent) Growth Performance Year Total Assets Equity Sales Financial Performance Net Profit Margin DER ROE ROA 1990 1991 1992 1993 1994 1995 1996 1997 23.7 1.2 1.7 15.4 1.7 2.1 2.3 308.8 1.1 2. Note: Ratio of ordinary income to sales = (ordinary income/sales).0 0.7 3.China 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 2.3 6.3 11.8) 297. Net profit margin = ratio of net income to sales.8 21.2 18.3 21.9) DER = debt-to-equity ratio.3 21.0 4.3 335. Financial Statement Analysis Yearbook.5 3.0 7.9 2.2 19.8 2.4 — 6.7 4.9 16.4 2.3 3. Financial Statement Analysis Yearbook.1 2.0 13.8 3. ROE = return on equity (ratio of net income to stockholders’ equity).5 0.9 5.7 3.0 8.6 318. Table 2.3 1.8 8.7 325.9 13.5 1.7 4.0 13.1 6.5 (0.2 13.7 15.6 4.9 8. Source: Bank of Korea.9 5.6 Growth and Financial Performance of the Nonfinancial Corporate Sector.4 10.4 4.6 9.0 3.2 1.8 1.4 1.6 424.4 19.2 1.5 4.6 13.1 8.4 1. Source: Bank of Korea.Table 2.9 18.7 International Comparison of Ratios of Ordinary Income to Sales in Manufacturing (percent) Year Korea US Japan Taipei.1 5.4 2.6 1.6 3.9 5. Ordinary income = operating income + nonoperating income (from financial activities) – nonoperating expenses (from financial activities).6 1.

followed by mediumsized firms and large ones. Listed Companies The number of listed firms increased from 334 in 1985 to 775 in 1997 (Table 2. In most years.10). while their average net profit margin was lower than that of medium firms.6). this may be an indication of the bias toward large firms in terms of access to credit. The manufacturing.9).5 percent while the aggregate sector recorded only 13. and transport sectors recorded negative profit rates in 1997. the exception being the electricity. gas. with equity in wholesale and retail trade even contracting. Small listed firms were hardest hit by the financial crisis. the sales growth of listed firms was higher than that of the aggregate sector (see Table 2. both ROA and ROE were lower for the listed firms compared to the latter. sales of listed firms grew 18.and small-scale firms (Table 2. The other financial ratios follow the general pattern of the aggregate corporate sector. However. and ROAs of all listed firms declined substantially in 1996 and turned negative in 1997.8). Performance followed similar patterns across different industries (Table 2. the average ROE was lowest for large firms.4 percent. construction. It is notable that the construction sector’s profit rate began its decline in 1995. The growth performance of large firms for the 1988-1997 period was better than that of medium. All sectors experienced a sharp decline in equity and sales growth in 1997. Net profit margins. In 1997. with the wholesale and retail trade sector and the construction sector having the highest figures. 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. . A comparison of performance by firm size reveals some interesting results. Again. but higher than that of small firms.Chapter 2: Korea 67 other three economies can be attributed to the emphasis on growth in sales and market shares rather than on profits. a year ahead of the other industries. Growth rates of total assets are generally high. trade. This may be related to its having the lowest DER. Profit rates of different industries also mirrored the downward trend of the aggregate corporate sector prior to the crisis. However. This preference of Korean firms has its roots in the structure of corporate governance. and steam supply industry. ROEs. Profit rates of most industries are also quite low. The profit margin of listed firms was generally higher than that of the aggregate corporate sector.

0 24.0 18.9 1.5 270.8 16.2 5.6) (6.4 458.2) 22.1 27.8 10.5 569.8 23.3 1.3 18.1 21.3 15.2 20.4 5.1 28.4 740.4 1.0 5.1 1.3 14.3 285.3 25.4 2.5 (1.5 5.9 10.2 36.0 2.0 (0.9 19.2 (1.4 3.2 6.1 0.2 0.9) 1.4 2.6 11.6 14.2 0.0 15.8 12.4 348.4 0.1 290.2) 6.0 5.8) 0.9 340.8 Real Estate.5 239.3 11.8 0.1 (0.8 14.3) (1.8 35.5 1.7) 2.0 1.5 1.0 1.2 18.4 2.5 30.4 9.4) 0.6 1.2 5.0 1.6 17.4 17.8 12.4 4.7 514.Table 2.3 2.2 16.8 22.7 (0.6 3.6 7.9 (0.6 3.5 3.0 22.6 16.4 1.8 16.4 (0.6) 3.6 5.0 1.0 2.8 1.8 461.0 22.7 520.3 15.3 31.3 8.2 0.9 (0.1 0.1 2.0 1.7 7.3 14.9 13.5 483.1 1.0 (0.3 8.8 0.4 474.0 37.0 24.7 21.1 0.4 10.2 12.0 9.6 0.5 4.2 24.3 10.5 16.7 17.3 11.8 2.3 8.2) 15.9 16.8 10.8 3.0 15.4 10.6 1.2 2.6 14.3 10.8 13.8 345.4 10.5 (0.0 16.5 6.9 10.5 Construction 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 18.6 12.6 24.6 6.7 10.8 616.5 13.9 3.3 288.4 15.7 1.7 30.1 396.0 12.0) 0.0) 4. and Business Activities 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 11.5 1.0 254.8 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 13.9 428.9 16.0 22.3 2.1 296.0) 1.0 (4.7 5.0 1.5 28.9 5.1 20.5 1.2 20.3 8.7 294.8 34.9 29.5 27.0 21.8 16.6 17.2) (0.3 1.4 350.9 9.0 23.2 315.6 12.1 1.5 23.5 432.2 16.0) 0.6 318.9 0.4 2.2 5.4 10.0 7.2 6.9 2.0 2.1 1.6 0.1 10.7 (3.1) 0.9 16.6 15.9 14.8 3.8 17.5 306.5 14.4 12.5 286.3 15.3 13.7 0.0 19.1 2.8 562.2 423.8 22.4 5.7 22.5 473.2 15.2 25.1) (3.6 655.4 2.7 9. Renting.2 7.9 31.8 2.8 24.0 3.1 16.8 2.5 19.3 15.8 302.5 338.0 245.7 228.8 24.4 0.8 1.8 526.1) 3.8 7.7 4.9 2.4 14.7 16.5 6.5 1.1 7.8 14.6 2.5 (5.0 1.0 16.0 18.6 375.6 14.0 2.4 291.5 5.4 .5 1.9 25.2 241.7 317.9 (0.5) 0.1 (0.8 32.1 17.9 538.4 5.1 22.

6 14.9 1.3 19.3 8.5 16.6 20.7 11.1 4.0 2.1 2.4 13.5 14.9 456.4 0.3 8.1 12.1 17.1) 1.3 (2.4 (0.9 17.7 15.9 8.6 0.3 543.9 12.2 3.6 19.9 9.7 7.6 — — — — — 17.4 633.7 0.5 117.3) 4.2 1.1 8.2 2.5 14.8 12.6 12.9 4.8 14.2 18.5 15.4 169.7 16.5 11.6 4.1) (0.1 (0.5 (2.9 18.7 7.8 6.0 2. and Steam Supply 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 12.4 16.0 5.6 2.1 323.2 — — — — — 2.9 3.1 (11.5 26.6 172.3 524.8 3.2) 13.7 20.8 0.0 14.9 6.4 — — — — — 448. Gas.8 14.4 7. Source: Calculated using data from Bank of Korea.5 344.4 11.9 (11.6 3.3 1.7 11.0 Transport.6 9.4 7.4 (2.5 2.3 125.4 3.9 18.1 15.062. and Communication 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 15.0 1.7 11.0 1.6 21.6 1.2 14.1 3.1 1.1) 5.5 15.6 8.7 116.0) (0.3 — — — — — 10.4 1.4 9.7 187.4 341.6 6.8 9.0 14.4 3.8 0.7 — = not available.0 98.5 12.6 8.4 14.3 0.0 5.3 18.7 14.4 30.6 (2.8 7.3) (1.1 21.5 4.5 482.4 0.0 921.9 4.0 21.5 14.9 (10. b NPM denotes net profit margin.0 106.0) 1.1 6.5) 22.8 12.6 6.9 332.0 13.3 4.4 1.0 7.3 112.1 11. Financial Statement Analysis Yearbooks.4 2.8 15.3 18.2 18.2 10.5 30.3) 11.4 6.2 698.3 4.4 10.6 4.8 11.5 47.3 3.2 7.1 11.0 89.7) 0.5 0.6 34.2 18.6 6.1 15.Table 2.5 539.4 2.5 462.4 21.3 9.3 4.7 2.6 (2.5 13.0 1.9 7.3 1.6 15.8 6.3 2.7 2.5 612.3 0.3 23.1) (0.4 12.3 34.6 9.8 3.6 8.4 1. .2) 9.6 18.5 11.9 17.6 — — — — — 0.4 6.9 Electricity.4 0.3 12.7 510.4) (1.1 16.2 10.2 10.9 8.3) 15.8 (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 — — — — — 31.8 529.2 90.6 512.6 9.2 15.5 14.0 (1.4 367.8) (12.6 19.0 (15.1 15.3 17.1 (2.9 321.3 740.5 8.7 — — — — — 14.2 143.1 14.6 16.9) (8.6 12.7 19.2 122.7 0.9 12.7) (4.8 8.8) 1.7 12.8 4.4 3.9 10.2 11.2) 0. Storage.8 111. a New equity does not include capital surplus.9 10.9 9.4 15.4 12.0) 1.2 14.5 307.6 1.

6 2.6 1.3 percent).4 1. In 1997.4) 1.7 percent) of the corporate sector.6 22. followed by the top 6-10 (Table 2.0 0.0 18. of which four were listed.3 15.7 Net Profit Margin 0.70 Corporate Governance and Finance in East Asia.8 0.5 19.9 1.7) 0. and net profits (46.3 2.4 0.5 ROE 3.7 1.9 percent). Vol. and close to half of total assets (46.1 6. Hyundai Group. sales (45.1) 4.1 1. 1998. of which 16 were publicly listed (Table 2. The number of Hyundai member companies rose to 57 in 1997.8 24.11). the 30 largest chaebols accounted for 13. In 1995.12). but the number of designated groups has been fixed at 30 since 1993.2 0.3 (0.5 0.6 23. debts (47.4 1. Kis-Fas.2 9. Between 1993 and 1997. it is the chaebols’ large firms that are listed.9 percent).3 4.6 and 2.4 22. Performance of Chaebols This section uses available data on the top 30 chaebols.2 6. It should also be noted that when the financial crisis struck in 1997.6 3.9 0.3 0.4 1.2 9. Chaebols have been the most important actors and engines of growth in the Korean economy.4 2.9 2.7 (5. unless otherwise indicated) Financial Performance Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average No.9 11.6 (1. The criteria for selection of largest chaebols have changed a few times.1 1.7 1.9 Growth and Financial Performance of Listed Companies. of Firms 334 351 386 503 626 669 680 681 687 698 715 754 775 Sales Growth 10. the largest chaebol.9 21. the top 11-30 chaebols experienced a decline of . Generally. II Table 2. The smallest group had 16 members in 1995.5 ROA 0.1 percent of the economy’s total value added (excluding the financial sector).8 6. the growth of sales of the top 30 chaebols exceeded that of the aggregate corporate sector (compare Tables 2.9 6. had 46 member companies.12).9 Source: Constructed using data from Korea Investors Service.5 19.3 20.0 3. 1985-1997 (percent. The top five chaebols registered the highest growth rates.9 26.9 2.5 5.8 5.2 2.6 0.

6 3.8 6.8 0.5 5.7 18.5 (1.9 1. 1988-1997 (percent) ROE Large 9.9 2.0 1.9 6.4 5.6 1.8 0.9 6. Others are medium firms.8 16.0 15.6 0.6 2.6 3.1 2.10 Growth and Financial Performance of Listed Companies by Size. .4) 1.9) (6.0 16.5 5.2 2.6 (0.5 25.6 13.2 10.5 Net Profit Margin Year Large Medium Small 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 2.4 6.9 0.7 (1.6 1.5) 1.3 6.5 1.0 10.5 2.4 1.7 3.2 1.9 22. Kis-Fas.1 8.5 17.2 12.1 1.1) 5.6 0.2 3.5 0.9 1.0 (4.6 1.0) 1.9 5.3 15.3 11.3 9.3 3.6 6.3 (0.3) 0.6 2.8 1.1 0.6 (1.4 3.3 Medium 14.0 6.8) 1.6) 0.0 1.0 4.6 7.0 1.7 (1.2 7.2 0.4 3.7 (0.3) 5.2 13.9 0.8 (5.4 2.6 5.6 8.8 6.5 3.7 2.4 11.2 Note: Large firms have a capital base greater than W15 billion and small firms smaller than W5 billion.7 4.8 0.2 13.2 2.2) (1.2) (1.8 10.4 1.9 0.1 11. Source: Korea Investors Service.8) 6.8 3.0 19.9 (0.5) 1.9 3.8 0.6 2.4 16.3 15.2 Small 13.8 17.7 1.3 1.7 2.4 Medium Small Large Medium Small ROA Growth Performance Large 17.2) 0. 1998.0 1.0 17.Table 2.2 (0.9 25.3 (0.0) 0.6 9.8 7.9 2.9 14.1 2.9 2.

158 1.313 14.996 1.774 7.761 31.929 12.457 14.445 4.129 2.423 5.346 3.180 2.117 4.376 35.690 3. of Listed Companies 1995 16 14 11 9 5 11 9 5 8 4 4 9 5 2 4 3 2 7 4 4 4 6 8 2 5 2 2 2 0 4 — = not available.951 3.956 3.177 — 6.640 4.486 6.677 3.246 11.924 2.427 9.475 2.287 10.995 2. Source: Fair Trade Commission.651 38.455 22.458 6.853 1997 53.11 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 43.743 40.910 3.398 — 2.927 16.766 3.599 — 2.158 7.090 6.364 5.597 351.501 13.935 2.798 — No.131 3.Table 2.303 3.433 3.309 14. of Member Companies 1995 46 55 49 25 32 23 24 16 31 28 27 26 18 21 16 17 16 16 14 19 22 19 24 11 14 8 8 11 18 16 1997 57 80 49 30 46 25 24 28 31 30 26 25 21 — 19 18 18 17 24 24 24 6 8 2 15 — 7 — 18 — No.395 31.147 5.370 6.574 3.990 2.873 2.756 5. .967 7.

2 20.7) ROE 5.2 (16.3 0.7) Source: Bank of Korea.0 0.6 19.Table 2.7 4.3 1.4 30.0 19.2 0.5) (0.7 10.6 1.2 0.5 5.1 (1.2) (2.2 0.0) 3.7 1.0 0. .0 2.3 0.3 27.7 15.6 25.0) 12.1 2.7 10.7 15.4 (2.4) (14.1) (0.5 20.9 20.7 13.9 18.8 27.7 0.1 19.6 18.9 17.0 2.4 38.5 32.5) (0.5 2.2 (2.0 1.2 3.9 3.3 16.0 17.5) (0.3 15.2) 1.3 3. 1993-1997 (percent) Growth Rates Year Top 1-5 1993 1994 1995 1996 1997 Top 6-10 1993 1994 1995 1996 1997 Top 11-30 1993 1994 1995 1996 1997 Top 30 1993 1994 1995 1996 1997 Sales 12.3 11.5 27.0 2.3) 0.3 19.9 1.3 14.2 1.5 (0.2 (5.12 Growth and Financial Performance of the 30 Largest Chaebols.0 6.1 10.2) (0.6 (0.1) (1.9 3.3 9.8 0.4 12.6 4.4) 1.2 11.4 26.1 (3.9 20.0) ROA 1.4) (0.6 Financial Performance Net Profit Margin 1.9 24.8 Assets 12.1) 0.5 19.1) (0.3 1.1) 0.8 18.2 (2.0 31.1 27.1 (2.4 0.

it refers to the degree of concentration and shareholdings in the hands of an “identical person.5 Founding families are mostly still the largest shareholders and. Their worst year was 1997 when ROE hit -15. except for 1995. Vol. By the end of 1997.13). includes the largest shareholder. 2. more important. The ROE of the top 30 chaebols was consistently higher than that of the aggregate corporate sector. and access to credit. In general. and the companies that are under the control of the largest shareholder. the net profit margin of the aggregate sector exceeded that of the top 30 chaebols. Ownership patterns. . a pyramidal structure of corporate ownership is prevalent. internal and external control mechanisms. The Commercial Code stipulates the basic governance framework and applies to all corporations. The better showing of the top five chaebols was a direct result of their dominance in human resources. The absence of a well-developed equity market and the provision of subsidized credit.74 Corporate Governance and Finance in East Asia.7 percent growth in total assets. However.3. chaebols had a higher average DER than the corporate sector as a whole. the average DER of the 30 largest chaebols reached 519 percent. in this instance.” in Korea’s legal and regulatory framework. resulted in the chaebols’ excessive leverage. However.1 Patterns of Corporate Ownership The ownership of most Korean listed firms is highly concentrated. 5 While “ownership concentration” can be defined and measured differently in different contexts. 2. coupled with weak corporate governance. loopholes and inconsistent policies spawned strategic behavior and agency problems. There has been a wide range in DER among chaebols.765 percent (Table 2. his/her relatives. from 190 to 3. weak corporate control. and government intervention interacted through a set of laws and regulations to bring about the existing structure. 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. II 2 percent in their sales and a very low 4. Only the top five chaebols registered a positive net profit margin in 1997. technology. and led to a high concentration of ownership.” This “identical person. and vulnerable balance sheets.3 Corporate Ownership and Control This section looks at the key aspects of corporate governance in Korea. The financial performance of the top 11-30 chaebols deteriorated during 1993-1997.95 percent.

Sunkyung 6.6 .3 328. Hyundai 2. LG 4.0 218.0 486.2 471.8 313.9 751.5 2. Hyundai 2.5 343. Kia 9. Dongah Construction 16.8 336. Kohap 25.6 2.7 688. Haitai 26.2 346. Lotte 11. Hanwha 10.2 2. Tongyang 22. Sunkyung 6. Hanwha 10.3 572.2 924. Dongah 14. Newcore 30.6 409. Samsung 3.5 337. Halla 13. Daewoo 5.Table 2.2 328. Hanbo 15.13 The Top 30 Chaebols’ Debt-to-Equity Ratio.244.0 370. Dongkuk Steel 19. Sammi 27.3 315.4 192.5 464. Doosan 15.8 312. Halla 17.6 936. Lotte 11. Daelim 14.1 3.1 674. Hyosung 18. Daewoo 5.7 354.7 620. Jinro Debt-to-Equity Ratio 376.2 292. Dongkuk Steel 19.5 3.7 416. LG 4.1 385. Samsung 3.1 477.065. Hanjin 8. Kumho 12. Kolon 21.855.7 267. Kukdong Construction 29. Jinro 20.4 175. Kumho 12. Kia 9. Ssangyong 7. Doosan 13. Hyosung 18.4 205.1 278. Byucksan 1996 1.764. Ssangyong 7.6 516.0 436.4 622. Hansol 23. Hansol 17. Dongbu 24.9 321.1 190. Daelim 16. Hanjin 8.7 621.5 383.4 556.0 506. Hanil 28. 1995-1997 (percent) Chaebols 1995 1.3 297.2 423.441.

9 465.8 338.6 Sources: aFair Trade Commission.5 323. LG 5. Hansol 16. Doosan 15. Lotte 12.3 347.0 419.0 505.1 438.5 386.6 424.6 478.214.7 1. Halla 13. .8 590. Hanjin 7.6 416.5) 404.498.7 944. Kolon 21.9 1. SK 6. Hyundai 2.6 335. Miwon 30.1 375.5 1. Hanil 28. Tongyang 24.3 399.1 472.9 490.5 (1. Shinho 1997 1. Tongyang 24.4 1.8 347.5 519. Hyosung 17.8 468. Anam 27. Dongbu 21. Anam 22.0 305.4) 513.3 1.501. Ssangyong 8.5 261.1 359. Kolon 19. Jinro 23. Haitai 25.3 676.5 (893.8 399. Keopyong 29. Daelim 14. Daewoo 4.6 590.225.9 216. Daesang 27.9 472.600.7 370.9 578. Dongbu 23. Kohab 18.8 647. Financial Statement Analysis Yearbook. Newcore 28. Dongkuk Steel 20. bBank of Korea.Table 2.8 307.5 576. Keopyong 29. Saehan Average of All Chaebolsa 1995 1996 1997 Average of All Industries Excluding Financial Sectorb 1995 1996 1997 Debt-to-Equity Ratio 317. Kohab 22. Shinho 26.0 907.8 658. Hanwha 9.784. Newcore 26. Samsung 3. Dongah 11.1 433. Kumho 10.13 (Cont’d) Chaebols 20. Kamgwon Industrial 30. Haitai 25.

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

2 8.6 16.9 5.2 9.8 17.7 3. etc.7 14.9 37.2 4.5 1989 498 0.1 60. investment trust companies.0 59.1 8.1 10.3 26.3 2.2 8.6 9.0 9.14 Ownership Composition of Listed Companies.4 5.5 Note: Ownership is based on number of shares. a The State covers the Government and state-owned companies.5 1992 508 2.7 59.4 1997 551 1.6 2.b A.9 15.1 3.5 6.3 17.5 62.5 18.4 6.2 5.8 4.4 13.6 8.9 2. c Data from Korea Stock Exchange.5 7. All Listed Companiesc 1992 681 1993 687 1994 698 1995 715 1996 754 1997 775 9.6 Year No.3 1.5 7.4 14.6 22.3 18.0 7.7 1990 531 0.7 18.5 1.4 18.1 8.4 34.5 6.2 B.1 2.7 4.3 5.4 Insurance Firms Other Corporations Foreigners Individuals 39.5 16.0 5.4 13.0 60. Listed Nonfinancial Companiesd 1988 406 0.2 2. .8 5.1 4. and finance companies.1 11.6 20.6 16.8 1995 548 2.2 3.” includes commercial banks.9 17.Table 2.6 12.1 1.9 26.9 1.2 1. mutual savings.0 4.6 19.3 5.3 17.3 8.6 16.2 1993 511 2.3 1994 521 1.1 21.7 9.8 2.3 39.7 8. etc. of Firms The Statea Banks.2 9.2 5.5 1.1 18.9 19.0 28.8 17.1 21.1 18.3 18.1 68.5 4. b “Banks. merchant banks.1 17. 1988-1997 (percent) Financial Institutions Securities Firms Total 28.9 2.0 8.8 2.0 5.6 9.4 5.8 59.6 36.6 1991 505 0.5 12.3 1.5 60.7 6.2 7.2 18.7 7.8 59.2 17.9 36.7 9.6 13. d Constructed from data files of the Korea Listed Companies Association.8 69.8 5.9 1.9 4.0 27.3 1996 570 2.

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

2 0.2 2.5 — — 0. Motor Vehicles Electricity.4 56.2 54.0 9.9 8.4 62.7 17.9 19.9 15.9 59.2 22.8 Individuals 83.4 8.6 — — 2.4 56. and Printing Pulp.3 7.8 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 .4 8.5 0.2 17.7 20.3 0.3 11.2 0.0 2.2 9..9 60.1 19.0 — 0.2 — — 0. Paper.1 8.0 1.8 7.5 3.2 9.3 2.0 0.6 11.5 7.0 10.4 7.3 57.9 0.3 62.6 1.3 13.4 2.0 Industry 1990 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.6 18.4 14.1 0.8 7.9 1. and Printing Chemicals.2 — 0.1 10.9 55.7 2. 1990 and 1997 (percent) Financial Institutions The Statea — — 0.8 8.9 52.9 16.Table 2.6 3.9 4. Elecl Mach.1 0.1 65.8 5.6 24.3 9. Gas.5 0.3 0.4 8.8 7.4 5.2 1.7 22.7 63.5 19.8 3.8 1.6 5. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.1 27.9 42. Rubber.5 12.3 2.1 0.1 7.1 8.8 3.5 — 0.b Securities Firms Insurance Firms Other Corporations Foreigners — — 0.8 6.4 1.7 2.3 1.0 8.2 7.0 9.7 14.4 0.2 9.9 1.8 7. Etc.7 20.4 1.7 29.5 0.5 0.0 — 39.6 8.0 9.3 1.3 38.4 Banks.3 0.0 20.5 6.9 10.7 6.9 66.7 1.7 64.2 0.7 22.9 23.2 0.2 1.7 2.2 64.1 88.3 4.15 Ownership Composition of Listed Nonfinancial Firms by Industry.3 10.1 0.7 14.0 9.4 — 0.5 17.7 59. and App.8 7.5 — 1.0 7.1 4.3 6. Paper.5 4.1 1.5 85.

6 2.4 20.6 20.3 60.9 57.4 2.8 6. Paper.7 2.7 2.2 8.2 7.0 43.5 — 2.8 11. . Paper.6 1.4 76.1997 Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.6 18.2 4.1 18.5 3.8 0.1 — 0.9 1.4 1.9 0.9 1.9 2.0 5.8 0. and finance companies. b “Banks.4 — 1.3 7.0 6.5 4.5 0.8 2.8 5.4 0.2 1. Note: Ownership is based on number of shares.2 23.3 8.9 6.7 1.9 20.2 6.0 3.3 2.3 1.3 6.6 2.9 18.2 5.7 2.1 9.3 65.2 13.5 3.8 5.8 57.6 6.3 57.5 6. merchant banks.5 5. mutual savings.4 68.0 7.7 5.4 2.3 31.0 4.5 7.4 9.2 4.8 2.4 16.6 14.6 6.7 4.4 2. and App.5 59.9 5.9 78.4 1.4 3.2 3. and Plastics Basic Metal Fabricated Metal and Machinery Office and Computing Machinery Electronics.9 5.8 4.4 6.5 12. etc.9 7.7 19. Elecl Mach. Motor Vehicles Electricity.8 12.7 6.9 2.8 54.0 11.1 2.6 59.9 1. and Printing Pulp.8 27.7 2.0 60.2 0.6 7.9 6.7 23.6 3.2 4.9 2.4 43.3 6.9 7.4 58.4 4.3 1.2 4.1 4. Rubber.1 3.1 9.0 1.9 2.4 1.6 75.0 8.3 0. and Steam Supply Precision and Optical Instruments Other Manufacturing Construction Service of Motor Vehicles Wholesale and Retail Trade Transport Telecommunications Other Business Activities Nonmetallic Mineral Products Average 1.1 1. investment trust companies.1 — 1.6 0. Source: Constructed from data files of the Korea Listed Companies Association.2 5.5 63.5 1.6 5.4 4.5 3. Gas.8 2.2 1.8 3.2 0.1 2.1 3.5 4.1 54.2 49.6 — = not available.5 3.9 20.6 0.7 17.1 25.9 69.0 6.1 6.6 60.4 58.1 1. a The State covers the government and state-owned companies. and Printing Chemicals.4 45.78 81.6 2.” includes commercial banks.3 15.

1997 (percent) The Stateb Foreigners 4.5 19.9 5.4 2.4 5.4 1.7 8.0 Other Corporations 16.9 2.5 2. The State covers the government and state-owned companies. .c Securities Firms Insurance Firms Other Corporations Individuals 58. of Firms Independent Firms Affiliates of 30 Largest Chaebols Total 316 117 433 Source: Constructed from data files of the Korea Listed Companies Association.8 4. and finance companies.4 17.5 6.7 1.7 Control Type No.16 Ownership Composition of Listed Nonfinancial Firms by Size.7 6.1 Banks. Source: Constructed from data files of the Korea Listed Companies Association.4 61.8 60. mutual savings.Table 2.6 60.5 8.5 62.4 4.5 16. etc.17 Ownership Composition of Listed Nonfinancial Firms by Control Type. c “Banks.8 1.8 6. b Table 2.4 2. 1997 (percent) The State 1.1 2.5 4.1 6.0 6.5 18.3 Banks. Securities Firms Insurance Firms 2. Others are medium firms.7 4.7 Foreigners 4.” includes commercial banks. etc.4 61. investment trust companies. etc.4 5.8 3.1 8.7 0. merchant banks.0 1.9 4.5 Individuals 60.4 Firm Sizea No.4 21.8 2.6 16.8 4.3 6. 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.2 1.

5 45. 1997 (percent) Country Japan Korea Taipei. Institutional Investors 42.8 10.5 20. investors (Table 2.1 percent and appear to be similar to the proportion of foreign holdings in the four other countries.20). the majority shareholder group in all listed companies consists of the corporate.18 Ownership Composition of Listed Firms in Selected Countries. and the companies under the control of the largest shareholder. Generally. This has had profound implications for corporate governance and the market for corporate control in Korea.6 Individuals 23. while family members accounted for only 30 percent. including those of the largest shareholder.6 39.6 Foreigners 9.19). Among nonfinancial listed firms.1 8. his/her family members. rather than the individual. minority shareholders. The majority shareholder group’s shareholdings in listed nonfinancial firms steadily declined from 1990 to 1996. 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. Concentration of Ownership The analysis of ownership concentration in this section focuses on shareholdings of the majority shareholder. and other shareholders who do not belong to either the minority shareholders or the majority shareholder group.China United Kingdom United States Source: Stock Exchange of Korea.Chapter 2: Korea 83 Table 2. for example.3 54.8 9. In 1997. defined as those holding less than 1 percent of shares.8 56. At the moment.3 47.4 26. the majority shareholder group on average held 23-30 percent of outstanding shares in the period 19881997 (Table 2.3 6.1 financial institutions’ establishment of corporate pension fund accounts. But these may . only closed-end investment companies and traditional investment trust companies are allowed.7 16. Foreign holdings of Korean shares were 9. corporations held 70 percent of the controlling blocks of shares.

1 4.0 2. and the companies under the control of the largest shareholder.4 5.0 4. .9 7.9 33.1 28.3 30.1 14.6 46.6 5.1 23.6 26.Table 2.0 25. Other shareholders are those who do not belong to either the minority shareholders or the majority shareholder group.1 5.4 7.2 2.7 Note: The majority shareholder includes the largest shareholder.1 15.9 Individual 2.9 32.6 2.0 Year Corporation Individual 1992 1993 1994 1995 1996 1997 41.7 18.6 22. 1992-1997 (percent) Majority Shareholders Corporation 15.0 22.8 72.7 16.3 2.2 Minority Shareholders Subtotal 71.9 3.3 Subtotal 5.2 2.0 29.6 73.0 69.1 5.0 66. Minority shareholders are those holding less than 1 percent of shares.4 3. Source: Stock Exchange of Korea.0 1.9 6.7 44.8 8.7 7.1 21.19 Ownership Concentration of All Listed Firms.9 2.2 26.8 73.3 18.7 6.5 43.8 Individual Subtotal Other Shareholders Corporation 3.1 32.1 37. his/her family members.

8 Majority Shareholders 27. In telecommunications.9 29. . In most industries. in the small firms. rubber and plastics.8 57. Besides.7 18. Across industry.5 60. Majority ownership is also high in the chemicals. Meanwhile.9 48.8 25.4 23.5 13.9 27.4 Source: Constructed from data files of the Korea Listed Companies Association.9 Other Shareholders 18. The practice of hidden shares seems to have been less prevalent in recent years. ownership was relatively diffused due to government regulation.Chapter 2: Korea 85 Table 2. thereafter. utility companies have a relatively higher degree of ownership concentration with the majority shareholder owning nearly 45 percent of an average company (partly because these companies were owned solely by the Government before their privatization [Table 2.8 54. have been underestimated because it was widely believed that the largest shareholder often had hidden shares registered in the names of relatives and subordinates of the company.5 12.0 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 2.3 62. The shareholders that held more than 1 percent but did not belong to the majority group held about 20 percent on average. the majority owner held more than 20 percent of an average firm.2 15.6 11.3 25.5 23. minority shareholders.9 25.4 28.1 50. collectively owned less than 50 percent of an average firm. hiding shares offers no additional tax or other benefits.20 Ownership Concentration of Listed Nonfinancial Firms.0 58.9 12.6 57. In such cases.8 28. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Minority Shareholders 53. and mining categories.21]).22). It was highest in medium-sized firms before 1993 and. the Government has retained a large number of shares. Ownership concentration tended to be lower in large compared to medium and small listed firms.6 58.8 12.0 22.

2 37.0 39. Elecl Mach.0 54.Table 2.7 26.8 31.6 50. and Printing Chemicals.8 25.5 16.6 34.3 39.0 51.21 Ownership Concentration of Listed Nonfinancial Firms by Industry.2 23.5 47.2 46. and Printing Pulp.7 21.3 19.7 29.2 20.7 36.5 23. 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. 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 36.1 49.2 26.5 20.2 48. and App. Gas.7 17. Paper.9 44.2 19.9 26.9 Minority Shareholders Majority Shareholders Other Shareholders 12.4 11.5 44.6 53.5 41. Motor Vehicles Electricity.0 30.8 44. Rubber.8 29.2 34. Paper.5 52. and Plastics Basic Metal Fabricated Metal and Machinery Electronics.6 25.3 26.9 10.8 51.4 16.7 24.5 19.4 Industry Fishing and Fish Farms Mining Food Products and Beverages Wearing Apparel and Fur Articles Wood.1 43.8 55.5 21.2 22.0 21..6 38.8 41.4 53.1 19. .6 19.8 24.8 21.7 27.1 17.

4 29.1 20.6 31.0 55.8 56.5 12.6 24.9 16.3 26.9 60.8 52.1 48.5 10. .7 31.2 21.0 66.6 59.5 12.2 52.4 47.8 27.4 30.9 56.7 22.4 30.2 21.6 15.5 27.9 17.3 21.7 14.1 27.5 19.7 17.2 Majority Shareholders 26.2 50. 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.6 55.2 11.2 56.6 27.8 17.6 62.9 23.2 26. 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 53.5 51.1 58.22 Ownership Concentration of Listed Nonfinancial Firms by Firm Size.8 62.8 11.7 28.2 Source: Korea Listed Companies Association.2 32.2 18.6 11.3 19.2 12.1 15.8 28.9 12.4 30.7 57.6 65.5 33.5 49.7 16.8 52.5 26.4 51.9 22.5 19.0 26.7 57.3 25.2 21.9 28.8 50.1 16.3 27.9 26.2 55.5 21.9 53.9 21.7 15.5 28.0 24.5 Other Shareholders 19.Table 2.4 21.9 55.0 59.3 55.

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

34 percent were foreign companies. For the same year.5 percent as of 1997. In Table 2. But the controlling power of the owners also stems from inter-company shareholdings of the subsidiaries. dominated the majority shareholder group in chaebol-affiliated companies is consistent with the results of the ADB survey conducted for this study. firms linked through partial equity investments could enjoy the advantage of consolidation without an actual formal consolidation or merger of operations taking place. Twenty-two of the 81 respondents were independent.5 percent. together having a total of 292 domestic subsidiaries. Of the 81 respondents. for example. This also partly explains why chaebols frequently opted to expand by establishing new firms rather than placing investments internally. If we define the internal shareholdings of a . Thus. financial institutions that are subsidiaries of a chaebol also hold shares in its member firms. and about 11 percent were domestic financial institutions. there are instances of direct cross-shareholding in Korean firms. although they are likely to be insignificant. not individuals. the top five shareholders consisted of 2. The fact that corporations. corporations hold about 20 percent of the outstanding shares of all listed nonfinancial firms.5 corporations and two individuals. together owning an average of 37. In many instances. neither the investors nor the relevant government authorities were active in monitoring such unfair dealings between firms. Thus. Among chaebol affiliated firms. The top five shareholders of the chaebol-affiliated firms consisted of one individual and 3. or about five subsidiaries each.14. 59 parent companies collectively had investments in 759 firms.Chapter 2: Korea 89 guarantees from other members of the group at no cost. or about four firms each. These shares should be added to the control block although the financial institutions belonging to the 30 largest chaebols are prohibited from exercising their voting rights in the member firms of the chaebol. Among the subsidiaries or firms receiving investments. the top 30 chaebols’ shareholding by subsidiaries was 34. standalone setups. 59 were parent firms with one or more subsidiaries.5 percent of shares. and 319 foreign subsidiaries. Only six firms (or 13 percent) indicated that their subsidiaries also owned shares in themselves. 62 percent (16 out of 26) had a corporation as the largest shareholder. or an average of 13 firms per company. together owning an average of 38. Until recently. In the case of the 30 largest chaebols. Partial results are shown in Table 2. For the whole sample.9 percent of shares. 53 percent were domestic nonfinancial firms.23. Among the 81 listed firms in the ADB survey.4 corporations. the average shareholding of the controlling owners and their families was 8. The extent of pyramiding can be seen in some of the previous tables.

3 26.1 1.5 2.4 18.4 42.0 1.4 1.0 13.5 2.5 31.Table 2.6 3.9 5.1 3.5 38.7 19.8 8.7 0.6 16.6 34.7 5.1 22.0 1.6 3.9 29.3 12.8 Note: The survey was conducted during the period January through May 1999 and included nonfinancial listed firms only.0 17. .8 31.5 24.5 2.4 21. of Firms Largest Shareholder’s Holdings (%) Compositiona Individuals Firms Shareholdings (%) Individuals Firms Total Classification Total Sample Non-Chaebol Affiliated Largest Shareholder is Largest Shareholder is Largest Shareholder is Chaebol Affiliatedb Largest Shareholder is Largest Shareholder is Largest Shareholder is CEO an Individual a Firm CEO an Individual a Firm 81 55 31 10 14 26 3 7 16 20.9 34.8 37.7 39.5 18.4 11. 1999 Five Largest Shareholders No.8 38.5 2.4 2.0 3.5 1.8 18.6 3.0 3.9 21. b The chaebol affiliated firms are those belonging to one of the 30 largest groups.7 37.0 21.5 4.2 25.2 37.5 4. A few companies reported less than five largest shareholders.23 Ownership Concentration in the Survey Sample of 81 Listed Firms.4 25.0 2. a Number of shareholders.4 38.

5 34.4 1990 45.2 12.4 10. Table 2.5 percent. “The Ownership Structure and Family Control in Korean Conglomerates: With Cases of the 30 Largest Chaebols. Thus it can be inferred that their strategy in designing the ownership structure of their business groups was to minimize the financial resources required to maintain their grip on the management of the member firms while maximizing their control.2 15. As of 1997. 79-95.7 31. the average internal shareholding ratio of the top 30 chaebols was at least 43 percent. 15 October 1998. “Japanese Zaibatsu and Korean Chaebols.8 33.5 Judging from the historical record.Chapter 2: Korea 91 chaebol as the shareholdings of the controlling family and the member companies of the group. Hattori (1989) identified three patterns based on data in the early 1980s. 1997. the ownership patterns can be described as follows. Table 2. Ungki Lim. Chung and H. .7 9. Family holdings include shares owned by the family members and by parties considered to be under the influence of the family.” In Korean Managerial Dynamics. Tamio. Jae Woo. H. 1989. the controlling families owned 8.4 1993 43. “Is the Fair Trade Policy Fair?” Korea Economic Research Institute.8 40.6 33. 6 7 Hattori. The relatively high internal holdings of the 30 largest chaebols were due partly to the fact that many of the chaebols’ firms are still privately held.2 33.24 shows the average internal shareholdings in the 30 largest chaebols.2 1994 42. Lee. Many attempts have been made by researchers to identify the typical patterns of ownership structures in chaebols. Lee. pp. 34. Based on these studies. Chicago.5 percent and member companies.24 Internal Shareholdings of the 30 Largest Chaebols. 1987-1997 Type of Shareholding Internal Shareholdings Family Member Companies Source: Korea Fair Trade Commission. New York: Praeger.0 8. 1998.1 1997 43. C. 1987 56.7 1992 46. Internal shareholdings in some chaebols also include shares owned by nonprofit organizations operated by the controlling family.4 13. edited by K.” Paper presented at the Annual Conference of Financial Management Association. it appears that the chaebol families have had a strong desire to expand their business bases.6 Later studies by Lee (1997) and Lim (1998)7 find similar patterns. The family and member companies’ shareholdings have been declining over time.

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

It remains to be seen whether they will adopt the holding company structure in the future. A third disallows multiple layering of holding companies. . This limit was also applicable to banks and insurance companies. These conditions are aimed at restricting excessive pyramiding and expansion of chaebols. An operating holding company is defined by the Fair Trade Act as one whose investment in others does not exceed 50 percent of its total assets. However. the act did not have any important provisions except the standard clauses prohibiting monopolization of an industry through business combinations. thus hurting the shareholders of stronger firms. Another is that the holding company should own more than 50 percent of the shares of a nonlisted subsidiary company and more than 30 percent of a listed company. The Fair Trade Act was also revised in February 1998 to prohibit cross-guarantees of debt among members of a chaebol. Also. They hindered early exits (liquidation.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. Until the end of 1998. The prohibition of holding companies was also abolished in 1999. bankruptcy reorganization. Initially. direct control of the management of chaebols was attempted through amendments of the act in 1986 and 1990. there are reports that some top chaebols are studying the feasibility of transforming their organizational structure. following the amendment of the law. These amendments prohibited holding companies and direct cross-shareholding. the Credit Management Regulation rules were amended to prohibit financial institutions from requiring guarantees from affiliated firms when extending new loans. The Fair Trade Act was amended in 1998 to allow pure holding companies to be established under restrictive conditions. The first serious attempt to deal with this issue was the introduction of the Monopoly Regulation and Fair Trade Act of 1980 (hereinafter. This was the reason why chaebols chose to employ pyramidal structures. The Government is also considering whether to allow consolidated taxation for pure holding companies. One condition requires that the DER of the holding company should not exceed 100 percent. 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. only operating holding companies were allowed to be established. the Fair Trade Act). At this early stage. The limit on investments was reduced to 25 percent in 1994 and completely eliminated by 1997. Cross-guarantees are believed to constitute a form of wealth transfer from financially strong members to weak ones. Existing guarantees had to be resolved by March 2000.

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

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

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

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

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

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

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

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

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

amendments of the articles of incorporation require a “special resolution.77 percent of the shares.” meaning that it should divide its votes in accordance with the accept/reject ratio of votes cast by other shareholders attending the shareholders meeting. charter amendments. the Depository is instrumental in getting resolutions passed. These voters represented only 5.93 percent of the shareholders but 26.Chapter 2: Korea 103 2. Internet. Preferred shares can be nonvoting and issued up to one quarter of the total number of shares. Thus. The securities companies and banks are the second and third. However. The above results indicate that. for some firms. The Depository represented 20 percent of the shares attending the meetings.53 percent of the total shareholdings. attended the last annual general meeting.3. Citizens’ coalitions sometimes solicit proxies in order to file lawsuits against a management. respectively. and dismissal of directors and internal auditors require a “special resolution.21 percent of total shares issued. The management is the most important proxy.79 percent of the shareholders. corporations cannot issue common shares without voting rights.3 Shareholder Rights Voting Rights and Practices Under the Commercial Code. A total of 326 shareholders per firm. or 10. However.” The survey shows that the Korea Securities Depository holds 69. in general. or telephone. About 100 shareholders per firm voted by proxy at the last annual general meetings (of the 40 firms answering the relevant questions). representing 62. One common share should have one vote. This shows that a relatively larger number of shareholders send in their proxies. A “special resolution” requires two thirds of the votes attending and one third of total votes outstanding. the only purpose of allowing the Depository to vote was to help listed companies to meet the quorum requirement for the general shareholders meeting. The 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. No companies have so far introduced voting by mail. Approval of mergers and major divestitures. small shareholders do not attend the annual meeting and that. Under the Commercial Code.” Companies can increase the number . About one fifth of the listed firms issued nonvoting preferred shares. the Depository is subject to “shadow voting. 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.

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

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

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

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

5 The Market for Corporate Control Government Policy Toward Hostile Takeovers Until 1994. In cases where the creditors are unable to reach an agreement on a workout plan. and 1 percent by the Government. are summarized below. have been the driving forces for restructuring activities of the largest 64 chaebols. Separate from but emulating the CRA. Vol. Behind these new strengthened roles of creditors is the newly set-up FSC. 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. 2. the delegation has the right to approve wide-ranging financial activities of the firm. This agreement will provide guiding principles in coordinating diverse interests among creditor institutions and promoting cooperation.3.108 Corporate Governance and Finance in East Asia. First. In this connection. banks and other institutional lenders are playing more important roles than ever before. the creditor banks will send a delegation composed of bank officers to the workout firm to oversee its management. The leading creditor banks will continuously monitor the progress in implementing the signed Plans. the Corporate Restructuring Coordination Committee (CRCC) will provide arbitration. Second. 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 . including commercial and merchant banks. 2 percent by holding companies. 4 percent by subsidiaries. Under a contract signed between the creditors and the debtor. the lead creditor banks formally signed Capital Structure Improvement Plans with chaebols. especially banks. a Lead Creditor Council Agreement was signed for restructuring the top five chaebols. will get involved in the restructuring and workout processes. II by other affiliated companies. and in continued monitoring of debtors. major creditors. Third. 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. This committee was set up in accordance with the provisions of the CRA. the Korean Government maintained a policy of protecting the incumbent management of listed companies. The new ways through which creditors.

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

Currently the limit is 3 percent. In 1998. was newly listed.110 Corporate Governance and Finance in East Asia. Some had two or more large shareholders who had joint control of the firm but could not cooperate.6 Control by the Government State-Owned Enterprises Government ownership of listed companies is very limited. Another reason is that many listed firms belong to chaebols. Charter amendments have also been employed by some firms to limit the maximum number of directors. For the steel company. the Government became the largest shareholder of several commercial banks through equity participation purporting to recapitalize them out of financial distress. In their charters. Vol. are designated as public companies. the limit will be eliminated when it is fully privatized in two years. 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. 172 firms (or 22 percent of listed firms) belong to the 30 largest chaebols. 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). As of the end of 1997. in which the Government still holds the largest ownership. It is harder now to find such firms. a steel company. Firms affiliated with a large group are generally regarded as difficult targets as the other members of the group will come to the rescue or act as white knights. 2. which are allowed by the Securities and Exchange Act to set the limit on the ownership of shares by one single shareholder. Korea Telecom. 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 1999.7 percent on average as of the end of 1997 for nonfinancial listed firms). Hostile takeovers in Korea will be rare in the future. For the others. some firms have included a supermajority provision for the dismissal of directors and provided for a staggered board. an electric power company. As of February 1999.3. and a bank had government ownership. One reason is that the percentage of inside shareholdings (by the controlling shareholder group and the firms under its control) for an average listed firm is very high (26. The Government-owned listed companies.

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

Employees of companies have had the opportunity to buy shares of their employing businesses at favorable prices. Vol.654 employees per firm on average. 32 percent technicians and professional staff. 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 1968.9 in 1980. Under the Labor Management Council Law. In 70 percent of the firms with organized unions.1 in 1997. Local unions in the same industry have established industrial labor federations. Employee stock ownership plans became popular in 1974 when the Government allowed tax and financial benefits for stock purchases by employees. they delegate their voting rights to plans’ representatives. union members account for 54 percent of the employees. Collective bargaining is. Under another law enacted in 1972 to induce private companies to go public. Trade unions are organized on an enterprise basis. operation. II shares of their companies through employee stock ownership plans. the management usually consults the union on major issues relating to the management. carried out at the enterprise level. these firms have to offer 20 percent of the shares being issued to their employees at the public offer prices. there are two federations of labor unions. and 66 percent manual workers. The relevant regulation was amended recently in order to facilitate voting by individual employees. 2. employers are required to meet with representatives of labor unions at least once every three months. The percentage of shares held by the employee stock ownership plans in listed companies was 1. in principle. .112 Corporate Governance and Finance in East Asia. In actuality. This law is not intended for wage negotiations but for employers to seek cooperation and productivity increases from workers. and 2.5 in 1990. In 1987. the council meetings have been superficial. The typical collective bargaining agreement has a one-year duration. The union had no influence on the management in 17 percent of the firms. 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. This practice may be due to the fact that employees are typically submissive to their employers and that their total shareholdings are minimal. Two thirds of the respondents had an organized union. At the national level. employees of listed firms issuing shares through rights offerings are entitled to 10 percent of the rights. In these firms. of which 2 percent were senior managers. The respondents of the ADB survey had 2. and development of the company. which were generally much lower than estimated values.

Chapter 2: Korea 113

2.4 2.4.1

Corporate Financing7 Overview of the Financial System

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

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

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

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

Chapter 2: Korea 115

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

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

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

Chapter 2: Korea 117

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

Also. development of the money market. the Korean Government announced its Financial Liberalization and Market Opening Plan. Internal funds include retained earnings. It included such important issues as interest rate deregulation. the required reserve ratio was substantially lowered from an average of 23 percent in 1979 to 3. was liberalized drastically in 1998 after the financial crisis. especially the domestic bond market. Korean firms have been allowed to issue CBs in international financial markets. and the 30 largest chaebols. On the basis of flows of funds. the Government simplified various directives and instructions regulating personnel management. . Vol. implementing the first stage in November 1991.2 Patterns of Corporate Financing Corporate Financing Practices In this section. In June 1993. Meanwhile.1).118 Corporate Governance and Finance in East Asia. II Interest Rate Deregulation Plan. opting to bring in the plan step-by-step to avoid market dislocation from a sudden shift in the system. Since 1985. budget. The Government handed over its controlling stakes in four commercial banks to private hands in 1981-1983. entry barriers to banks and NBFIs were lowered in an attempt to promote competition. the Government announced a plan in 1981 that substantially improved foreign investors’ access to the domestic capital market.4. the following measures can be constructed: Self-financing ratio (SFR) is the ratio of change in internal funds to change in total assets. mutual savings. flow of funds analysis was used to examine patterns of financing of the aggregate corporate sector. The plan was launched partially to accommodate US demands for comprehensive structural deregulation and market opening of the financial sector. which resulted in the establishment of a number of new banks.2. With the privatization of nationwide commercial banks. and organization of commercial banks.5 percent in November 1981. depreciation. In addition. etc. the business scope of financial institutions was greatly widened from the early 1980s. revision of the credit control system. The Government adopted a cautious approach. and liberalization of foreign and capital transactions. 2. The Government began to considerably deregulate foreign exchange in 1987 due to the shift of the current account into surplus in 1986 (see 2. Some policy loans were also abolished. Moreover. finance companies. The capital market. as a first step toward liberalization of capital account transactions. listed companies. short-term finance companies.

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

3 6.7 — — — — 9.7 10.1 — — — — 12.0 — — — — 8.9 38.2 2.5 13. 1994.7 11.4 2.4 15.5 9.3 27.4 1.8 1.6 3.7 7.2 10.7 12.9 10.9 9.7 1.7 14.1 72.1 12.7) 11.1 1. 1988-1997 (percent) 1988 43.8 1.6 3.6 5.Table 2.0 17.3 1. Source: Understanding Flow of Fund Accounts.9 72.1 1.3 10.1 3.4 2.3 25.2 (0.8 27.1 0.3 30.2 0.0 3. .4 10.5 2.5 16.1 10.7 2.8 1.4 27.6 4.0) 12.5 2.4 1.4) 13.2 13.6 0.1 27.8 4.7 71.4 9. and net capital transfers from the Government. which is the excess of current value over issue value of stock.6 1.8 17.3 72.4 27.9 2.0 11.3 — 30.2 1.1 2.7 8.8 30.3) 15.0 5.2 14.9 28.2 13.3 3.3 6.3 5.4 11.6 25.3 3.1 23.1 1.4 — 28.3 1.0 3.0 0.0 9.1 3.2 5.5 2.9 73.6 9.1 (0.3 16.1 3.6 9.1 (1.0 9.9 34.8 1.4 71.2 — 28.7 2.6 (0.0 0.2 26.6 14.7 (0.4 (0.5 16.6 9.6 0.6 77.0 1997 26.8 (0.2 15.25 Flow of Funds of the Nonfinancial Corporate Sector.8 1.7 14.4 0.0 (0.8 — 26.7 10.1 2.0 22.7 1989 1990 1991 1992 1993 1994 1995 1996 22.6 0. Bank of Korea.6 2.4 2.2 6.7 15.6) 5.4 27.6 11.7 2.7 73. a Includes retained earnings.1) 4.6 0.6 4.8 15.2 6. depreciation.2 — — — — 9.9 6.7 4.6 4.9 10.8 -2.5 29.4 8.5 0.5 2. and Flow of Funds.7 1.7 10.1 8.1 36.0 16.8 8.4 0.6 Sources of Funds Internal Financinga External Financing Bank Borrowings Banks Nonbanks Merchant Banks Insurance and Others Securities Natl.7 4. 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.8 0.1 17.4 21.4 2. Bank of Korea.1) 6.3) 11.0 1.6 10.3 1.6 11.5 0.1) 4.9 0.1 0.7 8.0 70.3 6.6 8.7 13.7 6. b Includes capital surplus.4 (2.3 2.7 32.0 2.4 3.0 3.3 — — — — 8.5 0.1 — 27.0 10.2 34.8 56.

0 11. an average of 59. Incremental financing from equity was 40. Bank of Korea.0 5.1 26.7 28.6 Excludes capital surplus.4 IEFR 63. In periods of high economic growth such as in 1988. higher than the aggregate 28.2 37.5 percent in 1997. dropping to 26.0 42. additional equity to finance 12.7 26. average SFR was 37.3 59. While SFRs. There were significant time trends. 1994.7 40.6 62.5 68.6 percent over the 10-year period.1 39.7 40. On average.4 percent.7 40. higher than the aggregate 40.8 28.3 27.9 46.8 percent of its total asset growth through debts. IDFR reached 73. NEFRs.26 Financing Patterns of the Nonfinancial Corporate Sector.6 percent. Source: Calculations from Understanding Flow of Fund Accounts. and the total debt ratio was much higher in 1996 and 1997 at 62.6 percent and 1. and Flow of Funds. Lower income diminished the industry’s equity position toward crisis year 1997.8 62. the corporate sector relied heavily on external financing for its expansion.2 IDFR 36.3 73.5 percent. Across industry. .5 12. respectively. in the manufacturing sector.7 30. The balance.3 59. indicating a high financial risk position. declining to 26. Bank of Korea. NEFR registered 20.7 percent in 1997.9 percent by 1997 when net profit margins were negative.6 percent.3 11.8 10.1 17.2 percent of the growth in total assets. respectively. was financed by additional debts.Chapter 2: Korea 121 Table 2.1 percent in 1988 during the stock market boom.0 27.7 9. but also continuously fell.9 60. 45.3 percent in 1997. IEFR ranged from 32 percent to 64 percent of asset growth during the boom years. Its IEFR and NEFR dropped to 23.4 12.2 percent of incremental asset growth was financed by equity. but plunged to 5.5 and 76.0 57.27).3 60. SFR peaked at 44 percent. 1988-1997 (percent) Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average a SFRa 43.9 28.6 26.4 percent (Table 2.9 22.1 53.4 NEFRa 20.5 31.4 37.4 percent.1 12. and IEFRs were declining.4 27.3 12. It dropped to 28 percent the following year. Manufacturing financed 54.

6 54. with the total debt ratio much higher in 1995-1997 at 82 to 84 percent. and steam) and the transportation.and medium-sized firms. gas. the utilities (electricity. Vol.4 54.2 3.8 4. the proportion of short-term borrowings in total financing has been high.6 37.6 53.0 42.8 IEFR 65. and hotels sector and realty/renting/business activities sector were similar.0 57.9 percent of asset growth.6 45. Table 2.1 percent of total asset growth for the period.4 63. It had the highest average SFR in 1988 at 31.4 46.2 62. and fell to about 10 percent in 1997. Equity financed an average 25.9 6. large firms showed more cyclical patterns in these financing ratios than small.6 3.4 45.0 3. In 1997. These sectors had relatively low equity financing ratios and high total debt ratios in financing asset growth between 1988 and 1997. Total debt financed an average 74.5 7. and communication sector had relatively high incremental equity ratios. II The construction industry showed the most cyclical pattern in annual asset growth.7 47.2 5.8 percent in 1990. retail. from 17.2 21. storage.6 53.7 37. the two sectors also had low equity financing ratios and high debt financing ratios.3 28. Financing patterns of the wholesale.7 percent in 1996.5 76. this dropped further to 15.9 percent.4 3.122 Corporate Governance and Finance in East Asia.6 4.0 42.1 29.6 37.4 47. On the other hand.6 62. which decreased to 8.5 23.5 1. and low total debt and short-term borrowing ratios. one year ahead of the other industries.4 37.2 . their average SFR was higher.2 percent in 1993.0 30.3 52. Categorized according to company size.9 IDFR 34. Since large firms were more profitable. explaining partly the collapses of several construction companies in 1995.8 percent in crisis year 1997.7 37.7 47.6 36.5 NEFRa 9.27 Financing Patterns of the Nonfinancial Corporate Sector by Industry (percent) Year Manufacturing 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average SFRa 50.8 50. then increased to 20. Since 1992.

8 29.1 69.5 1993 22.0 34.3 57.3 21.2 18.7 15.2 Average 53.5 1.8 9.2 70.3 47.7 7.0 31.27 (Cont’d) Year SFRa NEFRa IDFR 53.8 54.9 1989 63. Household Goods.5 76.7 41.9 1.2 3. Hotels 1988 33.5 87.9 1992 56.6 37.9 9.9 1.8 1994 15.9 20.9 33.2 25.0 10.6 73.0 1992 24.9 1993 63.1 84.5 1996 42.2 1995 16.7 80.9 1.5 12.9 2.3 4.9 Average 19.7 15.4 26.2 74.0 68.6 7.0 4.4 62.0 1990 12.0 0.4 IEFR 46.9 52.0 3.5 70. and Communication 1988 64.2 5.7 6.7 78.2 23.0 65.7 78.0 1.1 4.3 8.6 14.9 15.Table 2.2 10.6 71.0 17.6 4.2 46.7 1989 26.6 2.8 70.3 1996 16.2 4.5 20.3 10.1 70.3 4.4 2.1 19.7 Wholesale/Retail Trade.0 40.6 1997 29.3 19.4 28.5 23.5 29.6 9.8 76.5 21.8 81.2 20.0 60.6 8.9 80.8 25.0 1990 50.4) 2.6 8.6 37.7 1997 8.1 1991 14.9 Construction 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average 31.9 16.8 4.7 42.9 30.4 1995 53.5 62.7 53.6 9.1 Trasport.3 7.2 29.3 84.0 74.7 1994 53.1 66.9 29.8 2.2 8.1 25.0 .0 82.1 59.8 74. Storage.8 1991 51.3 (9.9 47.

3 29.1 42. IEFR = incremental equity financing ratio. NEFR = new equity financing ratio.1 70.2 63.7 70.8 1993 11.1 71.9 IDFR 31.4 0 0 0 0 1.1 34. and Business 1988 51. Long.1 35.0 1992 51.4 1. Higher growth in total assets and sales and easier access to debts by large firms could be reasons for this.and mediumscale firms.7 18.0 0. Source: Calculated using data from Bank of Korea.3 Electricity. Gas.7 1994 8.4 0.124 Corporate Governance and Finance in East Asia.7 1996 18. Their average IEFR was also higher and IDFR smaller.5 77.8 135. The large firms had a higher proportion of external financing in 1996-1997.8 17.9 65.5 22.3 92.6 1.0 79. . and Steam Supply 1988 118.8) 7. SFR = self-financing ratio. Renting.1 1991 56.0 (0.2 1992 18.0 43.0 67.6 Real Estate.6 1989 118.7 14.3 85.4 5.0 1.7 37.9 Average 75. when large firms had much lower equity financing ratios and higher debt financing ratios than small.7 69.3 81.4 7.3 62.1 1989 34.0 56.6 1995 17.5 8.0 0.6 52.9 64.6 7.0 1997 24.8) (35.4 1995 62.3 7.8 Average 22. II Table 2.27 (Cont’d) Year SFRa NEFRa 6. however.9 45.6 1990 82.4 (107. Vol.6 1997 23.3 207.1 0.9 28.9 57.0 33.3 3.8 1990 19. The trend was reversed in 1996-1997.0 53.8 36.1 1993 55. Financial Statement Analysis Yearbooks.4 47.4) 3.0 21.1 54.6 1991 18.9 29.0 46.6 IDFR = incremental debt financing ratio.3 31. a Excludes capital surplus.and short-term borrowings of these firms shot up in that period.4 1996 45.4 IEFR 69.4 1994 72.

The largest borrowers were the top 11-30 chaebols. The debt financing ratio of listed companies was high since they relied more on external financing.9 percent. Many firms affiliated with the top 30 chaebols saw loan guarantees turn into their own debts because of defaults in debt payments. Another key feature of corporate finance in Korea is the widespread use of loan guarantees among the top 30 chaebols.4 percent. The proportion of their short-term financing averaged 72.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. Cross-payment guarantees have been declining since 1993 and reached 91. the IDFR of listed companies increased to 93. The chaebols’ drive to expand their empires resulted in heavy borrowings.6 percent.1 percent of their equity capital.28). for listed companies. In 1997. .8 percent. The average IEFR of the top 30 chaebols of 29. 91. compared with 89.6 percent of total asset growth. compared with the entire corporate sector’s 35 percent and 65.29). In 1997.30). and were large borrowers. 153.7 percent. and the top five chaebols. but higher than that of listed companies. at an average 70. They were able to borrow easily from banks by issuing corporate bonds and CP. Group-member firms borrowed less. the lowest ratio of 58. respectively. The average IEFR and IDFR were 10. and higher than that of listed companies (Table 2. the average SFR was 28.5 percent is lower than that of the corporate sector in general.7 percent for all listed companies. All of the top 30 chaebols relied heavily on short-term borrowings. In 1996-1997. Their shortterm borrowings accounted for 86.8 percent of their total finance in 1997. External financing reached 94. the top 11-30 chaebols had the highest guarantees commitments at 207. and using cross-payment guarantees among affiliated companies.2 percent.3 percent of their equity capital in 1997 (Table 2. They had easier access to bank loans and the markets for corporate bonds and CPs than nonlisted companies.3 and 89.5 percent and their total external financing. about the same as that of the corporate sector as a whole.9 percent.7 percent. the NEFR of the top 30 chaebols plunged while the debt ratio increased substantially. the top 6-10 chaebols. Financing Patterns of Chaebols For chaebols.

4 12.9 6.6 1.5 Year 1994 1995 1996 1997 Average a Excludes capital surplus.2 36.6 11.2 1.9 NEFRa IEFR 14.9 7.5 2.3 Year 1994 1995 1996 1997 Average a Excludes capital surplus.29 Financing Patterns of the Top 30 Chaebols.5 8. .7 12.1 93.3 5.3 IDFR 57. Source: Calculated from data obtained from data files of the Korea Listed Companies Association.6 IEFR 42.1 8.7 13.1 1. 1994-1997 (percent) SFRa 41. Korea Federation of Industries.28 Financing Patterns of Listed Companies.4 29.8 76.5 91.4 1.Table 2.5 2.4 88.2 23.5 8.4 38.2 10.2 NEFRa 1.3 86.8 89.6 61. 1994-1998 (percent) SFRa IDFR 85.7 1.6 0. Source: Calculated using data of Seung No Choi.3 28.3 1. Table 2. Largest Business Groups in Korea.8 22.6 70.

Interest payments on debts were considered a loss when calculating taxes. This attitude appears to have changed after the crisis because reserves and retained earnings and rights issues became the preferred financing choices. Second. Financial institutions did not strictly screen their loan projects and monitor their debtors. Third.3 200.0 1997 91.7 150. so that the firms engaged in lobbying to gain access to them. There were several reasons for this. in order of ranking. Source: Fair Trade Commission and the Federation of Korean Industries.1 — = not available.3 58. bond issues. company preferences in financing investment projects before the crisis were. and reserves and retained earnings. And fifth.30 Cross-Payment Guarantees of the Top 30 Chaebols.3 64. rights issues. and extended loans based on cross-payment guarantees. Fourth. Few firms ranked loans from NBFIs as their first preference. Korean firms preferred debt financing (bank and nonbank borrowings). and loans from NBFIs. First. poor financial and corporate governance resulted in overlending by banks. the Government provided implicit guarantees on bank lending and large businesses. loans from banks. Factors Influencing Corporate Financing Choices Until recently. 1993-1997 (as percentage of equity capital) Rank Top Top Top Top 30 Chaebols 5 Chaebols 6-10 Chaebols 11-30 Chaebols 1993 469. chaebols could easily borrow funds from banks and NBFIs by using cross-payment guarantees.Chapter 2: Korea 127 Table 2. Controlling shareholders usually tried to avoid dilution in their shareholdings for fear of losing control. . inefficient investment and excessive diversification of corporations.9 — — — 1996 105. especially in the 1970s when real interest rates of bank loans were negative. and underdevelopment of the stock market. Further.9 — — — 1994 258. According to the ADB survey.0 207. the Korean economy was plagued with high inflation.9 153. Firms now prefer internal funds and new equity capital. These are followed by loans from banks. more than half of bank loans were priority loans with low interest rates. This change implies that firms now give more attention to financial risks. the Government applied high tax rates on net profits of corporations.1 — — — 1995 161. bond issues.

2. The percentage of foreign currency denominated loans hedged against exchange rate risks was 21. and others (29 percent) expected the local currency to appreciate in value. Few companies felt that hedging was too costly or was unnecessary as the exchange rate was considered fixed. firms give their first consideration to minimization of transaction and interest costs. 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. some (36 percent) thought that a hedging facility was not available or not working properly. Korea now provides a better environment for financial risk management. Only a few firms sought foreign loans because domestic loans were not available. For these firms. About half of the respondents of the ADB survey borrowed foreign currency denominated loans from foreign banks. Diversification. Vol. 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. This preference has changed little after the crisis. in order of importance.128 Corporate Governance and Finance in East Asia. more than half (53 percent) hedged against exchange rate fluctuations. Other factors include. Nonetheless. ensuring the liquidity of the company. the majority (60 percent) of the firms responding to the ADB survey look first for nonaffiliated financial institutions. even with a heavy debt burden. they survived for two to three . many firms (or 42 percent) never considered hedging. A futures exchange launched in 1999 trades foreign exchange options. and futures and other financial derivatives. II In seeking external financing.36 percent on average for these companies. and reduction in tax burden. Among the responding companies that had foreign currency denominated loans. maintenance of the existing ownership structure. According to the survey. the percentage of foreign currency denominated debt in the portfolio was 14.4. in selecting financing sources. Among those that never hedged against exchange rate risks. These survey results indicate that many companies were not very attentive to exchange rate risks (and possibly to financial risks in general).5 percent at the end of 1997.

the top five chaebols’ ratios were much higher.Chapter 2: Korea 129 years before collapsing at the time of the 1997 financial crisis (2.13).2. . Interest coverage ratios of non-chaebols were higher than those of the top 6-70 chaebols during the entire period. However. Those firms whose interest payment coverage ratios are below 1 are likely to go bankrupt. 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.. as well as lax financial supervision (Nam et al. The ratios of the top five chaebols were similar to those of the top 6-70 chaebols until 1991 when the top five chaebols’ ratios shot up. (iv) In terms of EBITDA to total assets. They were also higher than those of the top five chaebols until 1991. (i) In terms of total borrowings to total assets. the top five chaebols and the top 6-70 chaebols had similar ratios. But since 1992. Operating earnings are earnings before interest payments and taxes plus depreciation and amortization (EBITDA). 1999). In order to determine the relationship between financing patterns and corporate performance. They were also higher than those of the top five chaebols until 1992. except in 1991. the ratios of independent firms were higher than those of the top five and top 6-70 chaebols during the entire period. but the ratios of independent firms were much lower. the ratios of nonchaebols were remarkably higher than those of the top 670 chaebols during the entire period. (1999) compared the financial positions of 504 chaebol affiliates and non-chaebol independent firms during the period 1986-1998. (ii) In terms of net income to total assets. except in 19931995 when semiconductor prices were extraordinarily high. Nam et al. The ratios of the top 6-70 chaebols were lower than those of the top five chaebols. Table 2. These findings indicate that independent firms have had a lower leverage and performed better financially.3. Among the main findings were the following. the trend was reversed in 1993 when the interest coverage ratios of the top five chaebols exceeded those of the independent firms. (iii) Interest payment coverage ratios are calculated as operating earnings over interest expenses.

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

6 3.4 (1.7 1.1 (3.8) (1.6) 0.9 0.3 3.1 1.4 (2.5 (0.9) 2.0 (0.5) (1.3) 0.4 1996 0.11.8) (37. .6) (12.6 0. p.8 3.1) — = not available.7 0.8) 0.2 4.3) (0.1 1.2 1995 3. Source: Whan Whang.9 1.1 0.3 0.6 1.6) 0.0 1992 1994 1.5) (7.8) 0.8 0.7 0.0) 0.2 (1.2 (0.5) (0.0 (7.5 (0.9 0.8 (0.2) (0.5) (2. Court Receivership.8 1.4) (2.9 1.4) (6.4 1.6 0.9 0.9) (8.1) (1.1 (4.4 1.3) (1.2) 0.6 1.4) (1.1) 0.4 0.8) (3.3) 0.3 0.8 0. Management Research Institute.4 (0.6 0.7) (0.7 1.0) (0.8 0.5 (6.4) (1. Background and Task of Structural Adjustment.6 0.3) 0.7 (0.8) (1.7) 0.1) 2.2 1. Chung Ang University.1 0.5 1.8) 0.9 1.6 (10.31 Net Profit Margins of Chaebols.4 0.5 1.2) 1.8) 0.7 (4.6 0.1 0.6) (12.6) (20.6 0.5 (0.1 1.9) (1.3 (0.1 (0.2) 2.5 1.5) (2.0) (3.6 1989 1.0 1987 1.1) 0.3 1.4 1.1) (1.0 6.6 (0.4) (0.1 1.1 0.8) (11.7 2. Beyond the Limit.3 1.4 (1.8) (20.Table 2.4 (0.3 (0.3) (0. and Reconciliation Kia Jinro Hanbo Sammi Newcore Haitai Chungku Kukdong Daenong Halla Workout Target Kuhpyong Kangwon-sanup Pyuksan Sinho Tongil Kohap Sinwon Anam Donga 1985 1.1 1.9) 0.3 (3.1 0.8) 0.5 1.3 0.8 0.0) 0.5 0.3 1.2) (13.3 1.4 2.2 1.8 0.2 (0.7 (1.1 0. 1998.3 (0.8 (0.7) (0.9) 2.2 1.0 0.7 — (0.1) 2.6) 0.7) (1.3 0.8) 1997 0.7 0.7 3.4 0.9 1.2) (0.3) 1.1) (5.2) (4.3 1.6 0.3 1.0) 0.2 (0.1) (6.3) 0.0 1.2 (17.7 0.8) (4.4 0.5 1.0) (0. 1985-1997 Item Top 5 Hyundai Samsung LG Daewoo SK Top 6-30 Top 31-72 Default.1) 1.8) 1.5 (0.9 0.5) 0.6) 0.1) 1.2 1.5 4.3 1.3) 0.6) (0.0 1.6 (0.1 1.2) 1.7 0.1 0.0 4.7) 0.1 2.8 1990 0.7 (0.1) (2.6 1.3) 0.3 (0.9 (0.2) (13.8) 2.2 1.2) (3.4 (1.4 (0.9) 2.2) (4.8 3.0 0.8 1.6 5.3 1.8 (0.4) (1.2) 1.1 0.0 (2.2 (0.0) (4.8) (0.5 (4.6 7.2 0.3 1.7 1.1 0.5 2.3 1.3) (12.3) 0.7 0.6 1.3 0.4 1.2 1.3) 1.1 (1.2) (4.4) (4.6 0.7 1.9 8.1 (9.6 1.1 (4.3 1.3) 12.2) 2.1 4.1 1.9) (9.6) (0.

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

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

II strong financial links among its member firms through investments and cross-guarantees. However. Further. Financing preferences changed drastically after the crisis. as the latter are well established in most business areas.5. Net profit margins of the top 31-72 chaebols were higher than those of the top five or of the top 6-30. and internal funds. share issues. while (non-chaebol) independent firms had much lower borrowing ratios. This effectively becomes an exit barrier for chaebols and would justify the intervention and support of the Government. Such problems may eventually cause ripples through the entire economy. As mentioned earlier. the intervention later resulted in the accumulation of adverse side effects: underdeveloped product. Vol. the authorities did not properly check on banks’ lending practices—banks did not screen the lending projects and evaluate the creditworthiness of corporations properly. capital. 2.3 Manifestations of Weak Corporate Governance and Government Intervention Preference of Debt Over Equity Financing in the Precrisis Period Before the crisis. prevalence of rent-seeking and morally hazardous behavior by economic decision makers.134 Corporate Governance and Finance in East Asia.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. The new preference ordering is as . financing choices of listed firms in order of preference were bank loans. The Government’s supervision and regulation of financial institutions were poor. 2.5. Profitability of the top 6-70 chaebol firms has been lower than that of the top five chaebol firms. and other individual markets. the typical chaebol firm had an extremely high DER. The Government and the Bank of Korea did not have accurate information on the extent of transactions that corporations and financial institutions had abroad. bond issues. This indicates that too much diversification and overinvestment in the top 30 chaebols resulted in relatively low net profit margins. although their subsidiaries had better quality workforce and easier access to cheap credit than the top 31-72 chaebol affiliates. the financial distress of one or a few marginal firms can lead to a chain of bankruptcies across the entire chaebol. and a high degree of inefficiency in the economy.

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

II Inefficient Corporate Investment and Low Profitability Ownership concentration among Korean firms. Meanwhile. nine out of the 30 top chaebols failed. the ratios of net profits to sales. However. the NPL ratio reached 7. Doubtful loans are those for which interest is not received for six months or longer. without strictly evaluating the creditworthiness of businesses and the profitability of projects. then 20. the NPL ratio8 of banks and other financial institutions began to increase. and shareholders’ equity of all industries.000 during January-September of 1998. and returned to about 1. has given rise to various types of self-dealings by the controlling shareholder. and estimated losses. 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. Following the “three months” definition. The number of insolvent companies increased rapidly in 1991 and doubled to more than 11. total assets. The banks and merchant banks lent to large businesses.7 percent in 1997. The Government could hardly help them because of the number and magnitude of business failures. Financial Sector Vulnerability Because of financial losses in the corporate sector. The monthly number reached more than 3.6 percent in June 1998. were low in 1996 and 1997. Moreover. These were the definitions until 30 June 1998.136 Corporate Governance and Finance in East Asia. and the pursuit of growth through excessive diversification and inefficient investment.000 from December 1997 to February 1998.200 in 1997. Fixed loans are those for which interest is not received for six months or longer. Before the crisis. They utilized mutual payment guarantees among their affiliates and believed that they would never fail.000 in September 1998 (Table 2. It jumped to 17. . especially chaebols. the NPL ratio of commercial banks increased rapidly from 4.000 per year starting 1992.1 percent in 1996.32). The inevitable result of inefficient investment was a fall in corporate profits. and there is no collateral. Further. In 1997 they became negative. decelerated from March 1998. starting 1 July 1998. The bank supervisory 8 NPLs of banks comprise fixed (substandard) and doubtful loans. reaching highs of 6 percent in 1997 and 8. excluding the financial sector. According to the “six months” definition. Vol. and there is collateral. legal and other barriers prevented the exit of financially nonviable firms. a large number of construction companies failed due to the recession in the real estate market and decline in real estate prices. regardless of whether it is caused by large personal holdings of the controlling shareholder or by pyramiding. they are defined as loans for which interest payments are overdue by three months or more.

Compared to ROAs and ROEs of domestic branches of foreign banks. and Taipei. and declined to 4-6 percent in 1994-1996 (Table 2. 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. In 1990-1993.255 13.769 9.992 11.850 3. ROEs and ROAs of Korean and Japanese banks were low compared with those of the US. and continuous and large current account deficits.673 Construction 380 354 242 195 294 585 1.517 2.647 8.32 Number of Firms with Dishonored Checks.265 6.544 2.979 8. European countries.33).859 3.5.159 10. This was mainly due to the high ratios of NPLs.553 3.890 4.Chapter 2: Korea 137 Table 2. Exchange rates were virtually pegged to the US dollar in all troubled Asian countries.502 11.259 2. Policymakers thought that economic growth would resolve the NPL problem without the need for corrective action.637 6.238 4.135 1.133 3. Meanwhile.573 3.053 5.69 20.210 1.244 3. 1986-1998 Year 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Total 4.472 2.855 6.107 6.114 811 706 696 866 1.759 6.754 3. 2.589 171.417 Others 152 132 108 97 88 161 326 252 274 302 553 861 952 Note: 1998 figures cover only January-September.985 Services 3. As a result they had largely overvalued currencies. low efficiency. the ratio reached 7-8 percent.4 Shortcomings in Macroeconomic Policy The macroeconomic framework also contributed to the crisis in 1997.027 Manufacturing 1.856 7.386 5. This speculation was said to be one of the causes of the financial crisis in Korea. Source: Bank of Korea.131 1.457 2.751 1. The current account deficits in terms .China.250 2. those of domestic banks were lower in the 1990s. and large government-directed loans.657 3. authorities were not too concerned about the high NPL ratios at Korean banks in 1997 simply because the high and rising ratios had precedents.

0 7. b Doubtful loans are collateral-free loans for which interest is not received for six months or longer.639 1. Source: Bank of Korea.649 375. Korea -4.077 NPL Ratio (%) 8. even in times of economic slowdown.929 11.138 Corporate Governance and Finance in East Asia. the hourly wage rate in the Korean manufacturing sector was higher than in Singapore or Taipei. In addition to the overvaluation of the won.8 percent (1996).190 9.176 7.160 11.China.910 1. It was estimated that the Korean won was overvalued by 20 to 30 percent from 1989 to 1997.736 8. Businesses served as a social safety net. II Table 2.827 289. The main result of the rigid labor market was a “high-cost and lowefficiency” economy. the ratio of short-term debt to foreign reserves was very high.475 143.537 10. Mass layoffs became legally possible only after the economic crisis.1 6. Related to this.390 12.874 22. The pegged currency also encouraged foreign borrowing as investors believed that the exchange rate would remain stable.832 337.170 1.221 8. of percentage of GDP were as follows: Malaysia -8.6 percent (1995).584 2. and Indonesia -3.430 12.192 Doubtful (B)b 952 1.0 7. Meanwhile large businesses could not legally lay off workers.8 5.266 10.562 18. which led to large corporate losses.116 1.484 11.705 160.652 29. 1990-1998 (W billion) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 a Total Loans 90.6 Fixed loans are those requiring collateral and for which interest is not received for six months or longer.954 9. although per capita income in Korea was much lower.584 Fixed (A)a 5. Vol.556 118.997 9.1 7.310 6.739 241.1 percent (1995).520 194. Thailand -8. the terms of trade deteriorated 12 percent in 1996 and 11 percent in 1997. Land prices and real estate rents were also high compared to trading partners.0 8. because of the rigid labor market. In 1997. and 30 percent in 1996. Real interest rates in Korea had been two to three times higher than those of Japan or Taipei.2 4. judging from the real effective exchange rate indexes using unit labor cost indexes as a deflator and 1985 as a base year.600 10.6 percent (1995).33 Nonperforming Loans of General Banks.237 Estimated Loss (C) 958 920 840 816 213 385 490 490 648 NPL (A+B+C) 7. .4 5.China.

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

the number of potential sellers decreased somewhat from 2.140 Corporate Governance and Finance in East Asia. In their first review. In many cases. Korean firms have been slowly stepping up their restructuring since the latter half of 1998 as the economy began to show signs of recovery. On the other hand.281 in April to 2. It was frequently observed that the negotiating parties could not agree on a price due to large discrepancies in valuation. because liquidation of debtor firms would exacerbate the banks’ already weak balance sheets. the creditor . II Divestitures to raise cash for debt reduction and to focus on core businesses have not proved to be easy. 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. Banks did not have the incentive to force financially nonviable firms to liquidate. 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. potential foreign buyers waited for the price of acquisition targets to come down further. Locally. they were reluctant to allow recontracting for fear of further deterioration in the capital adequacy ratio. This number was at 779 firms in April and grew to 1. Noticing this disincentive. FSC directed banks to appraise the long-term viability of client firms showing symptoms of failure. 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. Internationally. Vol. or to agree on debt-equity swaps demanded by potential purchasers as a precondition for the deal. More than 59 percent of potential buyers were foreign firms. while only 14 percent of the negotiations were completed from the beginning of the crisis up to April 1998.138 by the end of October. More important. The reasons are manifold. Involuntary Exits The Government has been involved in the restructuring process mainly through its supervisory capacity over banks. sellers could not find buyers as almost all domestic firms struggled to raise cash for debt reduction and for working capital needs while there was a severe credit crunch following the outbreak of the crisis. banks and other creditors were reluctant to absorb losses realized by debt compositions.045 in October.

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

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

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

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

beginning on 1 April 1999. (iv) during April and May 1998. administrative procedures for FDI will be dramatically simplified and made transparent. including tax exemptions and reductions. (iii) hostile mergers and acquisitions by foreigners were fully liberalized in May 1998. (ii) full liberalization of foreign exchange transactions was legislated and will be put into effect in two stages. Capital Market Liberalization Since 1998. 514 listed companies had appointed 677 outside directors). (vii) by the end of March 1998. According to the law. Measures for improving standards in corporate governance are already effecting a generally more open corporate culture and greater transparency in business practices. crossdebt guarantees totaling about W10 trillion—about 30 percent of the total guarantees among the 30 largest chaebols—were dissolved. only 31 out of 1. In addition. 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. either partially or fully. (v) by the end of May 1999. 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. 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. the Korea Trade and Investment Agency (KOTRA) will provide a one-stop service with respect to FDI. 21 industries were further liberalized or newly opened to FDI (now.Chapter 2: Korea 145 (as of the end of May 1998. have been instituted for FDI: . including financial subsidization. an additional nine industries will be opened or further liberalized. various supporting measures. which was passed in August 1998. These new standards are and will continue to be strictly enforced. 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. financial institutions could no longer require cross-debt guarantees. (vi) bankruptcy laws were revised in February 1998 to facilitate the exit of insolvent firms. As for promotion. to FDI). Foreign Investment Promotion Act The Foreign Investment Promotion Act was put into effect in November 1998.148 industries remain closed.

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

Twenty-five domestic financial institutions. If interest rates stabilize at a low level. Mutual funds (or open-end investment companies) will be allowed starting 2001. a primary dealers system will be introduced for healthy financial institutions. In order to promote a greater market demand for government bonds. with only minor standard exceptions. both domestic and foreign. As a pilot program. According to the law. In August 1998. Moody’s signed a joint venture contract with Korea Investors Service. to establish closed-end investment companies. These are expected to operate for the next three years. Related legislation was put into effect in September 1998. but it will also help improve financial institutions’ risk management. Prior to the introduction of this system. invested a total of W1.6 trillion in these funds: W0.Chapter 2: Korea 147 monthly. a debt restructuring fund and three balanced funds (funds that invest in both equity and debt) were established in September 1998. It also opened the credit rating service market to foreign competition. but may be extended as required. and the demand for longerterm bonds increases in the future. and is promoting joint ventures between foreign and domestic agencies. To ensure transparency and efficiency of the fund operations. they will be managed by foreign investment management companies. No qualification requirements are being imposed on investors who are sponsoring new mutual funds. 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. This law will not only provide an effective institutional environment for the disposal of NPLs. and W1 trillion divided equally between the three balanced funds. Asset-Backed Securities A new law providing for asset-backed securities (ABS) was passed in September 1998. It is now easy for private investors. the Government will correspondingly expand the issuance of government bonds that have a maturity of five years or more. financial institutions . including the Korea Development Bank. The Government established specific qualification criteria and selected the primary dealers in 1999.6 trillion for the debt restructuring fund. commercial banks were allowed to carry out dealing operations for government bonds starting in October 1998.

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

The Corporate Board. The annual shareholders meetings could also elect reputable “monitoring companies” to recommend director candidates (Latham. More effective measures to protect investors will enhance corporate transparency and also the accountability of directors to shareholders. There has recently been a general shift in individual investor preference from direct personal stock trading to investing in traditional investment trust companies and the newly introduced (closed-end) investment funds. the Korea Stock Exchange could incorporate provisions of the Code of Best Practice in Corporate Governance in its listing rules. September/ October 1997. Further. 23-26. using audit. 1997). and other committees. 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. Companies could also invite nominations from such organizations as the Korea Listed Companies Association or citizens’ coalitions that have been active in monitoring corporate management through proxy solicitations. Institutional investors will play an increasingly important role in corporate governance. One way of motivating institutions to do this is to 10 M. . Proposed: A Governance Monitor. The Government can prompt institutional investors to contribute more to good corporate governance by paying greater attention to corporate affairs. If and when the law is introduced. pp. One action that has yet to be taken is the introduction of an act to facilitate class action suits against corporate directors and internal and external auditors for their wrongdoings. The Securities and Exchange Act will then require large listed companies to switch to a board audit committee system from an internal auditor system. and requiring that all directors hold shares of their companies. it will have to include making self-dealings by directors and officers. Listing rules may recommend that all or large listed companies adopt an audit committee. Since the economic crisis.Chapter 2: Korea 149 investors or their trade associations. various measures have been implemented to promote investors’ rights. 1997.10 Other means to improve independence of the boards include mandating that independent outside directors form the majority. governance. Latham. thereby helping to strengthen board independence and enlisting boards’ more active involvement in monitoring corporate management. Each listed firm should be required to disclose the extent of its compliance with the Code in its annual report. and also negligence of external (independent) auditors actionable. Class action suits are an efficient means for corporate monitoring.

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

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

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

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

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

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

Banks have significant presence as members of affiliated business groups. nationalist sentiments led to policies that favored import substitution and heavy government intervention in business. emerged to influence industrial policies. their growth could not be sustained. Sugar refining and textile mills are examples of industries that floundered in the 1980s because of government import substitution policies.2. and responses to the financial crisis. and on the financial crisis. Companies finance long-term investments with short-term debt. An industrial elite. This study reviews the Philippine corporate sector in terms of its historical development. Companies were profitable because of protection from foreign competition. composed mostly of families previously in trading businesses. While new manufacturing industries were successfully established. therefore. But protectionist policies made labor relatively more expensive and. yet they did not risk new capital required for modernizing and expanding manufacturing capacity. on family-based and controlled conglomerates. Investments of large corporate groups tend to focus on obtaining market shares and industry dominance. The Board of Investments (BOI) was created to draw up an investment priorities . the corporate sector showed structural weaknesses similar to those in neighboring Asian countries. The highly concentrated and family-based ownership of corporate groups has resulted in governance structures that depend largely on internal control systems. companies were necessarily large and capital-intensive.156 Corporate Governance and Finance in East Asia. The policy was crafted by the martial law regime at that time.1 Overview of the Corporate Sector Historical Development During the 1950s and 1960s. patterns of ownership. II Still. To implement these policies. 3.2 3. control by internal and external governance agents. Corporate financing relies excessively on bank loans. It analyzes the impact of corporate governance on company financial performance and financing. usually with the acquiescence of bank creditors. These early industrialists naturally opposed any initiative to reduce tariffs. Vol. Government interventions under the notion of “master planning” for economic and social development characterized the 1970s and early 1980s. patterns of financing. the Government overvalued the local currency and imposed high import tariffs. regulatory framework. which leads to their easing of due diligence and monitoring standards when lending to group members.

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

7) 10.0 7.8 percent growth in fixed 2 The SEC-BusinessWorld Annual Survey of the Top 1.0 8.9 7.2) 4. 3.0 (0. With economic reforms introduced in the 1980s and 1990s. This rate of growth was sustained by a comparable 18.9 5.3 9.8 8. 1990-1999 (percent) Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Indonesia 9.1 5. only to be unsettled by the crisis of 1997.8 4.2 Korea. however.5 8.9 6.000 corporations. In this section.5 (7.2 Source: ADB.1 8.0 (6. Its growth rate began to catch up with others in 1996.7) (10.9 (1.2 9.000 Philippine companies grew 17. .2.2 8.8 5. net sales of the top 1.4 Philippines 3. Table 3.2 7.1). Vol.1 GDP Growth of Southeast Asian Countries.2 7. Rep.7 5.1 5.5) 5.2).5 percent per year (Table 3.3 2.1 4. 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. The Philippines substantially lagged behind other countries from 1990 to 1995 (Table 3.8 5. competition from liberalized imports had somewhat reduced oligopolistic tendencies and concentration in many industries.8 10.5) 3.6) 0.4 4.8 8.7 Malaysia 9. Key Indicators of Developing Asian and Pacific Countries 2000.5 8.3 7.2 (0.3 8.7 8.7 (13.2 Growth and Financial Performance Performance of All Companies The analysis of corporate performance in this section used financial data from the Securities and Exchange Commission (SEC)-BusinessWorld Annual Survey of Top 1.000 Corporations covers financial and nonfinancial companies.5 9.158 Corporate Governance and Finance in East Asia. II market. which was taken as a representation of the Philippine corporate sector.0 8.2 Thailand 11.2 During 1988-1997.2) 0. of 9.6 7.3 9. only nonfinancial companies were used.

394.5 192.4 555.8 411.1 72.9 3.781.1 66 12.1 6.123.2 Compound Growth (%) 17.4 411.3 107 13.4 3.8 26.9 1.4 602.9 629.978.5 14.8 6.7 1.8 902 1.5 1.3 862.4 898 1.1 1.5 446.3 306.6 896 0.1 468.6 102 16.225.7 73 6. . return on assets (ROA) = net income/total assets.6 426.6 18.191.4 260.7 903 0.1 714.4 776.341.8 5.332.160.5 193.9 149 6.4 861.6 1990 1991 1992 1993 1994 1995 1996 1997 1.6 149 12.131.4 Financial Ratios (%) Leverage ROE ROA Turnover Net Profit Margin 222 14.1 54 11.8 741.512.5 570.2 1.6 954.3 941.7 20. Source: SEC-BusinessWorld Annual Survey of Top 1.5 4.3 60 10.4 1.2 Growth and Financial Performance of the Top 1.893.5 119 12.6 290.2 900.5 887 0.7 1.Table 3.697.1 73 5.1 51.5 Leverage = total liabilities/stockholders’ equity.7 218.6 144. net profit margin = net income/net sales.2 338. 1988-1997 1989 519.6 109 12.1 197 14.2 707.1 181 11.6 35.000 Companies.5 64.3 68 7.6 5. of Companies Sales per Company (P billion) 899 0.9 96.2 Average 146 12.3 898 1.5 508.2 2.6 75 6.2 4.5 1.9 78 6.3 121 12.5 51 4.561.0 1.8 22.9 2.8 4.317.2 2.5 72 7.1 Other Indicators No.4 63.1 1.6 900 1.3 382.2 27.9 617.0 148.1 95.8 618.5 1.1 881.000 Corporations in the Philippines.1 5. return on equity (ROE) = net income/ stockholders’ equity.6 1.9 896 2.4 8.2 Indicators 1988 Growth Indicators (P billion) Net Sales Net Income Fixed Assets Total Assets Total Liabilities Stockholders’ Equity Retained Earnings 464.8 77 7.4 188.7 28.1 615.2 378.647.7 238.1 33.9 480.209. turnover = net sales/total assets.177.0 1.9 952.0 900 1.1 4.3 46.7 443.2 136.9 898 1.

000 Companies Year 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Average Growth (%) a GDP (P billion) 799 925 1.352 1.000 Corporations in the Philippines.3 The Corporate Sector and Gross Domestic Product. II assets. The data suggest no evidence of excessive borrowing in the run-up to the crisis in 1997. Asset growth was funded by debt that grew at an average of 20.474 1. The debt-toequity ratio ranged from 222 percent in 1988 to 102 percent in 1994. Key Indicators of Developing Asian and Pacific Countries 1999. but the extent of the increase was not as dramatic as in other Asian countries.9 23.394 1.5 16.5 Ratio of Estimated Value Addeda to GDP (%) 17.693 1. Total assets grew at an average annual rate of 22. various years. for the 10-year period. Net income consistently increased from 1988 to 1996 and declined only in the crisis year 1997.3). leverage increased from 109 percent in 1996 to 149 percent in 1997.4 24.979 17.160 Corporate Governance and Finance in East Asia.697 1.172 2. The growth rates of corporate sales for the period 1988-1997 exceeded those of the country’s GDP for the same period (Table 3. and the SEC-BusinessWorld Annual Survey of Top 1. indicating that the corporate sector’s exposure to foreign currency-denominated loans was not as significant as in other countries.7 percent.427 13. This is high compared with developed countries but compares favorably with other Asian countries.5 17.9 21. Sources: ADB.2 percent.6 percent and 5.248 1.3 percent.5 Value-added is assumed to be 30 percent of net sales. Assuming Table 3. .077 1.1 Net Sales (P billion) 465 519 630 741 862 954 1. respectively. 1988-1997 Top 1.8 17. These rates of return are high compared with other Asian countries.178 1.906 2. Vol. Net profit margins for the top 1. Return on equity (ROE) and return on assets (ROA) averaged 12. and by equity that grew at a higher average annual rate of 26.1 19.8 19.9 percent for the period.4 20.8 percent per year.000 companies averaged 7. Further.

8 14. Performance by Ownership Type The Philippine corporate sector can be categorized into four groups based on ownership: (i) publicly listed. 1988-1997 Indicators Publicly Listed Privately Owned Rate. various years.5 Source: SEC-BusinessWorld Annual Survey of the Top 1.7 22.0 5. A study of company performance by ownership type.4 Growth and Financial Performance of the Corporate Sector by Ownership Type.3 22.4 Total Liabilities 26.0 142 22.9 22.0 Net Income 19.4).9 196 1. of Companies 73 Sales per Company (P billion) 2.5 Other Indicators Share of Sales (%) 17.0 4.8 ForeignOwned 21.7 2. (iii) Government-owned.8 606 0. and (iv) privately owned.4 Stockholders’ Equity 32.3 9. Averaging 42.1 ROA 8.1 12.9 26.2 9. privately owned companies constituted the largest group (Table 3.9 17.1 22 10.0 Turnover 53 Net Profit Margin 15. and industry reveals further structural characteristics of the growth and financial performance of the corporate sector.3 11.3 22.8 22.0 5.4 190 5.3 27.4 28.000 Corporations in the Philippines.8 percent of the corporate sector’s total sales between 1988 and 1997.5 Retained Earnings 30. (ii) foreign-owned.5 23 4. corporate control structure.8 No.0 31.2 103 5.8 Growth Indicators (Compound Annual Growth Net Sales 20.8 3.3 146 6.4 Fixed Assets 19. The premise is that these variables have a direct bearing on corporate performance and growth.5 GovernmentOwned 4.0 28.1 Financial Ratios (%) Leverage 89 ROE 15.3 42.8 2.Chapter 3: Philippines 161 a constant ratio of value added to sales.6 Total Assets 29. size.5 27. %) 17. The foreign-owned companies were the Table 3. .9 158 13. these figures suggest a significant and increasing contribution of the corporate sector to GDP.

reflecting the significant presence of holding companies as the gross revenues of holding companies flow through to operating income. the highest net profit margin of 15. Bases Conversion Development Authority. although small in number. and government-subsidized agencies such as the National Food Authority and Local Water Utilities Administration. The privately-owned companies were only about one third of the average size of per company sales of the publicly listed companies. But by being most efficient in employing assets. these companies were comparatively large.8 percent for foreign-owned companies and 20 percent for publicly listed companies during 1988-1997.000 companies in 1997. and low return on investment is the norm. 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.5 percent average growth rate of the entire corporate sector.000 list. Their ROA and ROE were both more than twice as high as those of government-owned companies.2 percent and ROA of 9. foreign-owned companies borrowed more than publicly listed ones. while there were few of them. or 38 percent.5 percent. Governmentowned companies in the top 1.162 Corporate Governance and Finance in East Asia. the second best ROE and ROA. with an average ROE of 22.1 billion per company in 1997. It should also be added that the profit margin of Government-owned companies is distorted by the presence of holding companies such as the Philippine National Oil Company. The privately-owned companies had a high average leverage ratio of 158 percent. Only 84 of the 221 public companies listed on the Philippine Stock Exchange (PSE). meaning that the remaining 62 percent were relatively small in sales and assets. but lower than those of foreignowned and publicly listed companies. Publicly listed companies had a minor though steadily increasing share in total sales. were among the top 1. . The compound annual sales growth rate was 21. II second largest at about 27.3 percent. registered the largest per company sales at about P9 billion in 1997.9 percent. the asset base is large. selling an average of P4. exceeding the 17. followed by publicly listed ones. With an average leverage ratio of 142 percent. However. Publicly listed companies had the lowest leverage at 89 percent. they generated the highest return on investments.75 billion per company for foreign-owned companies. These were mostly large public utilities. compared with P2. a level high by Western standards but at par with those of other Asian countries. Privately-owned and Government-owned companies grew at slower rates. Vol.

1 124 5. of Company 159 Sales per Company (P billion) 2.2 23.000 Corporations in the Philippines.5 Growth and Financial Performance of the Corporate Sector by Control Structure. But the conglomerates were larger measured in sales per company.7 Stockholders’ Equity 34. The independent companies contributed about 56 percent of corporate sales on average during the period 1988-1997. %) Net Sales 20. compared with 32.0 166 15. various years.0 Turnover 67 Net Profit Margin 12.7 2. had a lower leverage ratio.5).Chapter 3: Philippines 163 Performance by Control Structure By control structure.1 Source: SEC-BusinessWorld Annual Survey of Top 1. grew faster. and achieved higher returns on invested assets than independent companies (Table 3.0 55. and small companies. medium. a company can be a member of a conglomerate or independent.0 25.8 Growth Indicators (Compound Annual Growth Rate.8 6. Table 3. 1988-1997 Indicators Group Member Independent 18.0 22.2 Net Income 21.7 Total Assets 32.3 Financial Ratios (%) Leverage 98 ROE 15.6 715 0.4 24.3 Total Liabilities 30.6 26. depending on assets and sales. Performance by Firm Size By firm size. Sales and resources of the .1 Retained Earnings 32.3 No.8 ROA 8.3 percent for the conglomerates.3 Other Indicators Share in Sales (%) 32. the corporate sector is divided into large.2 Fixed Assets 25.

1 ROA 5. . 1988-1997 Indicators Large Medium 19. averaged only P920 million in per company sales during the same year.2 Other Indicators Share in Sales (%) 56.1 25.5 25.2 Stockholders’ Equity 18. Medium-sized companies also performed better in terms of ROE.1 No.0 730 0. which.2 25.9 Retained Earnings 13. Sales per company in this group averaged P13. indicating that they deployed resources more efficiently than large and small companies.0 32. defined in this study as the next 200 largest companies in the top 1.3 Source: SEC-BusinessWorld Annual Survey of Top 1. although they comprised only 8.6 31.4 Total Liabilities 18.4 28.9 Financial Ratios (%) Leverage 158 ROE 13.6 49. for this study. are defined as the largest 100 companies in the top 1.0 156 16.3 Fixed Assets 15.000 list.6 Growth and Financial Performance of the Corporate Sector by Firm Size.6 Small 19.1 81 9.6 36.9 89 1. %) Net Sales 15. Medium-sized companies.5 12.7 Net Income 1. Table 3.4 billion in 1997.9 26. referring to the remaining companies in the list.5 Total Assets 18.164 Corporate Governance and Finance in East Asia.7 44.1 percent of the total sales of the corporate sector. II Philippine corporate sector are highly concentrated among the large companies.3 Turnover 65 Net Profit Margin 8.000 list. various years.2 29. Vol.000 Corporations in the Philippines.5 73 6. of Companies 79 Sales per Company (P billion) 7.5 128 10.6).5 Growth Indicators (Compound Annual Growth Rate. sales of mediumsized companies grew faster than large companies. However.0 7. averaging 16 percent.6 47. Large companies accounted for 56. while small companies. averaged a far less P3 billion in per company sales.8 percent of the total number of companies in the list (Table 3.9 32.1 4.

net income. manufacturing. ROE dropped from 10. Sales revenue and net income declined from P76. at 158 percent on average during 1988-1997. Leverage was the highest for large companies. at 128 percent for the period. profits. and construction. compared with 9.Chapter 3: Philippines 165 Small companies. averaging 10. reflecting to some extent a “bubble” phenomena in the former two sectors. The Asian financial crisis affected large companies most severely. with their ROE dropping to 3.2 billion in 1997 for this sector. assets.7. Net income declined from P54.8 percent in 1997. at -12. Large.8 percent. and the construction sectors than for the manufacturing. and equity up to 1996. But small companies’ leverage was significantly lower. but lower than that of construction. as indicated by the negative annual growth. net income. real estate. although the largest in number. ROE dropped to 7.6 percent. and utilities and services sectors. The leverage ratio of the manufacturing sector was higher than that of the real estate and property sector. but suffered its largest decline in net profits in 1997. The growth and financial performance of selected industries. especially during the period 1994-1996.8 the previous year. are shown in Table 3. i. utilities.7 percent in 1996 to 8.4 percent in 1997 from 11. from 14.5 percent for medium-sized companies and 8. Growth of sales. Performance by Industry This study also looked at corporate performance by industry. The real estate and property sector also suffered significantly in sales. and utilities and services sectors. Manufacturing companies represented more than half of the corporate sector in number in the period 1988-1997 and accounted for about 82 percent of total sales.7 percent in 1997 for medium-sized companies.1 percent. and profitability in 1997 when the crisis started. For small companies.and medium-sized companies did not substantially increase their leverage in years running up to the crisis in 1997. Poor returns appear to have been caused by the low profit margin at 6.2 percent for large ones. unlike their counterparts in other Asian countries. showed the lowest ROE. at 156 percent.. Medium-sized companies apparently enjoyed efficiencies associated with economies of scale and made more productive use of their assets. of net income.e. The sector showed consistent growth in sales.7 percent a year earlier. specifically those industries least and most affected by the financial crisis. Mediumsized companies’ leverage level was slightly lower.1 billion in 1996 to P4.7 billion and P35.8 billion in . and assets was much higher for the real estate and property.

7 10. and was also much more limited compared with the property sectors in other Asian countries. various years.4 16.0 23. respectively.8) 17.5 12. But the impact of the Asian crisis on the real estate and property sector was much smaller than that on the manufacturing sector.7 52.0 25. With a modest increase in total liabilities and leverage level of less than 100 percent in 1997.9 2. The sector’s buildup in equity during the stock market boom of 1994-1996 may have cushioned the impact of the crisis.0 31 0.6 69 16.3 5.000 companies’ total sales on average during 19881997.9 23.2 45.7 19. Its knock-on effect on the economy was small as it accounted for less than 3 percent of the top 1.6 Growth Indicators (Compound Annual Growth Rate.4 Source: SEC-BusinessWorld Annual Survey of Top 1.7 Net Income (12.8 Stockholders’ Equity 21.2 12. of Company 454 17 Sales per Company (P billion) 1.7 billion in 1997.0 21. 1988-1997 Utilities Real Estate and and Services Property 39. 1996 to P56.2 8.4 19.9 17.1 2.9 2.1 10.0 Turnover 112 24 Net Profit Margin 5. the sector’s ROE dropped from 15.8 41. As a result.2 37.6 Total Liabilities 18. it does not appear to have been excessively exposed to foreign currency-denominated loans.9 5.9 billion and P24.6 No.3 Fixed Assets 20.4 3.8 48.6 Financial Ratios (%) Leverage 142 181 ROE 13.7 Indicators Manufacturing Construction 27.000 Corporations in the Philippines.1 24 42. II Table 3.4 Total Assets 19.3 Retained Earnings 17.7 ROA 5.7 Growth and Financial Performance of the Corporate Sector by Industry.7 192 9. Vol.7 83 2.3 20. . %) Net Sales 16.4 percent.5 Other Indicators Share in Sales (%) 82.7 percent to 10.7 28.3 55.166 Corporate Governance and Finance in East Asia.2 28 0.

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

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

Chapter 3: Philippines 169

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

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

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

Chapter 3: Philippines 171

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

3.3 3.3.1

Corporate Ownership and Control Patterns of Corporate Ownership

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

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

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


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

Chapter 3: Philippines 173

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

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

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

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

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

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

In 76 companies. Vol. With such high levels of ownership concentration. or 3 percent of the total.2 percent of outstanding shares of publicly listed companies. and 20 shareholders? In Table 3. the top five controlling shareholders were classified into eight groups. Through these. including pure holding companies. a single shareholder held operating control of a company. holding only an average of 2. Individuals did not constitute a significant shareholder group among the top five shareholders. In four companies.174 Corporate Governance and Finance in East Asia. or almost 75 percent of the total. or 78 percent of the total. nonfinancial corporations held majority control. The limited volume of shares issued to the public is one of the causes of the underdevelopment of the Philippine stock market. or 51 percent of the total. a single owner owned more than 80 percent of outstanding shares.1 percent of publicly listed companies in the Philippines in 1997.9 shows that in 44 companies. and share prices are sensitive to movements of foreign funds. Composition of Ownership of Publicly Listed Companies Another important issue concerning corporate ownership is the composition of the controlling shareholders. large and family-based shareholders pool the family’s ownership over many . In 111 companies. the top five shareholders owned more than 50 percent of the voting shares. 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. Parent companies usually spin off operating units into new companies that they continue to control as affiliates. There are advantages to establishing pure holding companies. The largest group is nonfinancial corporations. In 116 companies. five. The shares of publicly listed companies are thinly traded and illiquid. 66 percent (signifying strategic control). or about 30 percent of the total. Who are the top one. or 14 percent of the total. the top five shareholders held more than two-thirds majority control of a company. or 80 percent (only nominally publicly listed) of outstanding shares. II analysis of the number of companies in which the top one. Table 3. a single shareholder held two-thirds majority control. Nonfinancial corporations with controlling shareholdings are likely to be holding companies. the top 20 shareholders collectively owned a majority of a company’s shares. controlling an average of 52. five. or 20 shareholders owned more than 50 percent (signifying operating control). In 21 companies. which are mostly privately owned and controlled by family-based shareholder blocs.10. In four of 11 nonfinancial sectors.

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

9 36.6 0.0 0.1 6.3 0.3 0. and Tobacco Holding Companies Manufacturing.0 0.4 19. Distribution.4 2.6 12.5 0.3 37.3 2.3 0.0 1.2 0.0 5.1 0.7 0.4 8.3 1.8 66.9 6.6 2.2 5.8 0. and Other Services Property Mining Oil Average Shareholdinga 33.3 0.0 1.4 0.2 0.0 0.0 1.5 4.2 0.1 5.2 0.3 5.0 0. Recreation.0 5.0 4.8 0.0 2.2 1. 1997 (percent) Nonfinancial Investment Nominee Commercial Company Trust Fund Company Individual Bank Government Securities Broker Insurance Company Sector Financial Company Banks Financial Services Average Shareholdinga Nonfinancial Company Communication Power and Energy Transportation Services Construction and Other Related Products Food.1 8.0 45.0 5.2 10.5 0.0 0.0 0.0 1.6 5.0 0.2 3.6 18.6 0.3 26.0 1.2 3.0 0.7 0. .4 1.0 2.2 3.2 3.9 52.1 a Weighted by market capitalization.7 0.4 29. and Trading Hotel.0 0.1 9.0 5.9 0.6 0.0 0.1 7.0 1.0 0.0 0.7 0. Source: PSE Databank.2 0.1 0.5 12.6 33.6 0.6 2.0 0.5 2.7 3.3 12.0 1.7 0.0 1.0 10.3 5.6 9.5 53.8 0. Beverage.7 67.4 5.10 Composition of Top Five Shareholders of Philippine Publicly Listed Companies by Sector.8 11.9 0.Table 3.7 3.3 0.6 0.5 4.3 1.7 0.6 0.8 21.0 0.5 26.2 59.7 1.1 1.5 13.6 0.6 1.0 0.0 7.

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. and insurance companies (0. .7 percent of market capitalization of the nonfinancial publicly listed companies. The 7. They can also better manage their income taxes because income from affiliated companies passes through a holding company. These are mainly the Social Security System (SSS) and the Government Service Insurance System (GSIS).1 percent). The investment funds’ presence in these sectors ranged from 8. there was no real market for investment information. Investment trust funds were the most important institutional investors.5 to 12.2 percent in 1997. Such advantages have contributed to the popularity of holding companies among publicly listed companies. These include Philippine Long Distance Telephone Company (PLDT) in telecommunications. while still allowing the public to own minority shares.7 percent of shareholdings). securities brokers (1. respectively. These institutions keep a stock portfolio mostly in shares of a few companies with large capitalization and high liquidity in select industries. Funds of SSS and GSIS consist mainly of compulsory contributions from members of the country’s private sector and government workforce. accounting for P258. Petron and MERALCO in power and energy. This complex layering of ownership masks the identity of individuals or families that actually own and control operating companies.2 percent shareholding by the financial institutions was even inflated to some extent because securities brokers held trading portfolios for their clients rather than long-term investments. As a group. 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.6 percent of market capitalization in 1997.6 billion or 26.1 percent). with an average of only 7.Chapter 3: Philippines 177 companies and share in the risks and profits of the group. Holding companies as a sector had the largest market capitalization in PSE in 1997. The financial institutions among the top five shareholders of nonfinancial corporations are investment trust funds (with 4. financial institutions did not have a significant ownership in nonfinancial corporations. and San Miguel Corporation (SMC) in food and beverages. commercial banks (1. Holding companies were themselves 66 percent owned by other nonfinancial corporations. The Philippine capital market did not have an active analyst community comparable to those in more developed capital markets.3 percent). Because of limited ownership by institutional investors.

Commercial banks hold the largest share. Corporate financing depends on intermediation by banks. Still. a nonfinancial company that owns a commercial bank has better access to loans at favorable rates and terms. This could further increase the concentration of ownership and expand the scope of own-group lending by these larger banks. For this reason. The process identified a total of 238 companies belonging to 39 business groups from the SEC-BusinessWorld Annual Survey of the Top 1. suggesting that most publicly listed companies are parts of business groups. the study put together a list of prominent business groups. Banks that are members of business groups have an advantage in raising funds from the internal capital market of the group. so far limiting their involvement to selected products.8 percent of total companies in number. All major industries were represented. This is significant considering that there were only 31 local commercial banks in the country in 1997. . but they comprised only 23. the Central Bank’s reforms are probably changing the conduct but not necessarily the structure of the banking system. including SBL and DOSRI rules. suggesting that business groups are common in all major markets. 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. remain in force to control excessive lending of banks to insiders. many companies in family-owned groups are not publicly listed.11). To understand the ownership and governance characteristics of family-owned business groups. identified the companies belonging to each of these groups.000 corporations’ sales. Family-based groups have larger companies since their total sales were about 33. Large shareholders and their families own these banks directly or through their controlled companies. about three fourths.178 Corporate Governance and Finance in East Asia.7 6 7 The study used publicly available shareholder information and published reports. However. A common feature of corporate ownership of a business group is the centrality of a commercial bank. using data on the Philippines’ top 1. 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. The Central Bank deregulated interest rates and foreign exchange. including 16 commercial banks.000 Corporations in the Philippines. and tracked the financial performance of each company from 1992 to 1997.6 The total sales of these groups in 1997 were estimated at P806 billion (Table 3. Prudential regulations.000 companies. of the financial resources in the country. and increased the capital requirements for all types of banks. Foreign banks have a growing presence but have not necessarily increased the supply of credit to the corporate sector. Vol. Some 20 financial institutions were affiliated with these groups. More than three fourths of the respondents are either a parent or subsidiary (about 70 percent of these are domestic nonfinancial companies). liberalized the regulations on entry of foreign bank branches and foreign ownership of local banks.4 percent of the top 1.

Chapter 3: Philippines 179 Compared with other Asian countries. In terms of sales. and banking. 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.000. including business groups and independent companies. as discussed in previous sections. it was manufacturing (36. To show this. In terms of number of companies. and Henry Sy—as examples. for the Gokongwei Group. namely. with 27 affiliated companies in the top 1. Lopez. the principal owner of SMC. the three largest entities were family-based groups. in most .6 percent of the total sales of the top 1. It is also noteworthy that. nonfinancial companies contributed about 36 to 60 percent of total profits for these groups. with the exception of Banco de Oro. Gokongwei. Foreign-owned companies mainly serve the export markets. the largest was the Eduardo Cojuangco group. and Ayala. the biggest private company in the Philippines. The significance of family-based business groups in the Philippine corporate sector is immediately evident in the 50 largest corporate entities. retail merchandising (69. The main constraint may be the availability of family members that could be drawn for top management positions. for the Lopez group. an average group in the Philippines has fewer member companies. Cojuangco. the largest family-based business group was the Ayala Corporation Group. 25 out of the 50 top corporate entities were familybased groups. the nonfinancial sector was real estate (60.8 percent).4 percent of the group’s 1997 profits). the top 10 family-based business groups had only 119 companies in the top 1. Commercial banks are often affiliated to a particular business group. for each of these groups. Together.000 companies. broadcasting (49.1 percent). which was majority-owned by the Henry Sy group.12). ranged according to their sales (Table 3. Significantly. a substantial proportion of group profits came from its financial subsidiaries. In the meantime.000 corporations in 1997. construction. For the Ayala group. Lopez. Family-based business groups are most dominant in sectors such as manufacturing.2 percent). These corporate entities accounted for 53. Commercial banking contributed about 40 percent of group profits for the Ayala group and Gokongwei group. real estate. In 1997. and more than 20 percent for the Lopez group and Henry Sy group. Also. and for the Henry Sy group. the study used the four largest business groups—Ayala. or an average of about 12 per group. the two were closely related through their affiliations to business groups.

and Affiliated Bank of Selected Business Groups. Flagship Company.0 26. 8.5 26. and mining Management.4 .5 44.3 15.0 Average Sales Per Company (P billion) 6. real estate. 6.0 13.9 2.5 6.5 2. Beverages. and tourism Credit card 18.0 17. 3.9 3. and food Food. 4.2 16. telecom. 17.1 4.5 17.5 47. and tobacco Telecommunications Cement and construction materials Pharmaceutical and distribution 12. agriculture. 11. 15.5 49. food. 5. and dairy products Investments.6 3. 10. 13.11 Total and Per Company Sales. 2.1 2.2 1. Consunji 4 3 Food and dairy products Construction and mining 10.3 3. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/ Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go Wilfred Uytengsu/ General Milling Group David M.4 6. 14. and car manufacturing Car manufacturing and real estate Food and telecommunications Department store and real estate Airlines.5 46.2 1.1 4.7 98.3 2. beverages.5 13.3 11. 7. Sector Orientation. food.8 84. and packaging Power distribution and mass communications Real estate. Eduardo Cojuangco Lopez Family Group Ayala Corp.6 7.4 48. coconut oil. power.0 5. Real estate. construction.6 3. 1997 Business Group 19 15 27 12 12 9 4 6 11 4 8 9 5 4 5 6 Major Sector Orientation Estimated No. 9.4 10. beverages.Table 3. of Affiliated Companies Total Sales (P billion) 123. and personal care prods Shipping.6 2. 16.

19. Ramos Gaisano Family Group Felipe Yap Felipe F. and real estate Retail merchandising Ceramics and real estate Department store and real estate Cement and sugar central Real estate and securities trading Bookstore. Cruz Jose Luis Santiago Keppel Group Robert John Sobrepeña/ Fil-Estate Group Total Real estate Sources: PSE Databank.7 0. P.5 2. 28.8 6. SEC-BusinessWorld Annual Survey of Top 1.9 1. 21.1 805. 37.7 4.3 2. 20.4 3.0 2.5 8.9 0. 34.0 0.2 4.2 6. 38.8 1.6 0.7 0.9 1.1 0. 27.1 1. 31. 29. mining.6 3.6 5.3 7.8 1. 36. and real estate Department store Mining Construction Telecommunication Shipyard and power 4 7 5 2 4 4 3 2 5 7 5 5 2 3 2 3 2 2 2 2 8.3 2. distribution.8 Jollibee Foods Luis Lorenzo Family Group Alcantara Family Group Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J.6 2. 30.9 7.7 1. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C.7 0.7 3.1 1. 4 238 1. 24.4 1.9 6. 26.9 1. 23. 39.4 5. and various company annual reports.0 5.4 3. 33.9 0. 32.6 Fast food Beverages and agro-industrial products distribution Cement and wood products Retail merchandising Electronic appliances Real estate Mining Real estate Telecommunication.000 Corporations (1997).0 1. 35.1 2.8 1. . 25.2 1. 22.

9. 8. 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. 13. Inc. 15. 7. Alaska Milk Corporation DM Consunji. 18. Uytengsu/General Milling Group David M. 14. Eduardo Cojuangco Lopez Family Group Ayala Corp. 1. 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. and Affiliated Bank of Selected Business Groups. Long Distance Telephone Phinma Zuellig Pharmaceutical Metro Pacific William Gothong and Aboitiz Swift Foods/RFM House of Investment Anscor Equitable Card Network Inc. 10. Sector Orientation.Table 3. Group George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Del Rosario/Phinma Group Zuellig Group First Pacific/Metro Pacific Group Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Andres Soriano Family Group George Go W. 20. 19. 11.11 (continuation) Total and Per Company Sales. 2. 5. 4. 16. 17. 21. 3. 6. Jollibee Foods Corporation Pepsi Cola Products Alsons Cement . 12. Flagship Company.

Fil-Estate Development Inc.48 billion. F.. Kepphil Shipyard Inc. .48 billion. 25. Ramos Gaisano Family Group Felipe Yap Felipe F. 35. 37. small = less than P1. 27.65 billion. 29. Cruz & Co. 31. 32. unless otherwise indicated. Sources: PSE Databank. 26.East-West Bank International Exchange Bank Ecology Bank (Savings Bank) Dao Heng Bank Orient Bank International Exchange Bank International Exchange Bank Philbanking Corp.65 billion to P4. 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. 24. 33. Keppel-Monte Bank Bienvenido Tantoco Elena Lim Andrew Gotianum Brimo Family Group Andrew Tan J. a b Size class is measured in terms of sales: Large = greater than P4. 22. medium = P1. P. 38. Enrile/JAKA Group Jaime Gow Guoco Group Jose Go Jardine Davies Gerardo Lanuza Alfredo C. SEC-BusinessWorld Annual Survey of Top 1. Refers to commercial banks. 30. 36. 39. 34. Inc.000 Corporations (1997). and various company annual reports. 23. 28. PT&T Corp.

24. 7. 18. 5. Texas Instruments (Phils. of the Phils. and real estate Banking.0 24.5 47.1 17.3 15.7 98. Aboitiz Family Group Jose Concepcion/RFM Group Alfonso Yuchengco Philippine Associated Smelting and Refining Corp.Table 3. construction. 3.5 15. 1997 Sales (P billion) Control Structure Major Industrial Orientation 123. 4. 12.5 44. banking.5 46. coconut oil.5 26. First Pacific/Metro Pacific Group 21. Beverages. and car manufacturing Power Refined petroleum products Refined petroleum products Banking. 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.6 18. and personal care products Shipping. 15. 2. Petron Corporation Pilipinas Shell Petroleum Corporation George Ty John Gokongwei Henry Sy Lucio Tan Ramon Cojuangco Family Group Caltex (Philippines) Inc.). mass communications.1 60.5 17.2 49. 6. 9.12 Control Structure of the Top 50 Corporate Entities. and packaging Power distribution. and bank Real estate. 13. 22.8 84. food. 23. bank. and mining Gold and other precious metal refining . and food Food.0 38. food.0 37. food.4 48. 20. and telecommunications Department store and banking Airlines. telecommunication. 11. 14. 10. 16.2 Business Group Business Group Business Group Government. beverages. Eduardo Cojuangco Lopez Family Group Ayala Corporation Group National Power Corp. 17. Del Rosario/PHINMA Zuellig Group Toshiba Information Equipment (Phils.8 22. Inc.6 26. beverages. Philippine National Bank Mercury Drug Corp. car manufacturing. Inc. agriculture. and dairy products Investments.and Foreign Jointly Owned Business Group Business Group Business Group Government-Owned Publicly Listed/Foreign-Owned Foreign-owned Business Group Business Group Business Group Business Group Business Group Foreign-Owned Foreign-Owned Business Group Business Group Foreign-Owned Privately-Owned Publicly Listed/Foreign-Owned Privately-Owned Business Group Corporate Entity 1.5 77.2 16. 8. power. Fujitsu Computer Products Corp.). 19.4 19.8 53.

. 50. 47. and other grains wholesaling Other amusement and recreational activities Motor vehicles Food and dairy products Construction and mining Television and radio transmitters. real estate.290 53. EAC Distributors Inc. Jollibee Foods Citibank N. and various company annual reports.0 12. 32.8 9.6 1.5 8. 41.8 6. 43. Philips Semiconductors Phils. 14. 44.6 9. Consunji Uniden Philippines Laguna.9 7. W. Inc. 49. Inc.4 10.5 10. Philip Morris Philippines.6 Foreign-Owned Foreign-Owned Foreign-Owned Business Group Foreign-Owned Business Group Privately-Owned Government-Owned Business Group Business Group Business Group Business Group Business Group La Suerte Cigar and Cigarette Factory Land Bank of the Philippines Procter and Gamble Philippines Andres Soriano Family Group George Go Hitachi Computer Products (Asia) Corp. and apparatus for line telephony and line telegraphy Tobacco products wholesaling Cigarettes Radar equipment.3 8. 31.0 13. radio and remote control apparatus Fast food Bank Beverages and distribution of agro-industrial products Drugs and medicines. 36.2 7.9 6. 27. Uytengsu/General Milling Group David M.3 13. including biological products Bank Cement and wood products Retail merchandising Electronic appliances Mining Real estate Sources: SEC-BusinessWorld Annual Survey of Top 1.1 9. 30.5 8.6 12. 28.7 10.000 Corporations (1997). 46. 29.7 13. 48. 33.9 14.8 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. Inc. 39. and tourism Banking Radar equipment and radio remote control apparatus Operation of rolling mills Palay. 35. 37. 40.A. Corp.9 7. corn (unmilled). 34. 26.0 11. 45. 9. National Steel Corporation National Food Authority Phil. 42. 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 1.0 5.25.7 10.4 8. PSE Databank.000 Companies Sales (%) Cigarettes Bank Soap and detergents Management.. Amusement and Gaming Corporation Mitsubishi Motors Phils.

approval of management contracts. and declaration of cash dividends. sale or disposition of a substantial portion of corporate assets. shareholder voting in general meetings and legal protection of their rights. Vol. and financial disclosure. removal of directors. amendments in the bylaws. the board of directors plays a crucial role in corporate governance.186 Corporate Governance and Finance in East Asia. . such as amendments of the articles of incorporation. The Corporation Code holds members of the board of directors liable. Shareholders have the right under the Code to file derivative suits against directors and officers and other third parties to redress any wrongdoing committed against the corporation for which the board refuses to sue or to remedy. The review is based on an ADB survey of listed companies in the Philippines conducted in 1999 for this study. Of course. jointly and individually. accounting and auditing. voluntary dissolution. The Philippine Corporation Code mandates the board of directors to exercise its control over a corporation. appointment and compensation of senior executives. However. 8 The ADB survey of corporate governance practices was conducted in the first semester of 1999 using a questionnaire prepared by Juzhong Zhuang of the Asian Development Bank.3.2 Corporate Management and Shareholder Control The main mechanisms by which shareholders control corporate management are the board of directors. A total of 44 companies responded to the survey (out of about 221 financial and nonfinancial listed companies). investments of corporate funds in other companies or purposes.8 The Board of Directors As the representative of shareholders in a company. issuance of stocks. II publicly listed commercial banks affiliated to these groups. 3. these were dispersed shareholdings. issuance of corporate bonds. Actual control of the banks was still held by the groups. corporate mergers or consolidations. to the corporation and its shareholders for damages caused if they agree to unlawful corporate acts. determination of compensation to board members. They are likewise liable if they pursue financial interests that conflict with their duty as directors. This section reviews practices of corporate management and shareholder control in Philippine publicly listed companies. business groups had only minority ownership. although public investors held a majority of shares. Shareholders limit the broad power of the board by ratifying their decisions on critical corporate affairs.

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

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

Only one respondent indicated that its CEO was entitled to a substantial amount of compensation. A substantial number of respondents also considered looking after interests of other stakeholders and the general public as among the important responsibilities of the CEO. the 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.. (ii) contracts with companies linked through interlocking directorship. The majority of responding companies compensated their CEOs by using a fixed salary plus a performance-related bonus. Among others.Chapter 3: Philippines 189 was not related to the chairperson by blood or marriage in all of the cases except one. and (iii) involvement of directors in businesses that compete with the company. of directors representing minority shareholders. 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. Companies are not allowed to issue shares with different voting rights. Shareholder Rights and Protection Under the Corporation Code. to help ensure the representation of minority interests in the board. and prohibits the removal. The longest service rendered was 27 years. i. or (iv) enters into a merger or consolidation with another corporate entity. Third. About 60 percent of respondents of the ADB survey considered maximizing shareholder values as the CEO’s most important responsibility. They can vote through proxy. (ii) disposes of or mortgages a substantial portion or all of corporate properties and assets. But about 27 percent viewed it to be ensuring steady growth of the company. Fifth. (iii) invests in another company for a purpose different from that of the corporation. An overwhelming 70 percent of respondents said a CEO who was not the chairperson of the board could make key decisions only after consulting the chairperson or the entire board. shareholders have preemptive rights to maintain their proportionate ownership of a company under any financing plan that may be undertaken by the company. including electronic means. shareholders may exercise appraisal rights. equal to three years’ pay. without cause.2 years.e. . Second. the Corporation Code allows cumulative voting for directors. The “golden parachute” was apparently not a common feature of CEOs’ compensation packages. Fourth. shareholders enjoy a number of rights and protection. first. if the CEO’s contract was preterminated. The average service length of CEOs was 5.

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

1999. Nevertheless. Yes 100. An average of about 4. About 93 percent of the respondents contracted . The brokers or securities companies were the most important proxy voters. An average of 327 shareholders per company attended the last annual meeting and they represented about 63 percent of total shares.4 No 0. followed by management and banks.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.4 70.3 56. and their activism in the corporate sector.6 Independence of Auditing The ADB survey revealed that all the responding companies had an independent auditor.6 30. the successful hostile takeover by First Pacific Group of PLDT.8 56. protection. appointed either by the board or shareholders during the annual general meetings. About 333 shareholders per company voted by proxy. The ADB survey provides further evidence on shareholder rights. Table 3.0 36. Table 3. Nominees held about 45 percent of the outstanding shares.0 63.2 43.8 92.522 shareholders each.2 69. demonstrates the feasibility of developing a market for corporate control if publicly listed companies were widely held.2 7. The responding companies had on average 43. a company that is widely held but has a large shareholder. representing 3.13 summarizes rights that the shareholders of the responding companies enjoyed. representing about 24 percent of outstanding shares.0 48.900 shareholders per company did not vote during the last annual general meeting.4 percent of shareholders but 58 percent of outstanding shares.Chapter 3: Philippines 191 in a few controlling shareholders and families.8 30.0 51.7 43.

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

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

The first three companies are publicly listed while the fourth.1 percent of Ayala Land. active minority or passive minority holdings. Ayala Corporation’s majority. It has a majority control at 71. the parent company plays an active role in management.and minority-controlled operating companies are also holding companies. an active minority share at 44.2 percent. II equity investment for public listing. is privately owned. of Cebu Holdings (a publicly listed government-owned company). as an example (Figure 3. . These investments can be classified according to the role of the controlling shareholders in the management of the invested company. Inc. financing. Ayala Land fully owns Makati Development Corporation and holds a minority stake. Depending on the performance of the company. They are operating companies but at the same time have majority or minority share ownership in other operating companies..6 percent of Globe Telecom. controlling shareholders of a parent company hold these shares as “strategic investments” that they could increase or reduce depending on business opportunities. Some holding companies are not pure holding companies. Minority-owned companies may also need access to resources of the group. Controlling shareholders gain additional leverage in management control over minority-owed companies.194 Corporate Governance and Finance in East Asia. Honda Cars (Philippines). 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. with 59 percent of shares. a family-owned pure holding company. Vol. controlling shareholders of the parent company may eventually increase their shares to a majority position. especially its management.1). Selective public listing combined with use of pure holding companies to own and control member companies lead to various organizational structures of business groups. at 47. minority control at 42. The stylized features of control structure of business groups in the Philippines can be illustrated by using a leading Philippine family-based conglomerate. controlling shareholders of the parent company do not participate in management. Public investors collectively hold a minority of 41 percent. This is most evident when a minority-owned company transacts with other members of the group where the controlling shareholders hold majority control. In a passive minority-owned operating company. and customers. In cases of minority ownership. and a passive minority investment at 15 percent in Honda Cars (Philippines). namely. Ayala Corporation. In an active minority-owned operating company.4 percent of Bank of the Philippine Islands. They may have a representative in the board. Ayala Corporation is a publicly listed pure holding company. It is majority-owned by Mermac.

6%) <15% Passive MinorityOwned Pure Operating Company Honda Cars Phils. Inc.06%) <50% >15% &<50% Active MinorityOwned Pure Operating Company Globe Telecoms (44.Figure 3.2%) >50% MajorityControlled Pure Operating Company BPI Family Savings Bank (100%) <50% MinorityControlled Pure Operating Company Note: Data as of 31 December 1998. (58.44%) >50% MajorityControlled Pure Operating Company Makati Development Corporation (100%) <50% MinorityControlled Pure Operating Company Cebu Holdings. (47.96%) Privately-Held Pure Holding Company Public Investors (41.1 Corporate Control Structure: The Case of Ayala Corporation Family Members 100% Mermac. Inc. Inc..04%) <50% Ayala Corporation >50% Publicly Listed Pure Holding Company >50% MajorityControlled Operating and Holding Company Ayala Land (71. . (15%) MinorityControlled Operating and Holding Company Bank of the Philippine Islands (42.

a privately owned company.5%] [39. First Philippine Holdings Corporation.44%] = [42.7 times its cash flow rights by virtue of the double layer pyramid structure of the Ayala group. Benpres Holdings.76%)] [39.7 times its cash flow rights by virtue of its cross-holdings via Benpres and First Holdings. and 1999c.11 The Lopez family’s control rights over MERALCO was 5.3% x 1. Lang: 1999a.7 times 12 .14%] / [1. P.8%] 5. they exercise far greater control (two to five times more) than they are entitled to by virtue of their ownership rights. 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.196 Corporate Governance and Finance in East Asia.64% +37.10 The Ayala family’s control rights over BPI was 1. Fan. indirect shareholdings do not appear to be a prevalent practice in the Philippine corporate sector. The control of companies through indirect corporate shareholdings. is illustrated in the Lopez Group (Figure 3. Generally. 1999b.12 These examples show that even when large shareholder groups are minority shareholders. see the World Bank research papers by Stijn Claessens. MERALCO. See also Stijn Claessens. and Larry H.14%] / [6. Diversification and Efficiency of Investment by East Asian Corporations. and First Philippine Industrial Corporation are indirectly held by a majoritycontrolled holding company. Who Owns and Controls East Asian Corporations? 11 Ibid.7 times Ibid. [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. Expropriation of Minority Shareholders: Evidence from East Asia. Being in the public utilities sector.44%] / [58. companies in the Lopez Group are large and minority-controlled.2). Rockwell Land. II Bank of the Philippine Islands owns 100 percent of the BPI-Family Savings Bank. Joseph P. 1998. P. however.64%) + (37. defined as control by large shareholders of an operating company through minority ownership by several companies.5% x 14. The situation offers large shareholders tremendous incentive to move resources 10 For details. Simeon Djankov. [control right] [control rights via Ayala Corporation] = [cash flow right] [cash flow rights via Ayala Corporation] = [42. The Separation of Ownership and Control in East Asian Corporations.44%] / [25%] = 1.5%] / [(88. and a minority-controlled holding company.3% x 5.98% x 42. Simeon Djankov. Vol. Lang. and Larry H. H.

Figure 3.64% MinorityControlled 14.5% Operating Company MajorityControlled Operating Company Rockwell Land Corporation 24.3% 11.7% 62. . Privately-Held Pure Holding Company 88.2 Corporate Control Structure: The Case of Lopez Group Public Investors Family Members Lopez.5% First Philippine Industrial Corporation 50% 50% Note: Data as of 31 December 1998. Inc.5% Minority-Controlled Publicly Listed Pure Holding Company First Philippine Holdings Corporation Benpres Holding Corporation Majority-Controlled Publicly Listed Pure Holding Company Manila Electric Company 1.76% Operating Company MinorityControlled 24.

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

There are no legal or practical limits to the time period of suspension of payments. the litigation process. PD 902-A granted SEC blanket powers to intervene and adjudicate claims. a real estate-based business group. Publicly listed companies do not represent a cross section of the Philippine corporate . a company’s assets are of sufficient value to cover all of its debts. Inc. wait for 14 years from the time the company petitioned for suspension of payments in 1984. The second mode is for suspension of payments with the appointment of a management committee (Mancom) or rehabilitation receiver. 3. There are two modes of suspension of payments under PD 902A. under which. it is not clear whether the corporate borrower’s assets are of sufficient value to cover its liabilities. SEC could intervene to avoid asset dissipation. The law on suspension of payments envisions resetting the corporation’s business for a temporary period to prevent its irreversible collapse.Chapter 3: Philippines 199 agreement. SEC and the court required that the creditors of BF Homes. In practice.4. Under such circumstances. Commercial banks hold about three fourths of the resources of the financial system. Under this mode. which determines the viability of the rehabilitation plan and appoints a Mancom or a rehabilitation receiver to implement the proposal if approved. the borrower requests to defer payments for a certain period to enable it to generate the necessary liquidity. profitable companies from going public. Consequently. 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. bank credit is the main source of corporate financing. For example. including the rehabilitation of the corporation. The borrower will propose a rehabilitation plan to SEC.. could take an indefinite period. Markets for equity and debt instruments are small and there are serious structural problems that discourage large.1 Corporate Financing The Financial Market and Instruments The Philippine financial market has remained underdeveloped compared with other countries in the region. This explains why creditors invariably oppose any move by borrowers to file for suspension of payments at SEC. The corporation continued to be under rehabilitation receivership as of June 1999.4 3. The first mode is for simple suspension of payments.

The market capitalization of the Philippine stock market in August 1997.g. Interest rates. companies expanded only at a moderate pace. The crisis affected the Philippine corporate sector. Foreign funds were wary of the Philippine stock market because of its limited liquidity. Korea) ($143 billion). and fiscal management were among interrelated factors explaining the underdeveloped state of the Philippine financial market. however.7 billion. The corporate sector raised a substantial amount of . is far ahead of the flock. most listed companies are controlled by their five largest shareholders. Equity financing through IPOs was active. Malaysia. the Republic of Korea (henceforth. The period 1993-1997 was one of lower inflation and declining lending rates. preferred stocks. Philippine companies were less leveraged. was one of the smallest in the region at $47. The Government financed its chronic fiscal deficits by issuing short-term Treasury bills. Most companies invested only in projects that met hurdle rates as high as 20 to 30 percent and had short payback periods. compared with Malaysia ($186 billion). From the 1970s up to the early 1990s. only 84 had sales large enough to be placed in the top 1.200 Corporate Governance and Finance in East Asia. Of the 221 companies listed in the Philippine Stock Exchange in 1997. especially short-term debt. 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. Foreign portfolio investments also remained small. Equity instruments include common stocks. Korea and Thailand).5 billion). Table 3. In part. However. compared with other economies. inflation.000 companies. Vol. less exposed to foreign debt. while interest rates were at high levels and volatile. and convertible securities. II sector. and less engaged in risky investments. the minimum required to qualify as a public corporation. about the size of Thailand’s. Even in the real estate sector. the country experienced double-digit inflation. but not to the same extent as it did in other Asian economies. They invested in only a few large companies whose shares were relatively liquid. Most publicly listed companies issue only up to 20 percent of total shares to the public. The Philippine stock market is not a liquid market. Rising stock prices during the Ramos administration reflected to some extent the business optimism. and Indonesia ($61. 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.. As a result.14 shows that the average volume of daily trading in 1997 stood at P2. this is because.4 billion (or $59 million using the average exchange rate). The stock market was depressed up to the early 1990s.

121.0 2.2 0.3 0. P billion) 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 19. 1983-1997 Daily Trading Volume (P million) — — — — 129.515.5 1.7 0.386.3 2.3 0.2 57.5 16.9 608. P billion) Gross Domestic Product (current prices.906.7 207.4 728.5 Year 369.9 12.6 1.2 297.4 Ratio of Market Capitalization to GDP 0.0 1.7 41.8 799.1 0.686.2 3. Source: PSE databank.0 161.5 72.9 2.7 391.3 314.1 5.8 102. Note: Combined transactions of Makati and Manila Stock Exchanges are not available for the years 1983 to 1986.0 0.3 59.474.4 9.1 88.5 26.0 0. .2 925.7 1.14 Philippine Stock Market Performance.2 0.7 2.4 1.171.6 261.9 1.8 1.9 114.1 0.3 Market Capitalization (year end.421.3 4.248.9 2.2 59.088.1 0.8 1.3 158.Table 3.9 682.8 0.8 1.692.077.2 61.2 1.1 0.5 571.2 ($ million) — — — — 6.5 12.373.2 1.251.1 524.351.545.3 — = not available.445.5 1.6 1.0 0.

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

4 0.5 0.3 0.3 0. It measures a company’s reliance on borrowings in financing asset growth.15.2 0.2 0. New equity financing ratio (NEFR): ratio of changes in stockholders’ equity (excluding retained earnings) to changes in total assets.15 Financing Patterns of the Corporate Sector. the SFRT was low at Table 3.3 0. By definition.7 0.8 0.5 0. 1988-1997.6 0.5 0.8 0.000 Corporations in the Philippines.9 0.4 0. 1989-1997 Financing Indicators SFRF SFRT NEFR IDFR IEFR 1989 1990 1991 1992 1993 1994 1995 1996 1997 1.1 Average 1.5 0. Self-financing ratio of total assets (SFRT): ratio of changes in retained earnings to changes in total assets. the average SFRF was high at 109 percent.4 0.4 1.1 0. it is one minus IDFR. Incremental equity financing ratio (IEFR): ratio of changes in shareholders’ equity inclusive of retained earnings to changes in total assets.0 0.9 0.1 0.Chapter 3: Philippines 203 (i) (ii) (iii) (iv) (v) Self-financing ratio of fixed assets (SFRF): ratio of changes in retained earnings to changes in fixed assets. It measures a company’s capacity to finance growth in fixed assets by internally generated funds.9 0.5 0.1 0. Incremental debt financing ratio (IDFR): ratio of changes in total liabilities to changes in total assets. As shown in Table 3.5 2. . It measures a company’s capacity to finance asset growth by equity capital.3 0.2 0.4 0.9 0.3 0.8 0.1 0. It measures a company’s capacity to finance asset growth by internally generated funds.3 0. All Companies Financial flows data were derived from the SEC-BusinessWorld Annual Survey of Top 1.2 0.1 0. On the other hand.4 0.4 0. Retained earnings were sufficient to finance the entire growth of fixed assets in the corporate sector.3 0. during this period.6 0.000 Corporations in the Philippines from 1988 to 1997.0 0.5 0.5 0.2 0.4 0.6 0.5 Source: SEC-BusinessWorld Annual Survey of Top 1.5 0.5 0.

3 0. In 1997.16 Corporate Financing Patterns by Ownership Type.2 0. The corporate sector consistently relied on debt and new equity to finance asset growth throughout the period.5 Privately-Owned 0. II only 19 percent. Total assets grew by 23 percent that year.3 0.000 Corporations in the Philippines. debts were the most important source of financing. 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. implying that internal funds were far from sufficient to finance growth in total assets. except in 1991.0) 0.3 0.5 Foreign-Owned 1. 1988-1997. The corporate sector used new equity to finance 32 percent and new debts to finance 49 percent of growth in total assets. Retained earnings were the least important. the level of corporate leverage increased. Corporate Financing by Ownership Type As shown in Table 3.2 (0. for all three types of companies—publicly listed.1 a Excludes negative balances. As a result. In all the years. retained earnings declined and few new equity investments flowed into the corporate sector. Vol.9 0. On Table 3.and foreign-owned. . and 1997. 1991. Companies financed fixed assets from internal sources in hard times. reflecting the capital flight caused by political instability in the early 1990s.204 Corporate Governance and Finance in East Asia.7 0. In periods of an economic crunch such as in 1989. except for foreignowned companies that had a negative new equity financing ratio.16. 1989-1997 Financing Indicators SFRF SFRTa NEFR IDFRa IEFRa a Publicly Listed 1. This was mainly caused by the declining contribution from retained earnings. internal funds were not a significant source of financing growth in total assets. Source: SEC-BusinessWorld Annual Survey of Top 1. There were significant year-to-year variations.6 0. the SFRF was higher. with debt providing 93 percent of the financing requirements. suggesting that there was a deterioration of financial performance in the Philippine corporate sector in the years running up to the crisis.3 0. when it financed 45 percent of it. privately.8 0.5 0.

7 2.Chapter 3: Philippines 205 average.0 13.1 9.and foreign-owned companies.6 0.0 9.8 0.5 12.3 13. A breakdown of the financial structure of publicly listed companies measured in balance sheet items is shown in Table 3.3 51. contributing 90 percent of growth in total assets.9 16.0 10.6 43.5 9.0 1994 19.7 2.17.8 17.9 16.9 38. significantly Table 3.3 48.8 46.4 100.5 16.1 49.8 39.8 100.1 7. This financing pattern supports the earlier finding that foreign-owned companies had the highest leverage among the three types of companies.7 13.0 8.000 Corporations in the Philippines.9 0.2 51. It presents a composition analysis of assets and financing sources for the period 1992-1996.4 100. publicly listed companies relied more on new equity financing than privately.0 12.6 37.9 4.3 12.2 42.4 41.5 0.2 12.8 0.8 4.4 12.8 51. 1988-1997.2 100.0 1993 14.3 11.8 16.17 Composition of Assets and Financing of the Publicly Listed Sector. Foreign-owned companies relied more heavily on debt financing.0 10.0 38.5 41.4 3.2 100.0 9.0 Source: SEC-BusinessWorld Annual Survey of Top 1.7 4.6 26.3 12.9 3.8 3.0 100.0 53. compared with 47 percent for publicly listed companies and 55 percent for privately-held firms.4 10.6 48.8 38.8 3.0 9.0 9.3 4.4 100.9 16.7 23.0 6.4 2.0 1995 1996 13.9 24. The sector built up its short-term debts.9 12.7 13.1 10.7 100.1 13.3 12.6 48. especially bank loans. .9 100.4 100.4 2.7 7.4 43. 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 14.3 10.2 3.8 26.5 27.2 3.3 10.1 15.1 50.

1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Group Member 1. Group companies were generally more profitable than independent companies.5 0.000 Corporations in the Philippines. as opposed to 94 and 30 percent.5 Excludes negative balances Source: SEC-BusinessWorld Annual Survey of Top 1.18 Financing Patterns by Control Structure. The normal standard liquid position is a current ratio of 2 or higher. group companies were less reliant on debt financing than 13 Defined as total current assets divided by total current liabilities.3 0.3 0. the easier access to external credit.1 0. Table 3. for independent companies. compared with an average of 54 percent for independent companies.45 in 1996. indicating that many publicly listed companies were likely to be in a tight liquidity position. group companies usually financed their investment in member companies by equity rather than debt.206 Corporate Governance and Finance in East Asia.3 0.9 0. Group companies financed an average of 45 percent of growth in total assets by debt. and economies of scale in fund raising. For these two reasons. Further. respectively.5 0. . retained earnings financed 113 percent of growth in fixed assets and 23 percent of growth in total assets from 1989 to 1997 for business groups. the average SFRF of business groups was higher compared with that of independent companies. the current ratio. their inherent ability to pool risks. Vol. 1988-1997. The SFRF for independent companies would have been even lower if the highly profitable foreign-owned companies were excluded. As shown in Table 3.6 Independent Company 0.18. Corporate Financing by Control Structure Conglomerates have certain advantages in financing because of the opportunities offered by the internal capital markets. The traditional measure of liquidity. II in 1996 and became more vulnerable to the financial crisis in 1997.13 was at 1.2 0. On average.

000 Corporations in the Philippines.3 0. These years were 1991 with 110 percent. On average.5 0.3 0.2 0. 1993 with 96 percent.4 Small 0.6 0.1 0. These results support the earlier finding that the leverage of business groups was lower than that of the independent companies from 1988 to 1997.50 (Table 3.8 0. compared with 55 percent for large companies and 47 percent for small ones. equity financed 42 percent of incremental asset growth. Large firms consistently increased their reliance on debts from 1994 to 1997. Source: SEC-BusinessWorld Annual Survey of Top 1.20).5 Medium 3. The lower SFRF for large companies may be caused by their larger outlays for growth in fixed assets.08 and SFRT of 0. medium-sized companies used more debts. Corporate Financing by Firm Size SFRF was highest for medium-sized companies. There was also increased reliance on debt financing.2 0.19 Financing Patterns by Firm Size. averaging 61 percent of growth in total assets.3 0. Corporate Financing by Industry The manufacturing sector had an average SFRF of 1.47. Large companies’ IDFR of 0.19).9 0. With assets growing at a fast pace during this period. and 1997 with 131 percent.2 0.88 for large companies (Table 3.76 for small companies and 0. The medium-sized companies’ high debt financing ratio was due mainly to three years of complete reliance on debt to finance growth. Table 3. Excluding .Chapter 3: Philippines 207 independent companies.55 was substantially higher than the small companies’ 0.5 Excludes negative balances.06. 1989-1997 Financing Indicators SFRFa SFRTa NEFR IDFRa IEFRa a Large 0. The corresponding ratio was 0. 1988-1997. with an average of 3.6 0.

3 0. Its SFRF and SFRT were volatile because of chronic losses and reduction in fixed and total assets. Up to 1997.6 0.3 0.5 0.2) 0. SFRF for the sector averaged 0.5 0.5 (0.4 Construction 0.20 Financing Patterns by Industry.4 0.000 Corporations in the Philippines. The situation improved beginning 1994. many of the leading real estate companies successfully went public during that time. During the crisis year. the incremental equity ratios of the industry were high. ranging from 41 to 118 percent.7 0. the total debt ratio was much higher in 1996 at 0. the industry generated internal funds.1 0. The real estate industry financed its growth by substantial equity funds.27. Vol.58 and SFRT of 0.5 Utilities and Real Estate Services and Property 0.79 and in 1997 at 0.91.32. The utilities sector showed weaknesses in internal fund generation in 1989-1994.3 0.4 0. Source: SEC-BusinessWorld Annual Survey of Top 1. Incremental equity financing amounted to an average of 44 percent of total asset growth. 1988-1997. Since the real estate boom coincided with that of the stock market. Equity financed an average of 62 percent of total asset growth. 1989-1997 Financing Indicators Manufacturing SFRFa SFRTa NEFR IDFRa IEFRa 1. . In the eight years preceding the crisis. Excluding 1997 when fixed assets declined.29.6 0. increasing to 0.6 a Excludes negative balances. Low incomes diminished the equity financing position of the manufacturing industry toward the crisis year.04.4 3. Table 3. The effects of the crisis of 1997 were adverse.47 two years later.4 0. the manufacturing industry financed 57 percent of its total asset growth by debt.3 0. II 1991.6 0. when debts declined. While this level is considered prudent. achieving an average SFRF of 3. The sector had the highest leverage among all industries that year. The construction sector was a heavy user of debt financing.208 Corporate Governance and Finance in East Asia. while SFRT averaged only 0. with an SFRF as low as 0. debt financed about 78 percent of asset growth in real estate. 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.

ROE.421 0. ROE = return on equity. Using the PSE database.Chapter 3: Philippines 209 3. Exit. and the Failure of Internal Control Systems. measured by the percentage of shareholdings of the largest five shareholders. as the dependent variable. The Modern Industrial Revolution.008 5. creditors bear the consequences.21.00036 2. ROA = return on assets. knowing that if an investment turns out to be successful they could capture most of the gain. Financial Leverage. and Financial Leverage Dependent Variable Item Coefficient of Ownership Concentration T-statistics Adjusted R-squared F-statistics ROE 0.3 Ownership Concentration.004 3. ROE. while if it fails. 1992-1996. at the same time. Profitability. alternatively.009 5.4. and Performance Previous studies on corporate governance have often associated ownership concentration with heightened risk-taking by companies. As shown in Table 3.769 0. and financial leverage are all positively and significantly related to the degree of ownership concentration. Source: Author’s estimates based on the PSE databank. the coefficient of the ownership concentration measure in all the three regressions is positive and statistically significant. Three regressions were run with the shareholding of the largest five shareholders as an independent variable and ROA.130 ROA 0. Large shareholders may also overuse financial leverage to avoid diluting ownership and control. Table 3. ROA. ownership concentration = the total shareholdings of the top five shareholders. was regressed against measures of profitability and of financial leverage. . 14 See for example Michael Jensen (1993).287 0.860 Leverage = the ratio of total assets to total equity. Journal of Finance 48: 831-880. These results suggest that companies with higher ownership concentration tend to be more highly leveraged and.00125 2.14 Large shareholders may borrow excessively to undertake risky projects.00056 1.230 Leverage 0. more profitable. the degree of ownership concentration. and leverage.21 Ownership Concentration.

but its share had been declining by 4 percent per year since 1995. In sum. the country was less dependent on foreign private capital. with commodities accounting for the balance. Vol.210 Corporate Governance and Finance in East Asia. 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. Manufactures accounted for about 85 percent of exports. Net investment inflows were $3. After a . and agriculture at 21 percent. notably remittances of overseas workers. raw materials. Garments was the second largest export sector at about 9 percent. In 1997.5 3. About 80 percent of imports were capital goods (particularly power generating and telecommunications equipment).” that is. an overexpansion of capacities. and intermediate goods. Net trades in goods and services averaged a deficit of 4. which averaged 4. foreign investments in the country have been low. more than half (52 percent) of exports were semiconductors. Although much lower than those of other Asian countries.5 percent per year from 1992 to 1997. II 3. The Government explained that the country had “sound economic fundamentals” but that the problems were caused by “contagion. The structure of the economy may be understood by looking at its sectoral composition and export competitiveness.5 billion in 1996 and grew at an average of 48 percent per annum from 1992 to 1996. Because of limited local capital. The largest contributors to GDP were services at 43 percent.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 1997.8 percent of GDP from 1995 to 1997. Commercial and industrial activities in the country were largely oriented to domestic markets. the economy still showed vestiges of its import-dependent and substituting character. The export sector had a very narrow breadth. the growth in foreign investments fueled that of the manufacturing and services sectors in the years preceding the crisis.5. industry at 34 percent. Exports were growing at about 20 percent per year in the three years preceding the crisis. with a narrow exporting industry base.” The Government’s judgment that economic fundamentals were strong was based on stable growth rates. Historically. their growth gathering momentum only beginning in 1992. the country’s GDP growth pace indicated that it did not have a “bubble economy. The country experienced balance of payments surpluses but these were due to transfers. Compared to other East Asian crisis-affected countries.

During this time. in turn. From 1993 to 1997. 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. a government fiscal surplus from 1994 to 1997. Five years of stable growth before the crisis enabled the country to build its net international reserves to $10.1 percent. adjustments were focused on the quantity and quality of the banking system’s corporate loans. which. and a relatively healthy banking system. Economic performance during 1992-1997 was characterized by an average growth rate of real gross national product (GNP) at 3. Closer analysis. Total debts were only 52 percent of assets or 108 percent of equity. unlike their counterparts in the region.8 percent. In the Philippines. . 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. an average Treasury bill rate of 13. Financial institutions called on their shortterm loans and shortened the maturity of existing loans.3 percent. the Government restructured its debts into longer tenors with a maximum of 25 years. while sales grew by only 20 percent per year. a positive balance of payments from 1992 to 1996. the Government sought stability and achieved this in 19921997. shows that investments of the corporate sector were growing at a faster rate than sales revenues in the years immediately preceding the crisis. resulting in stability in the short-term debt to reserves ratio. From 1988 to 1996. The lessons from debt restructuring became the basis for the Government’s economic policies. however. an average inflation rate of 7. assets grew at a compound annual rate of about 31 percent. Profitable operations since 1992 had allowed it to build equity. fueled also by successful IPOs during the stock market boom of 1993-1996.5 percent. the country and the corporate sector had no access to foreign currency debts from the international financial market. Eventually. The Central Bank conserved international reserves by allowing the local currency to float within a wider trading margin. Prudent fiscal management and controls on foreign borrowings were part of the adjustments required by IMF and foreign creditors. After hovering in the range of 100 to 127 percent.6 billion as of March 1997. average ROE was 13. Since the regional financial crisis was triggered by the loss of confidence in some East Asian economies by foreign creditors and investors. the ratio of short-term debts to international reserves dipped below 100 percent beginning June 1998.Chapter 3: Philippines 211 long period of debt moratorium and restructuring that started in 1983 and ended in 1991. The corporate sector was in a relatively stable financial condition around the time of the crisis. depended on the quality of the corporate sector’s investments.

5 billion in 1995. or 114 percent of net foreign direct investment (FDI). Sources: Bangko Sentral ng Pilipinas and SEC.073 (406) 121. It rose to $2.101 billion or 196 percent of net FDI in 1996.47. net FDI remained stable at more than $1 billion. Vol. but to a lesser degree. 1997 = 29. .2 Impact of the Crisis on the Corporate Sector Aside from the foreign exchange adjustment. It financed 26 percent of corporate capital growth. These patterns in investment and financing are similar to those of other countries in the region.212 Corporate Governance and Finance in East Asia.0 1996 3.22). Table 3. But portfolio investment amounting to $406 million flew out of the Philippines.4 1997 762 1. In 1997. mitigated the effects of the pullout and liquidation of investments in the aftermath.650 32. Net foreign investments more than doubled from 1995 to 1996 but declined by 78 percent in 1997 (Table 3.22 Foreign Investment Flows.485 145.06.” 3. 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. The debt level of the Philippine corporate sector in 1997 was low by Asian standards but still high by developed country standards. In sum.7 Note: Peso-dollar exchange rates used are: 1995 = 25. Net foreign portfolio investment amounted to $1.718 30.71. Most of this leverage happened during the boom years in the region. 1996 = 26.517 1. Foreign investments in the Philippines have not been as high as the inflows to other Asian countries—and this.074 2. Debts financed a large part of this expansion. 1998 = 41.5. II The corporate sector indeed overexpanded after 1993 like its counterparts in the region.749 26.303 23. growing by about 34 percent per year from 1994 to 1997. It is understandable then that the effect of the Asian financial crisis on the Philippines was correspondingly that of a negative “contagion. the other immediate impact of the crisis was that on foreign investment flows.0 1998 739 555 328 69. precisely.609 1.300 1.22. 1995-1998 Item Net Foreign Investments ($ 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. Data for 1998 cover only January-August.101 92.

The banking system was able to absorb the impact of the crisis primarily because of its strong capital position. sparking a rise in interest rates on corporate loans. Companies deferred investments in new fixed assets. suggesting that commercial banks required a higher premium at about the height of the crisis but not beyond. albeit at current market interest rates.2 percent was barely above inflation rate. the sectors with the highest outstanding loans had reduced their credit exposures. Loans outstanding of commercial banks declined by the first quarter of 1998. lending rates also came down. Lending rates were well above the 20 percent level from July 1997 to March 1998.513 billion. Loan calls. By March 1988. new borrowings financed asset growth. ranged from 11 to 13 percent from 1993 to July 1997. then rose to a high of 22. they could not initiate a large reduction of their loans because these in part financed long-term growth in assets. with commercial banks holding P2. they were willing to restructure and renegotiate existing loans by corporate borrowers.7 percent in January 1998. A number of small banks closed but they represented less than 1 percent of the financial system’s total resources. With the increase in borrowings and reduced liquidity. depended on the liquidity and capital position of commercial banks. Because commercial banks were strongly capitalized. Manufacturing reduced its loans outstanding by 11 percent from October 1997 levels. the commercial banking sector’s capital remained strong at 17.9 percent.Chapter 3: Philippines 213 Corporate financial performances and conditions deteriorated during 1997.3 percent of assets. The real problem of the corporate sector during the crisis was the rise in interest rates. and leverage increased to 149 percent compared with 109 percent in 1996. the corporate sector became vulnerable to loan calls and high interest rates.2 percent in November 1997. Net profit margins were at a 10-year low at 4. Although corporate borrowers were not highly leveraged. and the wholesale and .369 billion. Because of weak internal fund generation. Bank loan pricing was based on the bellwether 91-day Treasury bill rates rather than inflation. in varying degrees for each sector. Bank spreads over Treasury bill rates increased in 1997 but were within the range experienced in the past. Average bank lending rates climbed to their peak of 25. meanwhile. which held about 75 percent of the assets of the financial system in 1997.2 to 28. When the Treasury bill rates eased in March 1998. By October 1998. The combined effects of shrinking demand and high interest rates reduced the corporate sector’s demand for loans. The interest rates on Treasury bills. ROE at 6. in turn. The resources of the financial system that year totaled P3.

The latter measure was especially beneficial to companies with unhedged foreign currency loans from commercial banks. II retail trade sector. The move retained the liquidity position of banks but lowered their cost of reserves. In March 1997. 3. and set up a hedging facility for borrowers with foreign currency-denominated loans. thereby reducing overall intermediation costs. As for nonperforming loans (NPLs). as with its counterparts in other Asian countries. This allowed the Central Bank to convince the banks.9 percent of bank loan portfolios. was a problem sector. set limits on overbought/oversold foreign exchange positions of banks. These figures show that adjustment problems were industry-specific and that the real estate industry. The pattern indicates that real estate loans were of substandard quality but banks had contained the problem by mid-1998.5. and the financial system.214 Corporate Governance and Finance in East Asia. The Central Bank introduced regulations on foreign exchange trading to control speculation and nondeliverable forward contracts. These peaked at 14. 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. the fiscal position.5-6 percent. real estate loans averaged 11. the ratio increased to a high of 11. Still.6 percent in June 1998. through the Bankers’ Association of the Philippines. and subsequently went down to 13. by 12 percent. But the Philippine banking system had gone through worse crises in the past. Vol. to reduce their lending spreads over the 91-day Treasury bill rates from 3-8 percent to 1.5 percent by September 1998. This “voluntary agreement” partly explains why the loan spreads of banks were within the range of recent experience. including (i) a regulatory limit of 20 percent on banks’ loans to the . single-digit NPL ratios began only since 1989.3 Responses to the Crisis Government Responses The Government’s policy and regulatory responses to the crisis focused on monetary and credit issues. However.3 percent in December 1997. and its experience of low. The Central Bank adopted other measures to strengthen the financial system. loans outstanding of the real estate sector increased by 11 percent from June 1997 to June 1998. 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.

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

the Cojuangcos. eventually took over PLDT and announced a restructuring plan for the entire group of companies. Although considered the prime industrial company in the Philippines. is whether there are sufficient safeguards to prevent controlling shareholders from . Its stock price and returns to shareholders had stagnated. Conclusions. First Pacific. 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. One mode was the outright purchase of shares in the open market.6 3. Consequently. The question. 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. however. II of investing to control companies that are dominant players in their industries. 3. the stock price of PLDT was buoyant during the takeover period. In a legal process that ended in his takeover of management. and Recommendations Summary and Conclusions The Philippine corporate sector has been shaped by the country’s economic and industrial development policies. SMC had lagged behind other groups of companies such as Ayala Corporation in financial performance for some years.6.216 Corporate Governance and Finance in East Asia. When Cojuangco took over. A second method was to purchase the shares of other large minority shareholders. concentrated ownership of companies is not equivalent to weakness in corporate governance. When companies are highly profitable. at a premium over the market price to reflect the value of management control.1 Summary. he restructured the company toward its core brewery business and sold off local and foreign subsidiaries. SMC is another widely-held company managed by a minority shareholder. using some or all of these means. Eduardo Cojuangco was able to assert his ownership of shares taken over by the Government during the transition of power in 1986. the Soriano family. Vol. Corporate governance is conditioned by the high ownership concentration of these large companies. Ownership is highly concentrated and a few dominant players control major industries. First Pacific could have acquired sufficient shares to take control of PLDT in three ways. controlling shareholders can capture these profits by excluding public investors from ownership. By itself. A third method was to make a formal tender offer to PLDT’s controlling minority shareholders.

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

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

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

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

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

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

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

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

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

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

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

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

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

compared with the 14. China—went to export-oriented manufacturing industries. Thailand became a debtor’s market. . The manufacturing sector became a dominant force in the economy. The Seventh Plan (1992-1996) The economy’s performance from 1992 to 1996 generally met the targets of the Seventh Plan. an oversupply of housing emerged. from only $31 billion in 1992. the bulk of domestic investments went to speculative ventures such as real estate. The exchange rate was steady at around B25 to the dollar. increasing its share in total export value from 42 to 76 percent.2 percent per year. with private foreign debt reaching $92 billion by the end of 1996.6 percent target of the Seventh Plan. while exports expanded considerably. From 1989. Most of the FDIs—originating mainly from Japan. the property sector began to collapse in 1996. Singapore. combined with its liberal financial policies.5 to 13. compounded by a slump in property sales. rather than to productive activities. The country also attracted a large amount of foreign direct investments (FDIs). Thailand’s rapid growth up to the mid-1990s made the country one of the world’s fastest-growing economies. II The Sixth Plan (1987-1991) Industrial sector productivity improved gradually during the Sixth Plan period. Inflation was 4. Growth rates during 1987-1991 ranged from 9.8 percent. lower than the target of 8. reaching an annual inflow of $2 billion in 1991. compared with the 8. invited a deluge of capital seeking profitable investments. On top of its predominantly “borrowed” nature.2 percent target. Key to this growth performance was the government’s adoption in 1993 of an aggressive program for attracting foreign capital to finance domestic investments. Private sector investment grew at an average annual rate of 7 percent. Average annual growth in real GDP was 8 percent. With loans increasingly becoming expensive and hard to come by due to a lending squeeze by the central bank and high interest rates. By 1995. United States.7 and 11. Vol. and the stock market. averaging 10. The country’s high ratings in the international capital market. respectively. Growth of exports and imports averaged 14.6 percent. and Hong Kong.2 and 13. better than the 5.4 percent targets.232 Corporate Governance and Finance in East Asia. property development.5 percent. Europe. the Government successfully balanced the budget and even settled its foreign debt of $4 billion before this was due.8 percent.

the capital markets didn’t play a significant role until 1975. Before the capital market emerged. In 1972. Included in the Second Plan (1967-1971) was a proposal to establish the country’s first authorized and regulated securities market. which was amended in 1979 and 1985. Foreign banks were barred from competing directly with domestic banks.2. the corporate sector’s main source of funding was the banks. the Government amended the “Announcement of the Executive Council No.Chapter 4: Thailand 233 Toward the end of the Plan period. prepared a comprehensive report entitled “A Capital Market in Thailand. on account of an overvalued baht that weakened export competitiveness. However. the Government passed the Public Limited Company Act. Under the 1962 Commercial Banking Act. Robbins. its policy had always been to protect domestic banks. SET officially became “the Stock Exchange of Thailand” in 1991. In 1969. 58 on the Control of Commercial Undertakings Affecting Public Safety and Welfare. A series of increases in customs and excise taxes on luxury imports did little to stem rampant consumer spending. the establishment of the Securities Exchange of Thailand (SET) was legislated and trading began on 30 April 1975. 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. In May 1974. the signs of an economy about to falter were there. 4. placing all publicly listed companies under regulation.” extending its control and regulatory powers to the finance and securities companies operating freely at the time. many companies considered the Act too restrictive and a hindrance to growth. the Bank of Thailand and . a former Chief Economist from the US Securities and Exchange Commission. Its most crucial role was to help mobilize funds to support Thailand’s industrialization and economic development.8 percent in 1995 to 1.3 percent in 1996. Sidney M. In 1978. Exports went into a tailspin. And because the Government considered the banking system vital to the development of the economy. a policy that held throughout the first six economic development plans. which raised the debt service ratio. The country had a current account deficit of about 8 percent of GDP in 1995 and 1996.” which later became the master plan for the development of the Thai capital market. with growth shrinking from 23. The deficits caused the Government to rely on even more external borrowing.2 Development of Capital Markets Although the corporate sector has long been the government’s main tool for economic development. In his report.

the financial and banking laws were generally ineffective. Thailand’s capital market entered a new era with improved legislation and regulation.” The Government also granted financial institutions overly generous bailouts. 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. to cater specifically to its . there were 29 commercial banks (15 domestic and 14 foreign banks) in Thailand. The resulting availability of funds propelled the corporate sector’s growth through the early part of the 1990s. At the end of the Sixth Plan. Thai banks gained access to a variety of funding sources from around the world. With the liberalization of financial markets. the Government was under international pressure to deregulate the financial sector. Earlier. The pressure dovetailed with the Government’s intention to make Bangkok one of the financial centers of the region.234 Corporate Governance and Finance in East Asia. While the Bank of Thailand had the regulatory power to influence business practices. 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. it usually relied on “moral suasion. A number of internal and external factors contributed to the Thai Government’s acceptance of the IMF’s Article VIII agreement. and new financial instruments. The banks and finance companies operated at insufficient levels of reserve capital and were overexposed in high-risk businesses such as real estate. The regulatory measures were inadequately designed and poorly enforced. the World Bank had recommended such a move. Thailand discarded controls on foreign exchange transactions and capital flows—a turning point for the Thai corporate sector. The Public Company Act of 1992 relaxed some of the rules and restrictions contained in the original laws. creating a moral hazard problem—the perverse expectation that imprudent bank behavior would be rewarded with forbearance and bailout. In the 1990s. 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. Externally. However. Laws were enacted to stimulate growth of the corporate sector. Financial deregulation and liberalization allowed the country to attract foreign savings and investments that helped finance the growth of the economy. Vol. increased financial market activities.

1 trillion and paid-up capital of B1. the country became recognized as an economic development model for other emerging economies. and Water Construction Wholesale and Retail Trade.394. 4.1).0 Paid-up Capital (B billion) 1.1 Public Companies Registered. and wholesale/ retail trade and restaurant/hotel sectors. Thailand. Hunting.3 83.101. Storage. in that order.3 Growth and Financial Performance Since the 1978 enactment of the Public Limited Company Act. The majority of the companies are in manufacturing. Real Estate. about 661 companies with total registered capital of B2.6 2.9 34. and Fishing Mining and Quarrying Manufacturing Electricity. 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.6 1. Ministry of Commerce. and Communication Financing. finance.9 261. Source: Department of Commercial Registration.9 1. Financial deregulation and liberalization were key to realizing that vision. Insurance.5 50.6 23. .5 791.291.0 21. The manufacturing sector is a far second with registered capital of B350 billion and paid-up capital of Table 4.1 78.2 Type of Business Agriculture. The stock market boom from 1991 until the financial crash of 1997 reflected international investors’ response to Government policies. the financial sector is the largest. with B1. Gas.6 350.0 110. Worldwide.5 111. and Business Service Community.4 trillion in registered capital and B791 billion in paid-up capital. The result was a corresponding growth and development in Thailand’s capital markets. however.2 11.2. and Restaurants and Hotel Transport.Chapter 4: Thailand 235 fast-growing neighbors. Social and Personal Service Total Note: The data for 2000 is as of October 2000. Forestry. 1978-2000 Number Registered of Capital Companies (B billion) 5 6 245 5 13 129 22 194 42 661 1.3 trillion have been registered with the authority (Table 4.0 19.9 16.1 30. In terms of capital.

1 54.4 96. moreover. Vol.9 31. reaching a precrisis peak in 1996 (Table 4. reducing the value of offerings to a little more than a quarter of the previous year’s level. the capital market became instrumental in the rapid growth and development of the corporate sector.4 277.1 — — — 6.6 174. the year before the crisis struck.3 6. Market capitalization.2 25.1 599.6 8.7 5. Source: Key Capital Market Statistics. Domestic and offshore debt issues reached B54.9 37. 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 1.4 51. from only B20.2). While a rebound was apparent beginning in 1998.5 — — 56.7 136.8 — 26.5 1.5 1.0 0. the value of public offerings rose steadily.6 7. The signing of Article VIII with the IMF. II B261 billion.6 39. The stock market also became an invaluable source of funds for corporations.5 billion and B1 billion the previous year.8 billion.2 5.0 20.7 billion and B27.4 34. The number of listed companies and securities steadily increased until 1996 (Table 4.3 1996 1997 65. respectively.7 7.236 Corporate Governance and Finance in East Asia. Securities and Exchange Commission of Thailand.3 22.8 1995 64. Table 4.3 31. Debt market activities also increased significantly with the establishment of the Bond Dealers’ Club (BDC) in 1994.7 billion in 1996. reached .9 1998 1999 15. These peaked at B89. The development of the corporate sector closely followed the development of capital markets.7 9.6 — = not available.2 Public Offerings of Securities. meanwhile.8 201. With the enactment of the SEA of 1992 that brought suppliers of finance services and their clients together.8 151.1 286. this was due to the recapitalization of commercial banks in compliance with the new loan provisioning requirement. The 1997 crisis battered the primary market for securities. The preeminence of the financial sector is a direct result of financial deregulation and liberalization. allowed Thai financial institutions and corporations to obtain funds overseas.5 39.2 12.3).7 27. After the passage of the SEA of 1992.1 2.3 194.0 1994 82.2 40.

in the end.281 832 373 356 482 Due to listing requirements and other reasons. The upward trends for ROE and ROA continued through 1989.4 percent in 1996. return on equity (ROE). Throughout the 1990s.3 percent in 1989 to 3.268 2.610 1. when long-term debt grew as Thai corporations began to borrow heavily to finance growth. the averages for all three profitability ratios took a downswing all the way until 1996.Chapter 4: Thailand 237 Table 4.565 2.6 trillion.3 Statistical Highlights of the Stock Exchange of Thailand.201 2. however. The financial leverage of all companies declined until 1994.114 1.5 at its peak in 1987. the average times interest earned (TIE) was down to 5.193 2.535 1. gross profit margin rose until 1991 before falling in 1992.8 percent.560 1. not all public companies are listed on the SET. corporate profitability had been declining. Foreigners accounted for an increasing proportion of SET’s turnover value.360 1. however. ROA dipped from 10. then stalled in 1990.325 3. The key financial ratios of all companies listed on SET bear this out (Table 4. their share rising from 17 percent in 1993 to 43 percent in 1997. The plunge in profitability and asset turnover—from 117 percent in 1985 to 65 percent in 1996 for the latter—cast doubts on the . the highly liquid financial system continued offering cheap funds to sustain corporate sector investments. The trend reversed in 1995.683 1. the companies could not generate enough net returns from their assets and equity.4 percent to 5. was the ominous deterioration in the key financial ratios of publicly listed companies.301 3. ROE similarly fell from 21.1 by 1996. resulting in their inability to fulfill debt obligations. While the decline in gross profit margin was not as sharp. 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 3.133 1. pulled down by active public offering activities. had been on the rise throughout the 1980s. But instead of shifting to a low gear. and gross profit margin. By the early 1990s. Side by side with this surge of financing for corporate growth. its high point in 1995 at B3. Source: Securities and Exchange Commission of Thailand. Corporate profitability.4).303 930 855 1. Meanwhile. From 10. as measured by return on assets (ROA).

4 7.7 12. which fell from 16 percent in 1991 to just under 6 percent in 1996.7 54.1 16. US. was also distinct in the region.2 161. II Table 4.4 26.0 139.2 215.9 66.9 144. Overall.4 47.9 39.4 51.5 51.8 14.5 30.8 54.7 27.4 139. resulting in higher collateral values for borrowers. and footwear industries also experienced losses.7 5. Hotels and travel showed the highest ROE of 15 percent while textiles.1 52.4 9.5 52.7 12.6 7.0 145. It has also been argued that family-based controlling shareholders borrowed excessively to avoid diluting their control over their corporations.1 60.4 18.2 27.8 5. but was most severe in building and furnishing material industries as a result of the downturn in the real estate market. and footwear had the lowest at 11 percent.6 138. 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 (%) (%) (%) 3.6 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.0 3. was felt across industries. practice of heavy borrowing. A major reason for this was the rapid rise in asset prices.3 8.4 Key Financial Ratios of Publicly Listed Companies.9 8.6 168.0 63.3 12.238 Corporate Governance and Finance in East Asia.2 27.5 9.7 35.8 5. which was particularly significant in the two years preceding the crisis.7 LongTerm Debt to Asset Assets Turnover (%) (%) 14.4 5. Severely affected by global competition throughout the decade.4 7. Among the crisis-hit countries.9 27.2 10.3 10.4 119. Vol.3 4.2 49. The downtrend in corporate profitability. these companies opted for debt.8 151.2 6.5 50.5).4 44. They were generally more efficient in managing their assets and .7 15.0 7.6 36.8 25.4 34.8 11.7 59.9 77.1 44.9 7.9 51.9 7.7 20.4 4. Thailand’s ROE.5 63.4 24.7 5.2 10.0 125.2 64. large companies (where size is reckoned in terms of assets or sales) were more profitable than small companies in terms of ROE (Table 4.4 12. Korea and Thailand had the highest debt-to-equity ratios.0 117.7 27.4 12. Despite the availability of the equity market.8 88. clothing.7 12.2 10.1 242.1 16.4 28.7 80.6 125.5 38.8 8.5 15.7 34.6 27.1 9.7 12.4 3.3 91.7 5.9 14.0 29.2 35.6 12.6 41. clothing. the textiles.1 114.7 4.7 21.9 140.8 51.1 120.

3 49. also deteriorated.Chapter 4: Thailand 239 Table 4.4 52.6 5. During the 1990s.7 14.8 142. However.7 10.4 8. They also tended to use more financial leverage than small companies as their total DERs show.6 30.2 134.0 20. it was thought.1 6. . which would be disruptive to company management. 1985-1996 Company Size by Assets Company Size by Sales Item Return on Assets (%) Return on Equity (%) Gross Profit Margin (%) Times Interest Earned Total Debt-to-Equity (%) Long-Term Debt-to-Equity (%) Total Debt-to-Assets (%) Long-Term Debt-to-Assets (%) Asset Turnover (%) Small Medium Large 6. the overall activities of listed companies.6 31.3 164.3 25.6 61.8 62.5 6.6 10.2 12.0 48.2. weaknesses became evident. Increasingly heavy borrowings rendered the sector even more vulnerable to lower profitability and sales. US. For instance. some rules and regulations of this particular law were believed to be too restrictive and were discouraging companies from going public.3 88.8 26. by the 1990s.3 43.5 Average Key Financial Ratios by Company Size. measured by total asset turnover. the law disallowed cumulative voting. although the performance of listed companies in the late 1980s was strong.0 83.2 10.4 116. There were also concerns that the provisions governing the criminal prosecution and penalties of directors and management were harsh and inappropriate.5 87. Although stable in the 1980s.7 6.3 52. total asset turnover declined after 1989.3 15. In sum.3 135.6 12.5 94.4 Legal and Regulatory Framework Before 1992.6 7. The argument was that having a Board of Directors whose members represented different groups of investors would create conflicts and hamper management effectiveness.2 18.6 6.6 30. Cumulative voting.8 6.8 10.8 47.1 Small Medium Large 5.9 20.1 5.2 121. capital despite the higher gross margins of small companies.8 6.3 49. 4.1 29.1 13. the Public Limited Company Act of 1978 and its amendments regulated Thai publicly listed companies.9 13.3 23.5 7.7 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. could lead to a high turnover in the board.1 25.3 176.

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

Thai.1 5. In contrast. . 33.Chapter 4: Thailand 241 4. Ownership was most concentrated in the packaging.7 7.3 7.0 3.9 6. this was not the case.China have the least concentrated ownership.3 16.6 27.6 4.2 4. these companies obtained funding solely from banks or from their own retained earnings.1 5. Most large Thai corporations listed on SET started out as family businesses.7 12.4 26. and 28.9 3.9 percent of shares of a company.4 4.2 56.3 5. In the past.4 26. This implies that the top five shareholders enjoyed full control over the outcomes of shareholder meetings.8 5.2 4.9 3.6 28.0 7.4 6. Ownership Concentration Between 1990 and 1998.9 52.9 4.1 4. and Hong Kong.4 5.0 5.7 percent.8 32. and minority shareholders to stake their claim in the control and regulation of these companies. respectively.2 11.7 11. with the top three shareholders accounting for almost 50 percent (Table 4.6).5 Average for 1990-1998 period.6 68. 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.0 53.3 11.7 6.4 6. Unfortunately.5 28. Indonesian.3.5 9. there were only slight variations in the pattern.4 percent of outstanding shares. Table 4.9 54. China firms have the highest single shareholder ownership concentration at 35.6 57.3 percent and 18.1 5.3 7.1 Patterns of Corporate Ownership A World Bank study covering nine Asian countries finds that firms in Japan and Taipei.4 10.3 percent. Stock Exchange of Thailand. Source: Comprehensive Listed Company Information Database.8 11.0 56.9 55. creditors. Across industries.0 7.4 26.9 52.1 11. with the largest shareholder on average controlling 10.9 26. one would expect the public. on average. 56.9 11.1 percent of control rights. But with their increased reliance on new varieties of equity and debt instruments.1 7.2 4. 1990-1998 Averagea 1990 1991 1992 1993 1994 1995 1996 1997 1998 1st Largest 2nd Largest 3rd Largest 4th Largest 5th Largest Top Five a 28. the top five shareholders of each of publicly listed Thai companies held.6 Top-Five Ownership Concentration of Publicly Listed Companies in Thailand.1 12.9 52.3 28.0 3.1 3.

Company size is significantly related to ROE and leverage.072) (0. II agribusiness.242 Corporate Governance and Finance in East Asia. *** at the 1 percent level. Source: Author’s estimation based on the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. Based on a regression analysis. Ownership Concentration. It is the practice of Thai corporate founding families to set up holding companies to own shares in affiliated companies or subsidiaries.001*** 0.034*** 0. results show a significant positive relationship between ownership concentration and financial leverage.003 0. 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. and Company Size Item Intercept Top Five Ownership Concentration Company Size Adjusted R-Squared F-Statistic ROA 0.8). Vol. Other industries had their top five shareholders controlling at least 55 percent of outstanding shares.090 0.533)*** Debt-to-Assets (0.7 Statistical Relationships between Corporate Profitability. and ownership types.169*** 0.7). Table 4.022*** 0. ** at the 5 percent level. as measured by debt-to-equity and debt-to-asset ratios.005** 0.031 3.037 0. year.001) 0.800 0. there is no statistically significant relationship between ownership concentration (measured by percentage of shares owned by the top five shareholders) and profitability of Thai publicly listed companies (Table 4.7 percent of outstanding shares on average (Table 4. Through these holding companies.115 9.029 3.001 0.058* ROE (0. and building and furnishing industries. On the other hand.080 6. including those that are publicly listed . Leverage. Composition of Controlling Shareholders Affiliated corporations comprise the largest group among the top five shareholders of publicly listed companies. * Denotes significance at the 10 percent level. US.647 Note: The regression included dummy variables for industry.116) Debt-to-Equity (1. founding families maintain effective control of entire groups. owning 26. with a top-five ownership concentration of at least 60 percent.

3 20.3 — = not available. Individual family members also hold a significant amount of outstanding shares. In addition.5 1.7 5.0 17. the affiliate firms rarely hold shares of their parent companies.5 26.9 19.8 28. the company increased its registered capital and became a public company listed in SET.9 0.5 Individuals 13.4 22. a joint venture among three families. Typically.9 15. including finance and investment companies.5 percent.0 3.0 19.1 1. The ADB survey indicated that listed companies held shares in an average of 11 companies.4 1.8 23.3 27.2 5.5 1. Source: Comprehensive Listed Company Information Database. Stock Exchange of Thailand.3 27. The roster of its major shareholders as of December 1997 illustrates the typical ownership concentration of a publicly listed company in Thailand. with 29. The largest shareholder is Central Holdings Company.6 1.7 1.5 2. This practice is illustrated by Central Pattana.4 1.3 percent of outstanding shares.9 18.1 0.5 0.7 Bank 2.1 1.6 28. a NBFIs denotes nonbank financial institutions. These individuals usually hold important management positions in concerned companies.1 4.5 Government Other 0. individual members of the Chirathivat family aggregately hold 25.8 Top-Five Shareholder Composition of Publicly Listed Companies in Thailand. the company.7 0. a company listed in the real estate sector of SET.5 0. in SET.5 5.2 1.3 27.8 1.3 1.9 7. 1990-1998 Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 Average Company 28.3 1.6 percent of outstanding shares.6 25. Although holding companies set up affiliate firms. The top 10 shareholders include a holding company owned by the Tejapaibul family.6 5.3 0.5 0. In 1994.2 7.7 — 1. founding families and their relatives maintain control of many companies by jointly holding on to the most significant chunk of shares.5 NBFIsa 6. Established in 1980 with a registered capital of B300 million.4 1. operates five of the most successful shopping malls in Thailand.0 18.6 1.Chapter 4: Thailand 243 Table 4.6 1.2 18.3 1. owned by the Chirathivat family.8 0. one of the founding members. . unlike in Japan where crossshareholding is common.4 20. averaging about 18.2 1.9 6.

244 Corporate Governance and Finance in East Asia.2 Corporate Management and Control3 Board of Directors The Public Company Act of 1992 stipulates the appointment process. 4.5 percent of total outstanding shares. qualification. For example. The Government holds. roles. the predominance of individual family members and holding companies in the top shareholder list remains valid. 3 Discussions in this section are based on results of company surveys by SET and ADB. In such cases. has the Ministry of Finance as its only large shareholder with 92. 1. holdings by individual family members and holding companies account for at least 50 percent of outstanding shares of an average listed company. Thai Airways International Plc. However.5 percent of total outstanding shares of listed companies. with the envisioned privatization master plan. both conducted in 1999. the Petroleum Authority of Thailand. . About half of listed companies have nonbank financial institutions such as finance and investment companies in their top-five shareholder list. Across industries. By owning 62 percent of voting shares.1 percent of total outstanding shares of listed companies.3. on average. Although the list of top shareholders of publicly listed companies includes financial institutions. In effect.. There was a trend of rising government shareholdings throughout the period 1990 to 1998. the Government’s role in public companies is expected to decline. duties. Moreover. Only a handful of companies have the Government among their large shareholders. and a state bank. commercial banks account for only 1. Vol. they exercise limited influence in operations because of the restricted size of their shareholdings. the Government owns the majority of the shares.9 percent of outstanding shares. and responsibilities of directors of public companies. Except in the hotel and travel service sector. Another example is Bangchak Petroleum Plc. they account for 80 percent of total outstanding shares. On average. these shareholders are able to control the company. Together. only one tenth of listed companies have commercial banks on their top-five shareholder list. where the top three shareholders are the Ministry of Finance. the top 10 shareholders consist predominantly of members of founding families and their holding companies. Nonbank financial institutions hold an aggregate 5. II another of the company’s founding members.

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

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

As a result. Forty-four companies indicated that they had proxy voting in place. shareholders have access to reliable information at no cost. and executive committees. Shareholders are also entitled to call emergency meetings and present proposals at AGSMs. (iv) The roles and responsibilities of the major government agencies regulating shareholder rights—the Ministry of Commerce. although recently. Minority Shareholders and their Rights Many different rights and entitlements of shareholders are laid out in the Public Company Act of 1992. Proxy solicitation tends to be abused to the extent that shareholders are inadequately informed about matters to be taken up in shareholder assemblies. debentures. For instance. with 13 companies allowing proxy voting through mail. including false statements to conceal information about the financial condition and operations of the company during the sale of shares. The Act. SEC. averaging about 14 years. However. Relationships between firms and external auditors are generally long-term. SET. The Act also holds directors liable for any damage to shareholders. SET’s rules and regulations closely follow this Act. likewise. there is the danger that top management may be capable of unduly influencing the board’s decisions. (ii) The prudential role of outside directors is limited by the noncompulsory character of their participation in key decision-making bodies such as the audit. The majority of the companies (85 percent) require the appointment of external auditors during annual general meetings. stipulates the proper conduct of shareholder meetings. as well as the registration and holding of shares.Chapter 4: Thailand 247 independent from the company. According to the ADB survey. At least 28 responding companies had the following . remuneration. (i) No standards are enforced in the content and timing of notices for shareholder meetings. there are also significant gaps in the system of shareholder protection. (iii) Because the chair is frequently also part of the top management team. most responding companies have rules and regulations intended to protect shareholders. and the Bank of Thailand— are not clearly defined. the corporate sector lacks a strong self-regulatory body to compel compliance with these standards. or other financial instruments. the Securities and Exchange Commission (SEC) and SET were actively prosecuting violating firms. the institutional machinery is not fully responsive to complaints about violation of shareholder rights. While safeguards are in place. In the majority of these companies (38 out of 46 respondents). shareholders can claim compensation in cases of negligence or dishonesty by management.

II mechanisms in place: mandatory shareholder approval of major transactions and interested or related party transactions. Almost 82 percent of shareholders. The SEA of 1992 and the listing rules also contain provisions for the protection of shareholders against transfer pricing. such protection has been insufficient. the new Public Company Act of 1992 inadvertently weakened the governance of public companies by diminishing minority shareholder rights. given their importance in providing finance and their stake in companies. While stimulating the growth of the sector. The ADB survey results reveal that the proposals presented by management were rarely rejected during the general meetings. 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. But with the ownership concentration of Thai companies. the only group of shareholders that can exercise rights is the top five shareholders. representing only about 28 percent of shareholdings.248 Corporate Governance and Finance in East Asia. and insider trading. minority shareholders are assured adequate legal protection. . did not vote in previous AGSMs. 4. 66 percent of total outstanding shares.3. These problems appear to be partly a result of the relaxation of the rules and regulations in the original Public Limited Company Act of 1978. But the exercise of these rights requires even higher shareholding levels. Banks would be obvious candidates to implement these mechanisms. In practice.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. and call an extraordinary session. The difficulty minority shareholders have in exercising their rights can be seen from the ADB survey results. In theory. they comprised only 8 percent of total shareholders. and mandatory disclosure of related interests and significant shareholders’ transactions. Vol. takeover of the company. however. Only a small number of shareholders attended the latest AGSMs. on average. On paper. Although the attendees held. minority shareholders may also appoint an outside inspector to examine the company’s operations and financial condition. In effect. it would be difficult for minority shareholders to gather the shares needed to take action.

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

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

most of these were forced mergers or related to rescue packages. Since 1994. they have mostly been concerned with short-term gains. Employee Participation in Corporate Governance There has been little. it remains small. The number of domestic institutional investors rose after the mutual fund industry was established in 1991. Because of the current crisis. employees are even less willing to accept common shares as a form of compensation or benefit. Provident funds for government workers and workers in public enterprises have been established only recently. trading by mutual funds in SET represented less than 10 percent of total trading. Eleven of the 46 responding companies in the ADB survey offer ESOPs.0 B billion 4.Chapter 4: Thailand 251 Table 4.7 11.2 6.3 6.7 Purchase Value Number of % of Tender Offer Value Companies 84. 1993-1999 Year 1993 1994 1995 1996 1997 1998 1999 a Tender Offer Valuea (B billion) 5.0 55.5 6. But instead of opting for an active role in the market for corporate control.2 7. .1 19.4 23. Pension funds are perhaps even weaker in Thailand.1 84.8 81.8 8 27 14 6 9 13 23 Tender offer value refers to the minimum offer value. but employees have never been represented in the board of directors since their shareholdings are minimal.2 8. Few companies offer employee stock option plans (ESOPs). tion activities increased after 1997. if any.3 60.3 11. Twenty-nine firms indicated that employees held shares of their companies. employee participation in corporate governance in Thailand. but the average shareholding is smaller than 1 percent of total outstanding shares.2 6. Even when companies offer ESOPs. employees regard the plans as monetary incentives.9 Merger and Acquisition Activities.1 75.9 3. not with a view to becoming involved in actual management. Source: Securities and Exchange Commission of Thailand.6 17.1 58. While the Thai mutual fund industry compares well to those in other developing countries in the region.

4 4.193.430.1 Domestic Debt Securities Outstanding 215. the banking sector was highly concentrated.5 4. Bangkok Bank Ltd. Vol.5 6. accounted for 28 percent of the banking sector’s total assets.3 1.4 519.133.372.325.0 8.10) shows that Thailand is a highly bank-dependent economy.912.5 4. and Bank of Thailand. Table 4.1 Corporate Financing Overview of the Financial Sector A breakdown of the Thai financial sector for the period 1992-1999 (Table 4.6 2.1 3. 15 of which were domestic banks.252 Corporate Governance and Finance in East Asia.663. Thai Bond Dealing Centre.6 1. The total values of loans from financial institutions and commercial banks were consistently larger than the market capitalization of SET.4 3.4 Year 1992 1993 1994 1995 1996 1997 1998 1999 Source: Stock Exchange of Thailand.4 1.0 424. II 4. the next four largest banks accounted for 63 percent. total assets of commercial banks amounted to B5.3 5.360.5 trillion.1 3.825.8 3.2 2.2 262.171.5 5.6 6.268.8 941.390.5 Outstanding Loans from Commercial Banks 2.485.906.477.564.559.9 2.4.4 4. .161.119. although its role increased in the wake of the crisis.. there were 29 commercial banks. The Banking System Until recently. In 1996.037.669.300. The share of domestic banks in the banking system’s total assets was 80 percent. 1992-1999 (B billion) Outstanding Loans from All Financial Institutions 2.775.1 5.3 546.0 SET Market Capitalization 1. The bond market played only a marginal role in corporate financing.1 6.0 339.979.0 3. Many large commercial banks had affiliates among the 93 finance companies that served the high-risk market. The country’s largest bank.1 7.10 Size and Composition of the Thai Financial Sector. Competition from foreign banks was limited as they were not allowed to engage in full branch operations.230.

SET was not very active. Licenses were granted to 15 Thai banks. the Government established the BIBF to expand the banking sector and reduce the borrowing costs of Thai companies. SET immediately recovered due to the strength of the Thai economy. 12 existing foreign banks. the stock market entered its first boom period in 1986. Easy access to commercial bank loans by family business groups. Stock prices tripled in the next three years until the market experienced its first crash as a result of the Gulf Crisis in 1990. banking. an over-the-counter market. Because borrowers carried the exchange rate risk. The Government removed controls on capital and dividend repatriation in 1991. finance. owning 70 percent of the country’s second largest bank. due to their close ties. the Bangkok Stock Dealing Center (BSDC). In 1993. self-regulatory organization under the . In 1995.8 in 1998. The number of listed companies also quadrupled between 1981 and 1993. hardly any progress was made in lowering the cost of domestic financial intermediation or in developing new financial instruments for corporations. Banking activity peaked in the mid-1990s.Chapter 4: Thailand 253 The Government was also a major figure in the banking system. Through the years. Despite the worldwide market crash in 1987. and 20 new foreign banks. was set up by 74 members with an initial capital of B500 million. the SET index declined. Turnover value reached B2. The Equity Market During the first few years of its operations. BSDC is a nonprofit. Benefiting from rapid economic and industrial growth. also made it unattractive to raise capital from the equity market. In contrast. Banks under the BIBF scheme were allowed to mobilize funds from abroad and lend to Thai companies in foreign currency. After that. reaching 355. and property have accounted for the bulk of trading volumes. the market rose steadily and reached a record high in the fourth quarter of 1993.3 trillion. In the following years. 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. and almost all capital account transactions were deregulated. the liberalization of interest rates and capital account transactions stimulated a credit expansion through short-term borrowings in foreign currency.2 trillion. The lack of supply of quality shares was a big problem for SET at that time. SET is organized into 32 major industries. BIBF banks also enjoyed tax incentives on their operations and profits.

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

however. it accounted for a small share of the entire financial sector. Companies generally issued short-term debt instruments like promissory notes or bills of exchange. led to the renewed issuance of Government bonds to finance the resurgent budget deficit and support cash-strapped financial institutions. in 1994.Chapter 4: Thailand 255 The Bond Market The Thai bond market has played a marginal role in corporate financing until recently. it represented only 9 percent of GDP. the first bond rating agency in Thailand. compared to 110 percent in the US and 74 percent in Japan in the same year. 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 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. at about 11 percent of the total value of outstanding loans extended by commercial banks and 20 percent of total equity market capitalization. Four years after the passage of the SEA. the Government issued more bonds to finance industrial development projects and perennial deficits. . The budget surpluses of the 1990s eliminated the need for new bond issuance. which encouraged limited companies and public companies to issue debt instruments. In 1996. Upon its founding in 1942. To gain some perspective of the size of the bond market in Thailand. State-owned enterprises became active issuers of bonds since 1993 because the Government constrained their borrowings (Table 4. while secured debt instruments accounted for just above 10 percent. the Bank of Thailand assumed responsibility for regulating the bond market. A turning point of the corporate debt market was the enactment of the SEA of 1992.9 billion.11). However. was also instrumental to the growth of the corporate debt market. the size of the corporate debt market rose to B132. and the Government did not issue new bonds during 1990-1997. The Thai bond market was also smaller than that of Malaysia (56 percent of GDP) and the Philippines (39 percent of GDP) in that year. The Thai Rating Information Services. The recent financial crisis. Investors had limited knowledge of debt instruments. The proportion of domestic convertible debt instruments increased until 1995. Beginning 1961. The bond market in Thailand started in 1933. the year the Ministry of Finance first issued government bonds to finance infrastructure projects and economic development. A breakdown of domestic offerings of corporate debt securities from 1992 to 1996 shows that unsecured debts accounted for about 60 percent.

turnover value had reached B51.0 — 26.2 28.3 3.5 — — — 3.3 13. A sharp rise in unsecured offshore debt offerings can be noted all the way through 1996.7 0.8 47.7 5.5 43.0 17.4 49. .6 — — 0.9 20. Vol. The club was considered the first organized secondary bond market in Thailand to serve as the wholesale market for debt securities.11 Offerings of Debt Securities.4 billion.3 46.1 315.0 — 5.9 0. 1992-1999 (B billion) Item Government Bonds Treasury Bills State Enterprise Bonds Guaranteed Nonguaranteed Other Government Bonds Corporate Bonds Domestic Secured Unsecured With Warrant Convertible Short-Term Offshore Secured Unsecured With Warrant Convertible Total 1992 1993 1994 1995 1996 1997 1998 1999 — — — — — — 400.0 7.0 333.7 0. The following year. a surge attributed to capital inflows encouraged by high returns on Thai bonds.3 46.1 10.6 billion. By 1995.7 — — — — — — — 77.0 33.5 billion.4 — — — 1.2 45. However.7 — — — — — 4.4 7.9 37.0 — 5.2 2.1 289. this had climbed to B200.0 86.6 19.7 538.9 40.7 — — 40.3 50.3 140.7 28.2 57.4 110.1 55.8 31.4 — 26.1 — — 6.5 — — 32.1 8.5 — 0.9 5.3 — 14.6 — 0.5 — 39.9 30.7 7.1 121.9 329. The domestic debt market declined after 1994 because corporations could borrow offshore at lower costs. total offshore debt offerings had plunged by 68 percent to a mere B28.5 10.5 37.8 167.3 6.3 22.7 90.1 59.4 57.2 43.8 55.7 5.3 29.5 138.0 5.3 — — 3.1 107.1 — — — 29.0 60.1 41.9 37.0 281. then declined substantially in 1996 and 1997.5 — — — — 1.8 Source: Securities and Exchange Commission of Thailand and the Thai Bond Dealing Centre.2 39.1 6.256 Corporate Governance and Finance in East Asia. by the end of 1997.1 61.7 821.8 191.5 5.4 — 9.0 27.7 132.1 21. the year the crisis unraveled and the baht was floated. BDC was established in November 1994 by 50 securities companies based on the provisions of the SEA of 1992. Total offshore debt offerings peaked in the run-up to the financial crisis.2 89.7 95.1 141.2 — — 50.0 0. The decline in total domestic debt offerings in 1996 can be ascribed to the increase in offshore convertible debts.0 26.5 55. II Table 4.3 8.1 12.8 2.

Retained earnings accounted for about 30 percent of total equity financing.2 Patterns of Corporate Financing An examination of financing patterns among Thai companies listed in SET shows that on the asset side. the use of debentures remains minimal even though the trend was generally upward until the 1997 crisis. Across industries. short-term loans accounted for more than 40 percent of total liabilities.2 billion as a result of the default of debentures due to the Asian crisis. cash balances. overall asset quality and liquidity of listed Thai companies deteriorated throughout the period. these accounted for 33 percent of total liabilities. BDC was renamed “the Thai Bond Dealing Centre” following its status upgrade to a bond exchange. judging by their relatively low levels of retained earnings. these comprised 31 percent. For the construction industry. The average for all industries was only 22 percent.1 billion in 1998.4. Companies in construction and property development seemed unable to generate internal funds. Turnover fell further to B72. 4. At lower than 5 percent of total liabilities.12). In addition. Thailand’s publicly listed companies rely mainly on loans from commercial banks and financial institutions to finance their growth. turnover value plummeted to B106. listed companies experienced liquidity problems with declining reserves of cash and marketable securities during the period 1990 to 1996 (Table 4. Equity financing remains an important part of listed companies’ long-term financing. while for the property development industry. they also had a relatively small proportion of equity and . Construction and property development industries tended to have high proportions of long-term loans and debentures. with equity levels remaining high despite an increase in debt. a trend most apparent in the leap between 1991 and 1992. The proportion of accounts receivable also declined steadily. In the same year. significant variations can be noted. The ratio of net working capital to total assets decreased from a peak of 31 percent in 1993 to 28 percent in 1996.Chapter 4: Thailand 257 compared with investment in equities. steadily easing up between 1990 and 1996. In 1997. The overall trend is consistent with the decline in profitability observed in the analysis of corporate sector performance earlier. and marketable securities holdings. Longterm loans accounted for about 20 percent of total liabilities. There was also little change in the trend in retained earnings within the seven-year period. In any case. The closure of 58 finance companies affected the BDC significantly since half of its members were suspended as a result. From 1990 to 1996.

2 16.6 36.9 20.3 2.2 15.1 17.1 36.8 10.2 2.0 100.6 38.5 9.8 34.9 17.5 43.7 0.7 7.9 6.8 21.9 10.9 3.4 8. medium.5 14.2 35.0 48.2 12.6 13. The level of total liabilities for the group characterized by high ownership concentration .1 2.6 12.4 6.1 18.4 7.3 34.4 21.2 1.4 49.0 100.0 12.0 100.8 20.6 15.6 18.2 2.0 7.7 52.9 43.5 37.2 2. Analysis of common-size statements by ownership concentration (based on the levels of top-five ownership concentration classified as high.3 21.0 13.13).7 9.2 2.0 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.3 17.0 100.1 50.12 Common-Size Statements for Companies Listed in SET.8 9.8 3.1 13.6 100. US.2 17.7 18.6 22.6 11.4 14. 1990-1996 (percent) Item All Years 1990 1991 1992 1993 1994 1995 1996 2.2 17.0 14.2 22.5 1.0 100.3 38.7 50.7 1.6 10.2 1.9 16.9 0.7 17.9 50.3 49.0 100. compared with the 44 percent general average.3 50.5 1.4 48.8 7.9 17.8 37.3 25.2 42.6 51. Printing and publishing companies had lower financial leverage than companies in other industries.0 100.2 17.6 8.0 10.8 25.4 49.0 51.9 49.9 2.2 16.6 0.2 17.8 17. II Table 4.2 45.4 17.0 1. Vol.8 19.7 36.8 6. and low) also underscores that companies with high ownership concentration had high levels of long-term loans (Table 4.2 43.7 14.0 100.5 1.8 35.0 2.3 14.5 11.9 18.6 2.2 34.8 46.1 49.1 7.8 37.7 16.2 43.9 6.258 Corporate Governance and Finance in East Asia.2 1.8 8.5 0.3 6.8 14.9 14.6 50.0 100.0 100.4 2.3 12.0 100.0 10.6 21.6 0.5 9.6 0.9 12.9 38.0 100.3 18.9 40.3 48.0 100.0 100.9 14.0 15.7 15.6 0.7 16.3 1.8 1.9 14.6 6.3 18.9 14.6 14.4 17.0 6.9 14.9 15.4 43.6 100.2 3. The agribusiness industry relied more heavily on short-term loans at 56 percent of the industry’s total liabilities.8 9.3 14.1 5.3 1.3 34. were highly leveraged.

3 8.0 16.1 36.4 50.3 1.5 100.1 44.8 37.7 percent for medium ownership concentration companies and 49. .0 100.6 2. 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. common equity accounted for a smaller proportion of total assets (47 percent) than companies with lower ownership concentration.5 13.6 14.6 9. was 53 percent of total assets compared with 49.2 14.9 16.0 Medium 2.9 50.0 7.4 37.8 13. This is consistent with the observation that majority shareholders try to maintain their control by utilizing debt as a major source of funds.2 0.9 2.5 percent for low ownership concentration companies.13 Common-Size Statements of Public Companies by Ownership Concentration.1 53.6 47.2 22.5 21.3 100.7 12.2 45.0 6.0 14.9 36.3 16.0 19.6 100.0 Source: Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.6 15.2 8.6 22.8 12.4 7. US.4 3.7 17.6 0.4 18.9 21.1 18.4 13.2 11.4 35. For the high ownership concentration group.0 6. Companies with medium ownership concentration tended to have a higher proportion of short-term loans.Chapter 4: Thailand 259 Table 4.3 1.9 0.4 1.5 11.9 100.0 Low 1.4 49.0 41.7 19.8 13.1 49.3 35.5 18.9 7.0 100.

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. these firms more easily increased their leverage.8 151. While further detailed investigations are necessary. 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 4.4 5. especially from 1994 to 1996.0 145.9 140.14 Financial Ratios of All Listed Firms.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island. More important.9 14.0 50.6 41. however.1 52. followed by bank loans. Vol. and maintenance of the existing ownership structure. however.1 in 1996. bond issues overtook loans from commercial banks as the second preference.2 35.0 25.1 16.4 44.7 in 1994 to 5.2 68. Generally.1 16. The direct relationship between the degree of leverage and the degree of ownership concentration is apparent in Table 4. minimization of transaction and interest costs. was the headlong deterioration of firms’ ability to meet their interest payment obligations.1 31.8 65. Short-term debt accounted for most of the increase.2 49.9 7. the choice of financing is determined by the company’s liquidity considerations. and rights issues.1 64.1 23. Such deterioration of financial positions during the period was a common feature of listed companies.1 31.1 144. bond issues.6 125. . Table 4.7 34. After the crisis.7 66.8 percent in 1990 to 52. Public companies relied more on short-term debt financing in the period before the financial crisis. II Results from the ADB survey reveal that Thai companies preferred to use reserves and retained earnings as their first choice of financing. The financing patterns indicate that companies with high ownership concentration were more highly leveraged than companies with medium and low concentration.0 28. it would seem that firms with concentrated ownership and associated links to the banking system have easier access to debt financing.8 65.1 44.4 7. The ratio of total debt to total assets increased from 50.7 5.7 12.7 percent in 1996.7 12.14).260 Corporate Governance and Finance in East Asia.3 31.15.6 138. US. As a result.3 61.7 11.4 139. The TIE ratio declined from its peak of 7.8 5.5 38.5 52.8 51.4 12.7 28.7 34.9 63. thus rendering them more vulnerable.9 51.4 51.6 7.

From 45 percent of total net capital movements in 1985.4 13.5 4. unhedged foreign exchange liabilities.8 29. however. the proportion of short-term debt increased from 15. on the other hand.9 percent in 1997.16).5 148. private debt accounted for 84.2 49. Their average annual growth rate declined from 28.8 28.8 Medium 7. and a preponderance of short-term debt liabilities. The corporate sector contributed significantly to the crisis because of its rising levels of leverage.4 27. US.2 124. The composition and term-structure of this debt. This decline was accompanied.4 63. is even more telling. debt-creating capital inflows rose to 65 percent in 1990.8 66.8 49. Nonbank private debt increased from 27.6 30.15 Financial Ratios of Listed Companies by Ownership Concentration.Chapter 4: Thailand 261 Table 4. continued to slide from 1985 to 1997. The proportion of external debt as a percentage of GDP consequently increased from 42. 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 percent between 1985 and 1990 to 8.3 Source: Estimated from the Pacific-Basin Capital Markets Database compiled by the University of Rhode Island.4 52.5 percent of external debt in 1996 (Table 4.4 percent to 46 percent during the same period. peaking in 1994 at 84 percent.5. From only 34 percent in 1986. 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. .0 64. The proportion of nondebt-creating capital flows.6 11. such as direct equity and portfolio investment.2 percent in 1986 to 251.5 126.1 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. 4.8 percent in 1986 to 52 percent in 1995.3 42.1 High 6. Additionally.7 percent from 1991 to 1996.8 14.5 34.

8 108.1 5.7 1.9 31.4 15.3 3.9 10.2 14.4 10.8 31.5 19.5 1.7 10.0 4.9 0.1 2. .9 5.16 External Debt.3 0.9 29.8 12.2 0.4 18.1 0.1 30.3 0.3 0.1 Source: Bank of Thailand.7 109.5 14.9 10.3 12.1 0.1 22.0 11.2 32. 1986-1999 ($ billion) Private Nonbank Long-Term Short-Term 3.Table 4.2 2.1 23.7 0.1 34.3 0.0 11.8 0.5 12.6 18.6 52.2 15.5 12.3 37.4 3.7 24.3 2.9 6.0 Long-Term Short-Term BIBF Commercial Bank Long-Term Short-Term 0.3 16.3 3.3 — — — — — — — 6.7 23.4 5.9 6.3 20.1 0.1 0.0 8.0 3.1 95.3 0.9 7.3 0.3 10.0 6.6 7.2 10.9 4.2 0.9 3.4 2.9 1.5 4.0 21.9 11.0 13.1 64.4 — — — — — — — 1.9 43.3 105.8 10.6 Total 18.9 35.3 0.0 0.6 — 0.8 3.7 13.8 13.5 4.9 1.3 0.6 1.9 3.2 2.5 16.6 Government Year Long-Term Short-Term 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 12.7 20.8 3.9 13.2 0.7 2.9 100.1 12.2 2.3 7.

The effects of the crisis were felt across all industry sectors.360. the SET Index stood at 1. banks would be recording more of such NPLs. Trading volume has since been thin. the number of newly registered companies dropped to a 10-year low in 1998. closures. Meanwhile. leaving domestic investors with large capital losses. On average. NPLs spiraled from 12 percent in the second quarter of 1997 to almost 40 percent in the third quarter of 1998. It hit a 10-year low in the second quarter of 1998. Due in part to liquidity problems on the one hand. nonfinancial companies also experienced severe liquidity problems as a result of the baht’s devaluation. The proportion of NPLs as a percentage of outstanding loans demonstrates the liquidity problem experienced by the corporate sector. outstanding credit also declined throughout the second half of 1998. Foreign investors retreated from the market. according to the Bank of Thailand. Even before the crisis. After that.Chapter 4: Thailand 263 This shows that although banking and finance companies suffered most because of their short-term exposure. exposing the companies to disaster when the baht started tumbling on 2 July 1997.6 in December 1996. SET’s dismal performance is indicative of the extent of the setback suffered by the Thai capital market. and poor business confidence on the other. from its peak in 1995. suggesting that serious investors have not returned to the market. large Thai companies had actively borrowed at low interest rates from foreign financial institutions. the liquidity problems faced by the corporate sector are likely to continue for some time.281 in December 1995 and to 831. Similarly. The severity of the impact of the crisis on the corporate sector was apparent from (i) the decline in the volume of public offerings. the index declined to 1. At the end of 1994. trading activity at SET had been on the downturn. Aside from the problem of NPLs. 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.17). and drastic decline in the number and capital of newly registered companies.6 billion from the 1996 level of B201 billion. The value of public offerings sank in 1997 to B56. reaching 45 percent of total outstanding credit in December. With easy access to foreign funds. and (iii) bankruptcies. If lending rates remained high. Most of these foreign debts were not properly hedged. foreign currency-denominated debts constituted 55 percent of their total debt portfolio. . based on the three-month past due definition. (ii) the rise in the nonperforming loan (NPL) ratio and consequent tightening of credit even for viable firms. the numbers of bankruptcies and company closures reached all-time highs in 1998 (Table 4.

112 9.288 35.224 4.977 Source: Department of Commercial Registration.17 Number of Newly Registered and Bankrupted/Closed Companies.904 20.677 Bankrupted/Closed 2.915 37.409 6. 4. Vol.902 3. 1985-1999 Year 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Newly Registered 10.925 12.2 Responses to the Crisis Initially.695 3.410 37. Thailand. IMF required Thailand to meet a set of performance criteria and implement various restructuring measures.307 4.410 5.134 31. It also explains the higher dividend yield ratio. But when assistance from other sources did not materialize.5 at the end of 1994 to 12 in 1996 and further to 6.218 3.264 Corporate Governance and Finance in East Asia. . The first Letter of Intent was cosigned by the Minister of Finance and the Governor of the Bank of Thailand on 14 August 1997.777 11.080 9. As part of the assistance package.201 24. The increase of the P/E ratio in 1998 was mostly a result of a decrease in earnings for most listed companies.797 4.6 in 1997.407 28. A steady price decline over the past few years has dragged down the ratio of market price to book value.052 36.2 billion for balance of payments support and buildup of the country’s reserves. The IMF financial package was a credit facility of $17. the Thai Government was lukewarm to the idea of obtaining IMF assistance because of the requirements and conditions attached to the financial package. Ministry of Commerce.066 19.095 14.312 25.5. The price-to-earnings (P/E) ratio deteriorated from 19.334 4.792 7.105 4. II Table 4.933 25. the Government was left with no choice.096 22.

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

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

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

who are also the managers. Where equity will come forward. the main problem is overlooked. minority shareholders are likely to be wary of increasing their equity without corresponding control mechanisms at their disposal. The proposal clearly delineates duties of care and loyalty for directors of public companies. they face the prospect of being unable to compete for the scarce funds available in the equities market. Vol.e. The only reason Thai investors placed their money in stock issues despite these legal cracks was the rapid increase in stock prices in the 1990s. The 1992 Act also allows directors to engage in business activities that may directly or indirectly affect the company. to borrow from the company without consideration to the fairness of the transaction or transparency of the approval process. subject only to approval by the board of directors. Consequently. minority shareholders have no chance of being represented in the board. i. The proposal for the amendment of the Public . without cumulative voting. This may be true in countries where publicly traded companies are widely held.268 Corporate Governance and Finance in East Asia. The regulators are drafting a proposal to amend the provisions on related transactions. Because of high ownership concentration. vis-a-vis the minority shareholders. In addition. disrupts the company’s management and decision making. this is not so in publicly traded companies in Thailand. The 1992 Act only prescribes—not requires—the use of the cumulative voting procedure. 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.. In the absence of such a stock market boom now. there are few provisions in the Act that deal with related or connected transactions that potentially reduce shareholders’ value. But because this is the assumption embedded in the regulation. However. with the approval of the board. and determine voting results on virtually any matter. which. The textbook separation between owners who sit in the company’s board and professional managers who run the company does not apply in Thailand. claiming that it creates fragmentation in the board of directors. II Another issue is the assumption in the 1992 Act that there is a separation of ownership and control functions. in turn. it will probably be expensive because of the higher risk that comes with weak accountability mechanisms. the dominance of controlling shareholders. Most companies decide against cumulative voting. it permits directors. the controlling shareholders have the exclusive domain to appoint or exercise management. 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. Otherwise. But as demonstrated.

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

The exchange has already required that listed companies’ quarterly reports be directly comparable with annual statements. Philippines. 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. Emphasis was on the structure of corporate governance and patterns of corporate ownership and financing of publicly listed companies. behavior. the Thai Government managed its economy with the corporate sector as the main engine of growth and development. In the next three decades. and even Indonesia.1 Summary. the Government protected certain corporate sectors through tariffs and regulation. Conclusions. and performance during this period helps understand the causes of the crisis.6 4. and Recommendations Summary and Conclusions This study has provided an overview of the corporate sector and governance in Thailand.270 Corporate Governance and Finance in East Asia. and promoted key industries through incentives. It required listed companies to establish their own audit committees by the end of 1999. 4. For this reason. The . Financial information from listed companies will also soon be required to conform to International Accounting Standards. Vol. Reforms through SET and Improved Disclosure The financial crisis prompted SET to introduce a range of improvements to its operation and regulation. II Malaysia. 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. 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. Such improvements in disclosure standards are part of the efforts of SET and SEC. Examination of corporate ownership. to push companies to harmonize their accounting with international standards. The study covers the period 1985 to 1996. Weak bankruptcy procedures were part and parcel of the perverse set of incentives that led firms to build up unsustainable levels of debt. The banking industry played a key role in the early stages of economic development because it represented the only avenue for funding Thai corporations.6.

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

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

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

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

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

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

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

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