The Governance of East Asian Corporations: Post Asian Financial Crisis

The Governance of East Asian Corporations Post Asian Financial Crisis

Ferdinand A. Gul and Judy S.L. Tsui

The Governance of East Asian Corporations

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The Governance of East Asian Corporations Post Asian Financial Crisis Ferdinand A. Gul PhD, MCom, ACA (Aust), FHKSA, CPA

Judy S. L. Tsui PhD, MSc, FCPA, FHKSA, CA

Selection and editorial matter © Ferdinand A. Gul and Judy S. L. Tsui Individual chapters © Contributors 2004 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2004 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 1–4039–4410–5 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Governance of East Asian corporations: post Asian financial crisis/ edited by Ferdinand A. Gul, Judy S. L. Tsui. p. cm. Includes bibliographical references and index. ISBN 1–4039–4410–5 (cloth) 1. Corporate governance–East Asia. 2. Corporate governance–Asia, Southeastern. I. Gul, Ferdinand A. II. Tsui, Judy S. L., 1955– HD2741.G6895 2004 338.6v095–dc22 2004047314

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Dedicated to the memory of my late father, Haji Mohamed Gul. Ferdinand A. Gul Dedicated to my dad, my husband and my three children for all their love and support. Judy S. L. Tsui

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Contents xi

List of Tables and Figures

xii

Preface

xvii

Acknowledgment

xviii

About the Contributors 1

Introduction and Overview Ferdinand A. Gul and Judy S. L. Tsui 1.1 Relationship versus market-based systems 1.2 What is corporate governance 1.3 Legal and regulatory environments 1.4 Legal systems and investor rights and protection 1.5 Board structure 1.6 Ownership structure 1.7 Corporate governance guidelines – Cadbury and others 1.8 OECD principles 1.9 Country overviews 1.10 Overview 2

2.1 2.2 2.3 2.4 2.5 2.6 2.7

Shareholding Structures, Related Party Transactions and Corporate Governance in China Wei Guo Zhang Introduction Background Main characteristics of joint stock company formation for IPO Main characteristics of the shareholding structure of listed companies in the PRC Corporate governance problems arising from the above characteristics Issues highlighted by analyzing financial information Adopted and proposed measures

vii

1 2 3 4 6 7 10 11 15 24

27 28 32 33 37 41 44

viii Contents

3 3.1 3.2 3.3 3.4 4

4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 5

5.1 5.2 5.3 5.4 6

6.1 6.2 6.3 6.4 6.5

Governance in Family-Owned Hong Kong Corporations Judy S. L. Tsui and Vanessa Stott Introduction Recent corporate governance developments Challenges for corporate governance reform in Hong Kong Conclusion Political Patronage, Cross-Holdings and Corporate Governance in Indonesia Etty R. Wulandari and Asheq R. Rahman Introduction Background Business regulatory framework Corporate governance Disclosure rules and regulations Corporate governance of the Top 100 listed companies Discussion Conclusions Corporate Governance in Japan: Role of Banks, Keiretsus and Japanese Traditions Huong N. Higgins Introduction The Legal framework and traditional characteristics of Japan’s corporate governance environment Economic pressures and corporate governance reforms Conclusion Paradoxes of Governance: Ownership and Control of Corporate Malaysia Edmund T. Gomez Introduction Defining corporate governance The state of capital: corporate development 1970–2000 Ownership and control: Top 100 firms Conclusion: paradoxes of governance

54 60 65 67

71 71 73 76 80 86 88 92

96 97 104 111

117 118 120 127 132

Contents ix

7

7.1 7.2 7.3 7.4 7.5 8 8.1 8.2 8.3 8.4 8.5 9 9.1 9.2 9.3 9.4 9.5 9.6

Corporate Governance in the Philippines: Legal and Institutional Aspects and Impact on the 1997 Financial Crisis and its Aftermath Stephen G. Lynn Introduction Governance mechanisms available Legal and regulatory influence Country-specific obstacles and difficulties Overall assessment

138 139 142 150 153

Corporate Governance in Singapore: Past, Present and Future Yuen Teen Mak Introduction 155 Corporate governance in Singapore: pre-crisis 156 Recent corporate governance developments in Singapore 164 Corporate governance practices in Singapore 168 Summary and conclusions 170 Chaebols and Corporate Governance in South Korea Francis C. Kim, Chung-Ki Min and Christopher Maden Introduction Corporate governance in Korea: pre-crisis Financial crisis in Korea Corporate governance developments in Korea Evaluation of Recent Developments Conclusion

10 Relationship-Based Business Enterprises and Recent Corporate Governance Reforms in Taiwan Ben-Hsien Bao, Chen-En Ko and Yin-Hua Yeh 10.1 Introduction 10.2 Legal framework 10.3 Accounting and auditing regulations 10.4 Corporate governance mechanisms 10.5 Obstacles and difficulties in improving corporate governance mechanisms 10.6 Recent corporate governance reforms in Taiwan 10.7 Conclusion

177 179 186 187 192 195

199 199 201 203 204 208 212

x Contents

11 Problems of Corporate Governance Reform in Thailand Deunden Nikomborirak 11.1 Introduction 11.2 Legal and regulatory framework 11.3 Governance mechanisms available 11.4 Obstacles in improving corporate governance 11.5 Future developments and conclusions

216 217 225 231 233

Index

236

List of Tables and Figures List of Tables 1.1 1.2 2.1 2.2 2.3 2.4 2.4a 4.1 4.2 4.3 6.1 6.2 9.1 9.2 9.3 9.4 11.1 11.2 11.3

Summary of Legal Protection and Enforcement in Different Countries Comparison of Different Countries on Consensus Economics Forecasts Development of PRC Stock Market and Promulgation of Laws and Regulations Related to Corporate Governance Stock Market Statistics in the PRC Market Value of Publicly Traded Stock of Listed Companies in the PRC Percentage of State Owned Stocks in Listed Companies in the PRC Breakdown of Controlling Shareholders Comparison of Total Assets (in Rp. Trillion) Enforcement Actions in the Capital Market Ownership Structures Malaysia: Ownership of Share Capital (at par value) of Limited Companies, 1969–2000 (percentages) Malaysia’s 20 Richest Business People, 2001 Number of Cases under Insolvency Laws Economic Indicators Firms with Interest Payment Coverage Ratio (IPCR) below 1 Shares (%) of Stock Holdings in the Top 30 Chaebols Leverage Ratio Among Listed Thai Companies Frequency of Multiple Directorships of Listed Companies, 1998 The Role of Institutional Investor in the Thai Stock Market

8 16 29 31 34 36 37 80 84 87 121 127 184 193 194 196 219 227 229

List of Figures 4.1 11.1

The Indonesian Capital Market Structure Percentage of Firms with (x number) of Independent Directors on the Board xi

75 226

Preface The 1997 Asian Financial Crisis (AFC) was perhaps the most devastating economic event of the 20th century. It saw East Asian stock markets plummet by an average of 40% while currencies throughout the region lost 50% of their value. The crisis involved both public and private institutions and, broadly speaking, the problems in the private sector can be attributed to excessive or unrealistic investor optimism (Shleifer and Vishny, 1997). The explanation proceeds along the following lines. Throughout the 1980s and 90s East Asian governments became involved in the corporate sector through “state led development”. Japan’s Ministry of International Trade and Industry, for example, selected industries for development, and the South Korean government (through chaebols – similar to keiretsus in Japan) followed the Japanese model. Similar patterns of government involvement may also be observed in Singapore, Malaysia and Indonesia. This “state led development” also meant that governments became involved in aiding troubled firms, or participating in other forms of political patronage, giving investors the impression of some kind of a government guarantee. Indeed, some investors got the impression that companies could succeed because of their political connections rather than through their own innate efficiency, but it assisted the “Asian miracle” (Shleifer and Vishny, 1997).1 Eventually, however, some large investors started looking a little deeper and doing their own sums. It became apparent that many companies lacked “economic fundamentals”: a term used broadly to describe low levels of debt and accruals and high levels of operating cash flows. In addition, there were several instances of company management expropriating the interests of shareholders. Johnson et al. (2000) cited some examples of this behavior in various countries around the time of the AFC. One example which epitomizes the problem is the Bangkok Bank of Commerce in Thailand – a case which the Asian Wall Street Journal called “patient zero” of the crisis. During the early 1990s and leading up to the crisis, the Bangkok Bank of Commerce extended loans to prominent politicians, and companies owned by bank officers, for the purpose of buying stakes in Thai listed companies. As the previously rapid growth of the stock market slowed, it became increasingly difficult for loans to be repaid. Around xii

Preface xiii

the same time, evidence suggested that the bank officers were moving funds to offshore companies that they personally controlled. When the problems of the bank became public, depositors began withdrawing funds, compounding the bank’s difficulty. Another, and possibly the most common type of expropriation during the AFC was the diversion of funds, profits, or losses from one company to another connected company, for example to a parent company, or other group member. Reasons for doing this included improving the results of an underperforming company or covering a cash shortage resulting from misappropriated assets. The biggest problem with this kind of activity is that the ownership of the companies involved was probably not the same, so it was likely that the shareholders of one company would suffer for the benefit of different shareholders of the other company (i.e., a shareholder has been expropriated). Another problem associated with these types of transactions was that the financial results would not accurately reflect the actual results of the individual companies. Three good illustrations of this kind of behavior are: • In November 1997, cash-rich United Engineers (Malaysia) Bhd. acquired a 33% stake in its parent company, Renong Bhd, paying an artificially high price for the shares. The company was then able to obtain a waiver from the regulators so that they would not have to offer the same deal to the minority shareholders of the parent company. The parent company was in financial trouble and needed the cash; • In 1997–98, managers of the Sinar Mas Group in Indonesia shifted foreign exchange losses from a manufacturing company to a groupcontrolled bank. This effectively expropriated the bank’s creditors and minority shareholders; • Samsung Motors of Korea incurred huge debts in order to finance startup costs until they could begin generating revenues by selling automobiles. These debts were guaranteed by Samsung Electronics and other related companies without the required disclosures. Around 1997, it also appeared that Samsung Electronics was funneling cash to Samsung Motors (and other related companies) that were losing money. According to an article in The Economist (September 11, 1999), this practice was not uncommon, and in a two year period around the time of the financial crisis, Korea’s biggest five chaebol (conglomerates) siphoned a combined amount of nearly US$12 billion to subsidiaries.

xiv Preface

Johnson et al. (2000) points out that the management of companies in emerging markets is typically the controlling shareholder, so transfers such as the ones described above are easy to achieve. Compounding this problem is that in many cases, the controlling shareholders do not have to break local laws to expropriate! All these factors led to the beginning of the loss in investor confidence that may be seen as the single largest factor precipitating the crisis. Investors also realized that in many markets, there was inadequate financial disclosure, poor financial transparency, high levels of debt, and too much discretion allowed in the choice of accounting methods under Generally Accepted Accounting Principles (GAAP). In other words, investors were concerned with “poor corporate governance”. They realized that they could not get a clear picture of their investments, decided their money was not safe, and left the market in a panic. The exit by investors resulted in a loss of foreign capital that has still not been replaced, and many economies in the Asian region are still reeling from the crisis at the time of this book going to press. An upshot of the crisis and the loss of investor confidence is a realization that poor financial disclosure and transparency have their roots in poor corporate governance. During and immediately after the AFC, mainly to stem the tide of an erosion of investor confidence, several countries instituted corporate governance reforms. Unfortunately, as chapters of this book will illustrate, some of the same characteristics of corporate governance prior to AFC can still be found: the outlook still has the potential to be bad. Even in countries such as the United States, where corporate governance is considered to meet very high standards, financial disasters such as Enron and WorldCom are still occurring. If the safeguards are insufficient to prevent or warn of such failures in developed markets, the potential for large companies to fail without warning in less developed markets must also be very real.

Objective and motivation of this book While several East Asian countries share some common heritage, there is also much diversity in the way the legal systems in each country have evolved and the extent to which corporate governance reforms have been implemented. What are the key institutional and regulatory corporate governance features in each of these countries? Of the countries which have instituted reforms, some have been more successful than others. Which countries instituted reforms and what impact did

Preface xv

these reforms have? This book is an attempt to answer some of these questions and better understand the characteristics and features of corporate governance in selected East Asian countries. In this book we examine the corporate governance landscape of ten East Asian jurisdictions: China, Hong Kong, Indonesia, Japan, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand. Our focus is on developments after 1998, the year the financial crisis was supposed to have ended. The descriptions therefore cover the years 1999 and 2000. Of particular interest are the legal and regulatory frameworks, and whether there were pre-existing characteristics that were significant in terms of contributing to the impact of the crisis in that market. The most important aspect of this survey will be the examination of what measures governments and regulators have made since the crisis, and whether or not they were effective in improving corporate governance. Since there is much diversity in the way political reform and corporate governance has evolved based on different institutional/legal frameworks in East Asian countries, the issues and emphasis of topics in the different country chapters naturally are different. A case in point is Edmund Gomez’s chapter on Malaysia where he emphasizes the role of the state and political parties in the corporate sector and, in some cases, going to great lengths to outline the role of various political figures in corporate governance. China is an interesting showcase of economic reform in a socialist system and Zhang Wei Guo provides insights on the difficulties of implementing capital market reforms but keeping the state economic control apparatus in place. These insights provide an interesting and contrasting view to other systems where such political patronage in the corporate sectors is less pronounced or absent or where capitalism has its roots firmly entrenched. The diversity in the approaches that different authors have brought into this set of readings provides contrasting emphasis on the way corporations are managed and function. The conclusions of these country investigations should provide future guidance on what steps governments and regulators should take to improve corporate governance in their region, learning from the combined experience of East Asian countries, and benefiting from the failures and successes of the years since the crisis. A limitation of the book is that it covers development up to the year 1999 (including in some cases up to 2003) and many developments in corporate governance reform have taken place since then. The dynamic nature of the corporate sector requires constant changes/modifications to corpo-

xvi Preface

rate governance and as such this is an ever-changing scenario. A final caveat relates to the fact that the views of the authors in each chapter are not necessarily the views of the editors. Ferdinand A. Gul Judy S. L. Tsui

Notes 1. An extreme view of this interpretation is that investors are partially rational and they are prone to extremes of “euphoria” and “revulsion” (see Kindleberger, 1989).

References Johnson, S., P. Boone, A. Breach and E. Friedman (2000) Corporate governance in the Asian financial crisis. Journal of Financial Economics 58: 141–186. Kindleberger, C. P. (1989) Manias, Panics and Crashes. New York: Wiley Investment Classics. Shleifer, A. and R. Vishny (1997) A survey of corporate governance. Journal of Finance 5 (June): 737–783. The Economist, Sept 11, 1999.

Acknowledgment We acknowledge the financial support of the Accounting and Corporate Governance Centre, the Department of Accountancy and an Applied Research Grant, of City University of Hong Kong. We would also like to thank Eric Cherneff and Chris Maden for editorial suggestions. The editorial assistance of Amy Kwan and Jenny Low is gratefully acknowledged.

xvii

About the Contributors Ben-Hsien Bao – Associate Professor, School of Accounting and Finance, The Hong Kong Polytechnic University Edmund T. Gomez – Associate Professor, Faculty of Economics & Administration, University of Malaya Ferdinand A. Gul – Chair Professor of Accounting, Head of Department of Accountancy and Director of Accounting and Corporate Governance Centre, City University of Hong Kong Huong N. Higgins – Associate Professor, Department of Management, Worcester Polytechnic Institute, Massachusetts, USA Francis C. Kim – Associate Professor, Queens College, City University of New York Chen-En Ko – Professor, Department of Accounting and Dean of College of Management, National Taiwan University Stephen G. Lynn – Associate Professor, Department of Accountancy, City University of Hong Kong Christopher B. Maden – Freelance writer and researcher with a wide range of interests Yuen Teen Mak – Co-Director, Corporate Governance and Financial Reporting Centre, The NUS Business School, National University of Singapore, and Council Member, Singapore Institute of Directors Chung-Ki Min – Professor, Department of Economics, Hankuk University of Foreign Studies, Korea, and Visiting Fellow, School of Accounting and Finance, The Hong Kong Polytechnic University Deunden Nikomborirak – Research Director, Economic Governance, Thailand Development Research Institute Asheq R. Rahman – Associate Professor, Accounting, Nanyang Technological University Vanessa Stott – Associate Professor, School of Accounting and Finance, The Hong Kong Polytechnic University xviii

About the Contributors xix

Judy S. L. Tsui – Chair Professor of Accounting, Dean of Faculty of Business and Director of Graduate School of Business, The Hong Kong Polytechnic University Etty R. Wulandari – Senior Officer, Indonesian Capital Market Supervisory Agency (BAPEPAM) Yin-Hua Yeh – Professor, Department of International Trade and Finance, Fu Jen Catholic University Wei-Guo Zhang – Chief Accountant, China Securities Regulatory Commission

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1 Introduction and overview Ferdinand A. Gul and Judy S. L. Tsui

In the late 1970s it seemed evident that U.S. corporations were losing their global competitive edge as the Asian economies grew far more rapidly than any other region in the world. The World Bank referred to a number of countries in the region as “high performing Asian economies.”1 Most notable amongst these was Thailand, which was described as the fastest growing economy, and which both the International Monetary Fund (IMF) and the United Nations Development Programme (UNDP) regularly used as a model for other nations to follow.2 Other countries that received favorable assessments from these agencies include Indonesia, South Korea, Taiwan, Singapore and Malaysia. China and Philippines also saw higher Gross Domestic Product (GDP) growth than the rich industrial countries between 1990–1996. While the rich industrial countries including the U.K. and the U.S. posted an average annual 2% GDP growth between 1990 and 1996, the Asian countries surveyed in this book showed higher levels of GDP growth for the same period. All the countries except the Philippines (2.8%) posted more than 5% annual average GDP growth (The Economist, March 1, 1997). What were the factors that saw the emergence of these “tiger” economies? To understand the growth phase of the Asian economies and the severity of the Asian Financial Crisis (AFC), we turn to an important stream of theoretical literature that has emerged in corporate governance research.

1.1

Relationship versus market-based systems

This stream of literature relates to historical factors that may be conveniently described as a “business culture” that has evolved over the years because of the colonial heritage of Asian countries as well as local 1

2 The Governance of East Asian Corporations

custom, politics and values. This thinking has spawned several theoretical frameworks of which the Rajan and Zingales (1998) framework is the most appealing. They classify economies as either “market-based systems”, such as that found in the U.S., or “relationship-based systems”, such as those found in many East Asian markets. The marketbased or “arms length” system depends more on the explicit contracts that are formed between parties. On the other hand, the relationshipbased system is based largely on implicit guarantees and trust between the individuals involved. Because of the reliance on relationships, an elaborate system of formalized corporate governance rules does not typically emerge in markets where this system is prevalent. The relationship-based systems have their roots in the close links between banks, businesses and government through family, political, and ownership connections. Chaebols in Korea, Keiretsus in Japan, and political patronage in Malaysia are some prime examples of such systems. However, this system suppresses the market pricing system and can result in the inefficient allocation of large external capital inflows that come from predominantly arm’s length lenders (for example, European Union banks). As Jackson (1999, p. 6) argued: “the abundance of inexpensive capital, in combination with local banks based on personal relationships rather than real business plans, resulted in widespread misallocation of capital into speculative and noncompetitive sectors and enterprises”. Since foreign investors are aware of misallocation and other abuse, they minimize their risk by keeping their claims short-term in order to exit at the first sign of trouble. The Rajan and Zingales (1998) argument implies that the contact between the relationship based system and the arm’s length system of foreign investors create a “fragile hybrid” which works well in normal times, but is prone to shocks such as the AFC (Walker and Reid, 2002). Some evidence supporting the relationship versus market based systems is that although both these systems are found in the Asian region, the markets with relationship-based systems (i.e., Indonesia, Malaysia, Thailand, and Korea) were generally harder hit by the crisis than more market-based countries (i.e., Hong Kong and Singapore) as measured by exchange rate depreciation (Johnson et al., 2000).

1.2

What is corporate governance?

It is worth clarifying what, exactly, corporate governance means. In the simplest terms, corporate governance concerns the relationships

Ferdinand A. Gul and Judy S. L. Tsui 3

between a company’s owners, managers, board of directors (BOD), and other stakeholders. Agency theory provides a theoretical perspective in which to discuss these relationships. Specifically, in order for owners to get what they want (i.e., increased value of their investment), they must contract with non-owner managers to run the company, and with the BOD to oversee the management of the company. The contracts attempt to regulate behavior to achieve the desired investor objectives. However, a concept which quickly becomes apparent is that of incomplete contracting, which suggests that contracts will never adequately cover all aspects of the complex set of relationships involved. The development of corporate governance is an attempt to oversee these relationships, and beyond the scope of formal contracts, to regulate behavior so as to achieve the desired outcome and appropriate rewards for all parties involved. Corporate governance can be addressed at many levels. It may be considered on a broader scale in terms of the rules and regulations making up the regulatory and legal framework of a country. However, it is not just a “big picture” issue; it is also considered on a much smaller scale within individual companies: the setting of a mandatory retirement age of directors, appointments of non-executive directors, how managers are appointed and remunerated and so on would be considered corporate governance issues. A thorough examination of corporate governance must include all of these areas, along with the mechanisms for ensuring that rules and regulations are not only in place, but are also enforced. It is therefore best to start with the rules and regulations or the legal infrastructure.

1.3

Legal and regulatory environments

The history of the development of countries, particularly colonization in South East Asia, is a strong influence in the development of legal and regulatory environments. Malaysia, Singapore, and Hong Kong have similar backgrounds as former colonies of the U.K. Malaysia was established in 1957, composed of Singapore and Malaya, however, Singapore seceded in 1965. Until 1997, Hong Kong had a long history as a British colony. In July 1997, it was returned to China, but continues to operate under a “one country, two systems” policy which essentially means that its legal system and regulatory environment continue largely unchanged from what they were under British rule (that is, a common law system prevails). Singapore and Hong Kong have sophisticated financial systems and stock markets and are widely considered to have

4 The Governance of East Asian Corporations

the highest standards of corporate governance amongst Asian countries. After a long history as a Spanish colony, The Philippines was ceded to the U.S. in 1898, and achieved independence in 1946. Its legal system is based mainly on Spanish and U.S. common law. Regions that have a German, Dutch, or French history typically have a civil law system; this includes Indonesia and to certain extent South Korea. Thailand was never colonized, but the legal system was heavily influenced by the civil law system from Europe, and Japan’s legal system, is itself based on European civil law, with some influence from English-American common law. China’s legal system is somewhat different from the others, but is basically civil law, with many adjustments in the past two decades, especially in the areas of civil, administrative, commercial and criminal law. The recent changes reflect the dynamic state of the legal and regulatory frameworks and the relatively immature capital market in China. Taiwan’s legal system originated from traditional China and adopted Western law when it was occupied by Japan in the 19th century. The common law system is based on judges’ previous decisions in court cases, dating back many years, often referred to as precedents. Rather than referring to statutory laws, a judge tries to decide a case by reference to similar cases in the past. Common law is undergoing constant, albeit slow, change and evolves to adapt to new situations brought about by technology, etc. Common law fills the spaces in areas that written law (statute) does not cover, and includes broad areas of law, including those related to property, torts and contracts. In contrast, a civil law system attempts to establish written rules (or legal codes) that provide a basis for making judgments. A judge is bound by the existing codes or statutes. The reason legal systems are relevant to the evaluation of corporate governance is that they offer different degrees of protection for investors, and affect the ability of investors to exercise their rights. It is also important to note that for rules to be effective, they must be accompanied by predictable enforcement. If there are no negative consequences for breaking rules, then there is little or no incentive for them to be followed. The following paragraphs describe why this matters.

1.4

Legal systems and investor rights and protection

There are two major factors that are key elements of the corporate governance system in any country. First, civil and common-law legal

Ferdinand A. Gul and Judy S. L. Tsui 5

systems result in varying degrees of legal protection for investors. The second major factor is corporate ownership concentration, which is discussed in Section 1.6. La Porta et al. (1997) found evidence that the breadth and depth of a country’s capital market was dependent on the legal environment, particularly the country’s laws and their enforcement. In surveying both common law and civil law countries, they found that common law countries generally had better investor protection and more developed capital markets when compared to civil law countries (La Porta et al., 1997, 1998). These studies suggest that common law countries offer better investor protection through laws and legal enforcement than do civil law countries. Regardless of whether a country has a common or civil law system, the basic mechanism for enforcement remains the same. The highest level of rules and regulations in any jurisdiction usually comes from that country’s corporate legislation, which sets out the basic law that all corporations must follow. Enforcement of these rules is typically the responsibility of the government or a quasi-governmental body. For companies that have publicly traded securities, and for the entities involved with the trading of securities (i.e., securities exchanges, securities dealers, other market participants), there are additional rules that must be followed. These are usually contained within the country’s securities laws, and are monitored and enforced by the country’s securities authority (or equivalent). The lowest level of regulation and enforcement is found within the individual stock exchanges. Often self-regulated, the exchanges are responsible for setting rules and regulations for market participants, and also for the enforcement of these rules. The authority of these rules generally arises from the explicit agreement of participants as a condition of their participation in the exchange as a listed company. The rules at this level often go hand-inhand with the country’s securities laws, and the exchanges will often work closely with the securities commission to ensure smooth operation of the market. The level of legal infrastructure is an important factor that has influenced the development of relationship-based systems. Emerging economies often have insufficient legal frameworks in place, and frequently are ill-prepared to deal with the complexities of modern corporations and their ownership. La Porta et al. (1997) analyzed a number of countries (including all of the countries in this book except China) and assessed them in the three areas of shareholders’ rights, creditors’ rights, and rule of law. They found that, in general, countries with civil law systems offered lower

6 The Governance of East Asian Corporations

levels of investor and creditor rights, as well as a lower rating of rule of law. This distinction can be clearly seen in the summary comparison table (see Table 1.1) – both shareholders’ and creditors’ rights are lower in the five civil law countries. The average rule of law score was 7.5 for common law countries and 5.9 for civil law countries. In addition to the lower numerical score, a much wider range of values is seen among the civil law countries. The average shareholders’ and creditors’ rights were 3.3 and 3.5 respectively for common law countries, and 2.8 and 2.2 respectively for civil law countries. The difference is even more apparent if the Philippines shareholders’ rights and Indonesia’s creditors’ rights scores are omitted. Since these two countries have the lowest rule of law scores of the group, it is more likely that even though rights exist, it will be more difficult for shareholders and creditors to enforce them. Corruption and expropriation of shareholders’ interests are other issues that have a bearing on legal protection and enforcement. As shown in Table 1.1, Philippines and Indonesia also have the highest (worst) corruption and expropriation scores, thus further exacerbating the poor level of shareholders’ protection. Compounding this problem is lax enforcement of the existing rules and regulations: a rule alone is worthless – it must be properly enforced for it to be taken seriously and obeyed. The same things are true of corporate governance. A formal approach to corporate governance was something few emerging economies’ governments had expended much time on. Even within the so-called “developed markets”, a formal approach to corporate governance was a fairly recent development. One of the earliest significant investigations into corporate governance was the Cadbury Report (see Section 1.7), which was published in the U.K. in 1992. It was prompted by a series of high profile corporate failures in the late 1980s, and resulted in the formalization of a voluntary code of conduct for corporate governance which was subsequently incorporated into the Listing Rules of the London Stock Exchange.

1.5

Board structure

When comparing corporate governance in common law and civil law countries, one of the first differences that becomes apparent is the structure of a company’s board. Companies in civil law systems generally have a dual board structure while, under common law systems, a unitary board is the norm. Regardless of the board structure, the objectives are the same: to run the company and increase company value.

Table 1.1

Summary of Legal Protection and Enforcement in Different Countries China

Hong Kong

Indonesia

Japan

Malaysia

Philippines

Singapore

South Korea

Taiwan

Thailand

Legal system

Largely criminal law, with civil code

Common law

Civil law (RomanDutch law)

Civil law, with Anglo-US influence

Common law

Common law

Common law

Civil law, with Anglo-US influence

Civil law

Civil law, with common law influences

Shareholder rights (Note 1)

n/a

4

2

3

3

4

3

2

3

3

Creditor rights (Note 1)

n/a

4

4

2

4

0

3

3

2

3

Rule of law (Note 1)

n/a

8.22

3.98

8.98

6.78

2.73

8.57

5.35

8.52

6.25

Corruption (Note 2)

n/a

8.52

2.15

8.52

7.38

2.92

8.22

5.30

6.85

5.18

Expropriation (Note 2)

n/a

8.29

7.16

9.67

7.95

5.22

9.30

8.31

9.12

7.42

La Porta et al. (1997) legal determinants (Note 1)

Note 1: Shareholder rights (range 0–5) is an index formed by giving 1 point for each of the following conditions being met: • Shareholders may vote by mail • Shareholders are not required to deposit their shares before the AGM • Cumulative voting is allowed • An oppressed minorities mechanism is in place • Minimum percentage of share capital required to call for an extraordinary shareholders’ meeting 10% or less Creditor rights (range 0-4) is an index formed by giving 1 point for each of the following conditions being met: • Restrictions, such as creditors’ consent or minimum dividends, to file for reorganization • Creditors can regain security once reorganization is approved • Debtor does not retain administration of its property during reorganization • Secured creditors ranked first in distribution of proceeds on disposal of assets of a bankrupt firm Rule of law (scale 0-10) assesses law and order tradition between 1982 and 1995. Higher scores indicate more tradition for law and order.

7

Note 2: Indices of corruption and expropriation, with a maximum score of 10. Lower scores indicate higher levels of corruption and expropriation. Source: La Porta et al. (1997).

8 The Governance of East Asian Corporations

However, the two different board structures have different strengths and weaknesses which have implications for corporate governance.

1.5.1

Unitary board structure

Under the common law legal system, management conducts the dayto-day running of the company, with a BOD overseeing them and conducting long-term planning for the company. Senior members of management, such as the Chief Executive Officer (CEO) are likely to be members of the board as well. When directors occupy management positions in the company, they are considered to be executive directors, and insiders with respect to the company. Membership in the board is achieved through recommendation by the existing board (possibly through a subcommittee), and confirmation through an election process by shareholders.

1.5.2

Dual board structure

In civil law countries such as China and Indonesia, companies will typically have a dual board structure. The two boards are the management board and the supervisory board. The management board is responsible for the day-to-day running of the business (much like management under the unitary board system). The supervisory board has an oversight role, similar to the role of the board in a unitary board system. In Germany (a civil law country), the German Code of Corporate Governance (GCCG, 2000), states that the essential tasks of the supervisory board include supervision, advising, and composition of the management board. Membership of the supervisory board is determined by shareholders, with recommendations for potential candidates coming from the shareholders themselves, or from the supervisory committee. In Germany, as in some other countries, other stakeholders, such as employees, may be permitted to have representation on the supervisory board. From its membership, the supervisory board will elect a chairman. The management board is responsible for running the company. The success in filling this role depends directly on the membership of the board, and the skills and qualities the individuals bring to the company. The supervisory board is responsible for appointing and dismissing the management board. Individuals may be a member of either board, but not both.

1.6

Ownership structure

As described earlier, two key elements of corporate governance are the legal system and ownership concentration. Ownership concentration is

Ferdinand A. Gul and Judy S. L. Tsui 9

important because without a large shareholder, or unified block of shareholders, management and the directors have no one to answer to. Ownership concentration can be seen as a corporate governance mechanism in terms of monitoring management (see Shleifer and Vishny, 1997). Corporations in Southeast Asia follow different patterns of ownership concentration, with some unique examples in the countries we examine. For example, companies in Japan often exhibit concentrated and stable ownership by banks (Yafeh, 2000). In Malaysia, the government has a large ownership in more than half the listed corporations (Cheong, 1997). More commonly in Southeast Asian companies we find a pattern of ownership that is often described as family based ownership. This pattern of ownership often shows a “pyramid” type structure, where one owner controls several entities, which in turn control other entities and so on. The complex web of ownership can be difficult to follow, but a study by Claessens et al. (2000) found that the majority of companies in Southeast Asia3 were affiliated to a group, controlled by entities that controlled other entities, and ultimately had one owner at the top. Most of the time the ownership was linked to family members, and hence the term “family owned corporations” (e.g., in Hong Kong). Clearly, the complexities and patterns of ownership affect the corporate governance systems in any one country and must be considered in any corporate governance reforms.

1.7

Corporate governance guidelines – Cadbury and others

Many of the reforms and changes in corporate governance in Asian countries find their genesis in several reports that have appeared in western countries in the last 15 years or so. The most famous and earliest is the Cadbury Report published in the U.K. in 1992. The report provided guidelines for financial reporting, and reviewed the roles of the board and the external auditor. The main objectives were to provide “best practice” for corporate governance while allowing enough flexibility for companies to adjust to their own circumstances. Although it was established as a voluntary code of conduct, it was eventually incorporated in the Listing Rules of the London Stock Exchange. In 1994, the Dey Report was published in Canada. It contained a full set of corporate governance guidelines and was noteworthy because it was one of the first set of guidelines to become mandatory. Companies listing on the Toronto Stock Exchange must explain any differences

10 The Governance of East Asian Corporations

between their corporate governance practices and the Dey Report guidelines. The impact of this requirement of listed companies was significant – for the first time, companies had to make explicit statements about their corporate governance, side by side with best practice. Investors would now be in a position to observe the differences, and question why the companies were not following best practice. In 1995, the Greenbury Report was published in the U.K. It was a report on executive remuneration, and addressed certain issues that were not covered extensively by the ground-breaking Cadbury Report. In 1998, the Hampel Committee was formed to consolidate recommendations of the Cadbury Report and the Greenbury Report, as well as develop additional guidelines for areas that were not covered by these reports. Another part of this committee’s review was to examine the extent of compliance with the earlier guidelines. The Hampel committee’s report stressed the importance of substance over form when addressing corporate governance guidelines and identified the “boxticking” mentality as being a serious problem. They advised that companies and boards should be prepared to apply informed judgment, flexibility and common sense to the individual circumstances of the company. Departures from corporate guidelines may be justifiable, and shareholders and other stakeholders should be prepared to show flexibility and judge on their own merits departures from best practice. In 1998, the guidelines in the final report of the Hampel Committee were published as the Combined Code. While the Code was not law itself, a listing rule of the London Stock Exchange made it mandatory for listed companies to comply with the Code, or explain departures from its recommendations. The Combined Code was, of course, tailored to the needs of a single, advanced economy. The Organization for Economic Cooperation and Development (OECD) recognized the need for more universal guidelines that could be applied to any country or market. These have provided guidance and influenced the various regulatory bodies in East Asia.

1.8

OECD principles

The OECD’s “Principles of Corporate Governance” was published in 1999 as a non-binding set of corporate governance principles for use by listed companies in OECD member countries. By their very nature, in order to be generic, the guidelines had to be very broad and avoid going into great detail. The main topics addressed are rights and

Ferdinand A. Gul and Judy S. L. Tsui 11

equitable treatment of all shareholders, disclosure and transparency, and the responsibilities of the board. Because they are not sufficient on their own, the Guidelines are intended to be a starting point for local regulators and if followed they will provide a uniform basis for corporate governance in different countries. Building on this OECD corporate governance foundation, the Pacific Economic Cooperation Council (PECC)4 released guidelines for its member countries in 2001. The intention was to build on the OECD Guidelines with consideration to existing practices in PECC member countries (which include all of the countries examined in this book).

1.8.1

Principles of corporate governance

It is not likely that there will ever be a uniform code of corporate governance accepted in all markets. There are simply too many variations in the legal systems, regulatory environments, company laws and local customs for it to be practical. Even within one market, there is great variation between companies: some are very large, some are very small, some have a long history and are very set in the ways they do business; some are new and dynamic. Because of these factors, the popular approach to corporate governance guidelines has been to develop principles, rather than rules, that can be used across different countries and markets. The “Principles of Corporate Governance” are a good example of this approach, and cover five broad areas, namely the rights of shareholders, the equitable treatment of shareholders, the role of stakeholders, disclosure and transparency, and the responsibilities of the board.

Rights of shareholders Rights of shareholders address the basic rights that all shareholders should have, regardless of their extent of ownership of a company. These rights include the right to secure methods of ownership registration, to convey or transfer shares, to obtain information about the company on a timely basis, to participate and vote in general shareholder meetings, to elect members to the board, and to share in the profits of the company. In addition to participation in general shareholder meetings, shareholders should have the right to be involved in decisions concerning fundamental corporate changes such as those affecting the statutes or articles of incorporation of the company. Shareholders should have access to sufficient information in a timely manner in order for them to make informed votes, either in person or in absentia. Finally, markets for control of ownership

12 The Governance of East Asian Corporations

(i.e., capital markets) should be operated in an efficient and transparent manner.

Equitable treatment of shareholders The OECD principles stress the equality of shareholders, regardless of the size of their shareholding, and regardless of whether they are domestic or foreign shareholders. All shareholders should have a right to obtain redress for the violation of their rights. This means that all shareholders of the same class should have equal voting rights and access to information. Insider trading and self-dealing should be prohibited and members of the board and managers should be required to disclose material interests in the company or transactions with the company.

Role of stakeholders The OECD has recognized that it is not only the shareholders who have an interest in the company, but also the stakeholders, who benefit from job creation and wealth from the sustainability of financially sound corporations. They recommend that the corporate governance framework assures that the legal rights of stakeholders are respected, and effective redress is available to those whose rights have been violated. It was also recommended that the framework permit performance-enhancing mechanisms for stakeholder involvement, and when stakeholders are involved in the corporate governance process, they must have access to relevant and reliable information.

Disclosure and transparency A large part of corporate governance is concerned with disclosure and transparency. The OECD principles state that the corporate governance framework should ensure the timely and accurate disclosure of all material matters relating to the financial situation, performance, ownership and governance of a company. Specifically, disclosure should include: • • • • • • •

Financial and operating results; Company objectives; Major share ownership and voting rights; Board members, key executives, and their remuneration; Material risk factors; Material issues related to employees and other stakeholders; and Governance structures and policies.

Ferdinand A. Gul and Judy S. L. Tsui 13

All information must be prepared, audited and disclosed to a high standard. In addition, an external and objective annual audit should be conducted by an independent auditor, and all information should be disseminated in a way that provides fair, timely and cost efficient access to information for users.

Board responsibilities The final section of the OECD principles addresses the responsibilities of the board. This section states that the board is accountable to the company and the shareholders for effective monitoring of management. The corporate governance framework should ensure these responsibilities are met, and that the company is guided strategically. The guidelines in this section are designed to help the board accomplish these goals, while at the same time protect the rights of shareholders and stakeholders. Key functions that the board should fulfill include: • Reviewing and guiding corporate strategy, as well as major short and long term decisions; • Selecting, compensating, and monitoring key executives; • Reviewing and ensuring transparency of the board nomination process and remuneration; • Monitoring potential conflicts of interest of board members, management, and shareholders; • Overseeing the accounting and financial reporting system, including internal controls, risk management, and independent audit; • Overseeing governance; and • Overseeing the disclosure process and corporate communications. In order to effectively accomplish these duties, the board must be able to exercise objective judgment, and remain independent from management. To improve independence, the board should consider using non-executive board members for issues where there are potential conflicts of interest. Examples of such issues include remuneration of board members and executives, nomination of board members and key executives, and financial reporting. Although there is only space for a summary of the key principles contained in the OECD corporate governance guidelines, it can be seen that they are general in nature and avoid being so specific that they would be difficult to apply in different markets or countries. By way of

14 The Governance of East Asian Corporations

a comparison, the London Stock Exchange’s Combined Code provides specific recommendations for corporate governance. They go further than the OECD recommendations by providing guidance on specifically how a company can help realize the OECD recommendations. Readers interested in the OECD recommendations and the Combined Code should consult the OECD (www.oecd.com) and the U.K. Financial Services Authority (www.fsa.gov.uk) websites and search for these documents.5

1.9

Country overviews

The individual chapters in this book will show that there is considerable diversity amongst the East Asian countries in terms of regulatory frameworks and corporate governance practices. While it is not the intention of this book to focus on differences in economic performance across the countries, it is worth noting that these differences are also considerable. For example, as shown in Table 1.2, while China, South Korea and Thailand have posted impressive economic figures, other countries such as Indonesia are expected to lag behind. As will become evident, the differences in economic performance are likely to have their roots in the quality of the legal system and corporate governance.

1.9.1

China

From a standing start in 1984, when China first de-nationalized a stateowned enterprise (SOE), through the creation of the Shenzhen and Shanghai stockmarkets in 1990, China has made astounding progress in the implementation of a regulatory and economic framework which will encourage transparency, disclosure, and protection of minority rights. At the time of going to press, some 90% of the companies listed in China’s stock markets were former SOEs. A large part of China’s transition to a market economy is mirrored in the voyage these companies have made – with varying degrees of success – to being privately owned corporations. Internally, there is a strong parallel to be drawn between the divestment of SOE’s non-business units, such as welfare centers and schools, and the People’s Republic of China (PRC) government’s own retreat from socialism. There is the replacement of the internal mechanisms of governance associated with social, non-business objectives, (in which the shareholders are there to serve the interests of other stakeholders), by mechanisms to maximize the value of the enterprise to all stakeholders.

Table 1.2

Comparison of Different Countries on Consensus Economics Forecasts China

Year 2002 GDP Current account ($billion)

Hong Kong

Indonesia

Japan Malaysia

Philippines Singapore

South Taiwan Thailand Korea

8.0 35.4

2.3 15.9

3.7 7.5

0.2 132.3

4.1 7.2

4.4 4.2

2.2 18.7

6.3 6.1

3.6 25.7

5.3 7.6

Year 2003 (Estimates) GDP 8.8 Current account 21.4 ($billion)

3.0 19.0

3.9 6.7

2.7 142.6

4.8 10.0

3.9 2.1

0.9 23.2

2.7 8.5

3.1 24.1

6.0 7.7

Year 2004 (Forecast) GDP 8.1 Current account 15.6 ($billion)

5.0 21.0

4.5 5.8

2.1 145.4

5.6 9.7

4.2 1.9

5.1 23.0

5.2 8.5

4.5 21.7

6.3 7.6

Source: Far Eastern Review (January 29, 2004).

15

16 The Governance of East Asian Corporations

Externally, there has been a similar change of purpose with increasing political recognition that smoothly functioning capital markets underpin economic growth, and that well-regulated markets function better – provide more efficient allocation of capital – than badly regulated ones. Despite the positive moves these trends have entailed, the stock market remains dominated by SOEs, and the ownership and control of these companies is still overwhelmingly in the State’s hands. The opaque ownership mechanisms employed by the State, and the lack of clarity in its continued purpose of ownership, are major obstacles to further progress.

1.9.2

Hong Kong

The families that built modern Hong Kong still dominate its stock market. With an average holding of 32.1% of the listed companies they created, they concentrate cash-flow rights in a proportion of 28%. Nonetheless, their companies have served Hong Kong well, and a balance must be struck between the family’s interests and those of minority shareholders. The former British colony’s legal system was maintained after China resumed sovereignty in 1997. At the time of the handover, ten pieces of legislation regulated corporate affairs. The enactment of the Securities and Futures Ordinance (SFO) in 2002 was a major step forward in the consolidation and clarification of both the detail and the intent of the law. A major advancement in this package of legislation was the criminalization of certain acts of malfeasance by directors, making Hong Kong one of the first jurisdictions of those surveyed to take this step. Corporate governance is, however, a rapidly advancing field, and the Standing Committee on Company Law Reform is considering further ways of strengthening minority rights. There are two broad streams to their recommendations: on the one hand, to increase transparency and disclosure, especially in the area of connected transactions; on the other, to provide statutory recourse to shareholders who have reason to believe their rights have been violated. Family ownership of firms, an under-developed culture of shareholder activism, and a scarcity of truly independent directors remain as obstacles to improvement. With many areas of governance encompassed in the listing rules, rather than given statutory authority, there is still room for improvement.

Ferdinand A. Gul and Judy S. L. Tsui 17

1.9.3

Indonesia

With 15 families controlling an estimated 62% of the market capitalization on the larger of the country’s two stock exchanges, and with un-listed SOEs accounting for almost the same capitalization as that stock market, Indonesia has a concentration of ownership second only to China in the countries we survey. The extreme rapidity of Indonesia’s economic development in the 1990’s led to a situation in which the regulatory environment had simply failed to keep up with the country’s economic growth. The 1997 crisis, the subsequent crumbling of the Suharto regime, and the ultimate democratization of the country, all contributed to an enhanced awareness of the need to improve corporate governance. As a result, the country has seen a rapid move towards the uptake of international standards in this area with significant improvements being made in clarifying board structures, diversification of ownership, including the opening up to foreign ownership and control of many previously protected industries and companies; disentangling bank ownership and tighter regulation on the banks; the introduction of audit committees and auditing standards in line with International Accounting Standards (IAS), and improved disclosure and reporting; and stronger regulation. Many companies, however, remain staunch resistors of change. For example, no company had an audit committee in place on 31 December, 1999 despite the main stock exchange requiring them to be in place by 1 July, 2000. Similarly, none had remuneration or appointment committees. Until ownership becomes more diverse, and enforcement stronger, it is unlikely that the change of mindset at the heart of good corporate governance will take place.

1.9.4

Japan

After the Second World War, Japan’s zaibatsu were re-incarnated as today’s keiretsu. These large industrial groupings, in conjunction with bureaucratic direction, played an instrumental part in a post-war rise that saw the country become the world’s second largest economy, with its market second largest by capitalization. The keiretsu resembled spider’s webs, with the banks in the middle largely supplanting the role of the market in terms of corporate governance. With privileged and detailed information on the affairs of companies through insiders on their boards, banks were able to exert strong – often decisive – influence on corporate strategy. They

18 The Governance of East Asian Corporations

withheld credit from under-performing keiretsu, while ensuring they only very rarely went broke, and similarly extended cheap credit to well-performing parts of the group. This arrangement was bolstered by a bureaucracy that micromanaged industrial policy. Able to protect the economy from foreign competition, the bureaucracy also injected huge sums of public money into industries that it believed had a future. With the opening of the Japanese market, however, this system began to unravel. While the export sector of the economy contained many companies that were able to compete on the world stage, the domestic companies often crumbled in the face of international competition. Loans turned bad, the asset bubble burst. By the mid-1990s, Japan’s economy was stagnant. In 2002, sweeping changes were made to the main piece of legislation regulating corporate conduct, the Company Code. While this has removed or mitigated many of the obstacles to better functioning market discipline – including takeovers, bankruptcies, shareholder suits and board independence – the driving force in business and politics remains the competitiveness of Japan as a whole rather than the strength of her markets. This deeply entrenched philosophy is a major factor in preventing Japan from maximizing the benefit to be obtained from her reforms.

1.9.5

Malaysia

Thirteen years after Malaysia had attained independence from Britain in 1957, British and ethnic Chinese interests still dominated ownership of the country’s businesses. In response to the resultant race riots of 1969 the government implemented a program of affirmative action to assist the indigenous Bumiputera people. This was effective in as much as, in the following two decades, the Bumiputera became far more prominent in business. The way in which companies were chosen to receive favored status from the government was, however, the opposite of transparent. It became increasingly the case that businesses were favored on political rather than on meritocratic grounds, resulting in a heavily skewed allocation of resources. The result was a paper tiger and, in 1997, Malaysia was pummeled by the Asian crisis. Refusing the auspices of super-national organizations in its aftermath, Malaysia is unique amongst the countries surveyed in that she largely retained her existing corporate governance regime during the ensuing re-structuring.

Ferdinand A. Gul and Judy S. L. Tsui 19

This regime was Anglo-American in origin, thus suggesting stronger shareholder protection; but had a major deficiency in the vulnerability of its regulatory bodies to political interference on behalf of businesses that were politically well-connected. However, lately, there seems to be a concerted effort by the Malaysian Ministry of Finance (MOF) to tighten up issues related to investor protection. For example, in 2001 new listing requirements were issued by the Kuala Lumpur Stock Exchange (KLSE) which amongst others require all listed companies to state in their annual reports how they have applied, and the extent of the application of the Principles and Best Practices of the Malaysian Code of Corporate Governance (see http://www.combinet.net/government/finalver/Malaysia.htm.) Other new developments include the establishment of a minority shareholders’ watchdog group to protect the interest of minority shareholders of public listed companies. Clearly, these two factors should see major shifts, for the better, in the investor protection and corporate governance practices in Malaysian companies. A final point worth noting is that since the Malaysian contribution was written the then Prime Minister Mahathir has stepped down. His successor, Abdullah Badawi, does seem to be moving away from this system of political patronage to a system that genuinely embraces shareholder value as the motor of corporate development.

1.9.6

Philippines

The AFC in late 1997 hit the Philippines hard – foreign capital fled the country in large amounts, and interest rates shot up, leading to dramatic declines in company profitability in subsequent years. Like in other countries in the region, the crisis exposed structural weaknesses in the Philippine corporate sector. The corporate governance picture in the Philippines is characterized by closely held family-owned businesses, often operated through a private or public holding company. The important private banks tend to collude informally and to follow conservative lending policies, keeping interest rates high. Despite this, the Philippines was not immune to the lending boom that swept the region just prior to the 1997 crisis. Other major problems are the weak accounting system standards, compliance and audit quality which are all in need of substantial improvement (World Bank, 2001). This contributes to poor disclosure. However, it may be noted that the Philippines was in many ways more successful than other economies in the region in responding to

20 The Governance of East Asian Corporations

the 1997 AFC (Saldaña, 2001). Apart from the government’s intervention that stabilized interest rates, a number of key initiatives have been put in place to improve long-term corporate governance, including the SEC’s Code of Corporate Governance, and the establishment of the Directors’ Training Institute to improve the quality and the functioning of directors. Important statements of corporate law are the corporation code, the Presidential Decree (PD 902–A) reorganizing the Securities Exchange Commission (henceforth SEC), the Securities Regulation Code (SRC), the insolvency law, and the general banking law. In addition to these, mention should be made of the Philippine Stock Exchange (PSE) listing rules. Many aspects of corporate law in the Philippines, e.g., the Revised Securities Act, reflect the influence of laws in the U.S. The patronage politic of the Marcos era has had an impact on Philippines corporate governance, contributing to poor disclosure practices and a few closely-held groups dominating the business landscape. This legacy is slowly being left behind as the Philippines takes concrete steps to improve corporate governance standards.

1.9.7

Singapore

Among South-East Asian countries, Singapore is regarded as having the highest levels of disclosure and corporate governance, both prior to and after the AFC. It has been said that these high standards could be the reason for the relatively smaller impact of the crisis on Singapore’s economy. Singapore’s corporate ownership is characterized by high concentrations of ownership among management and large shareholders, and dominance of government-linked corporations. In particular government directly and indirectly controls many companies, and still owns major stakes in some of the largest corporations. One consequence is that corporate takeovers are relatively few in number, and usually on friendly terms. There has been a recent proposal to revise the Takeover Code to make the rules clearer and less expensive to follow. The government has emphasized the need to meet international standards of disclosure and corporate governance. Accounting standards are identical to IAS in most cases, but in applying accounting standards and satisfying disclosure requirements, companies tend to follow the letter, rather than spirit of the rules. Additionally, there is poor enforcement of accounting standards when compared to western countries.

Ferdinand A. Gul and Judy S. L. Tsui 21

A Code of Corporate Governance was published in 2000. The Singapore Exchange incorporated the Code into their listing rules, and will require listed companies to comply or explain any departures from the Code, effective January 2003. Other recent developments include a program to fully align accounting standards with IAS.

1.9.8

South Korea

Korea won wide applause for the speed and decisiveness of its response to the 1998 crisis. From an agrarian society, devastated by the civil war in the early 1950’s, the country had risen to be a major, export-driven industrial power, with high income, and had recently democratized. Its corporate sector had not, however, democratized, and was dominated by family-owned conglomerates called chaebol. After years of largesse from the government in terms of tax credits, monopolies and protection from takeovers, the largest five of these companies accounted for 40% of the country’s economy, and controlled almost all of its industrial sectors. Although the chaebols had been instrumental in creating modern South Korea, they had attained this prominence at the expense of minority shareholders and government. They worked hand in pocket with the banks, which had themselves bailed out twice in the preceding two decades by the government. The chaebols were highly leveraged, with debt to equity ratios as high as 400%. Many of these loans were guaranteed by other units within the same chaebol group, with the shareholders of stronger units often paying the price for underperformance in weaker units. As part of the International Monetary Fund (IMF) package, the South Korean government had to make sweeping changes to the regulatory regime. Many of these changes were, in any case, long overdue. The government was canny enough, however, to present the changes as being imposed, thereby de-politicizing unpopular measures such as those related to labor, and to foreign ownership. Nonetheless, having now been rescued three times by government, the chaebols remain deeply resistant to change. While the legal infrastructure and enforcement have improved beyond measure, the cultural change needed to maximize the benefit of the reforms is only just beginning to take place.

1.9.9

Taiwan

The Taiwanese market is characterized by a turnover far greater than that of any other country surveyed in this book. Shareholders are

22 The Governance of East Asian Corporations

almost entirely transaction-driven, viewing shares not as equity, but as a means to a quick buck. This, in combination with the high concentrations of ownership found in most of the countries discussed in this book, and with the relatively low impact of the Asian crisis on Taiwan, has led to corporate governance that is, to say the least, lax. This is further reinforced by a market which is notably lacking in both the institutions and mechanisms of discipline: mergers and acquisitions are almost unknown, and there is little participation in the market by institutional investors. It is therefore paradoxical that the regime – measured in terms of regulations regarding corporate (board) structure and auditing, disclosure and transparency requirements – in fact offers to minority shareholders a higher degree of protection than that offered in the U.K. This illustrates, perhaps as clearly as any example, the difference between the form and the substance of good corporate governance. Although minorities are protected on paper, the enforcement is undermined by high costs, inefficient and incompetent courts, and a lack of will on the part of the authorities. It also illustrates the dominant effect of market forces on corporate governance. Many of Taiwan’s companies are involved industries, most notably semiconductors, that are highly capital-intensive. It is in these companies that strong internal pressure is building; and the awareness of the issues discussed in this book is most strongly felt.

1.9.10

Thailand

The financial system in Thailand has always been dominated by commercial banks. These banks offered relatively high interest rates on deposits which in turn inhibited the growth of bond and equity markets. Rapid economic expansion was achieved through credit extension, often provided through “connected lending”, which is a practice of lending based on personal ties. The combination of heavy dependence on banks for funds, connected lending, and the hard times of the late 1990s resulted in a large number of loans that were without collateral and largely uncollectible. BODs in companies with concentrated ownership are often merely shadows of large shareholders who pursue their own interests at the expense of minority shareholders. Due to regulatory loopholes, corporate decisions are rarely made at general meetings, and directors are able to do what they like. The law does provide recourse for shareholders whose rights are violated, but the financial and time burdens of going

Ferdinand A. Gul and Judy S. L. Tsui 23

through the court process are often excessive. The concept of independent directors is relatively new. The SEC mandated in 1999 that all listed companies must have at least two independent directors. However, the receptiveness of companies to independent directors is mixed, and regulators are having difficulty defining “independent”. Some of the other problems facing the development of better corporate governance include: • No independent regulator – the head of the SEC is a politician; • Accounting standards are not comprehensive enough, and existing standards are not always followed; • Unreliable information concerning unlisted companies, with which listed companies often have significant transactions; and • Corruption in the public sector.

1.10 Overview The chapters of this book provide a variety of perspectives on the corporate governance regimes of the countries surveyed. Many characteristics are present in more than one country: the role of government in controlling or influencing companies; companies that are controlled by families or dominant shareholders; and the presence of conglomerates. In addition to the role government plays in legislating rules and setting standards (either directly or through a recognized regulator/authority), some governments exercise a more active role in the direction of companies. SOEs are a significant feature of the Chinese and Indonesian business environment, and to a lesser extent in Malaysia. The respective chapters on those countries describe the difficulties facing the PRC in changing ownership of SOEs to publicly traded shares, and the continuing influence of the government over Indonesian and Malaysian companies. Family controlled firms or those with dominant shareholders are common in Korea, Indonesia, Taiwan, Thailand, and Singapore. This presents a problem for minority shareholder and creditor rights as the families or dominant shareholders are often in a position to exercise their power in order to expropriate value beyond their ownership rights from the company. The chapters discuss how these ownership patterns can be difficult to detect and prevent because of the use of holding companies, pyramidal ownership structures and informal agreements.

24 The Governance of East Asian Corporations

Japan and Korea stand out as countries in which the conglomerates play a big role in the business world. Although keiretsu and chaebol differ in some key fundamental features (for instance, keiretsu companies do not have legal connections between them whereas chaebol companies often do; keiretsu are not family controlled where chaebol are), they are similar in that they are large corporate groups that have broad interests in many sectors of the economy, including banking, manufacturing, and real estate. The interdependence between conglomerate member companies therefore means that financial difficulties in one sector can have implications for the other sectors as well. The AFC exposed many weaknesses in corporate governance. A very typical response to this has been the development and publication of some kind of corporate governance code. There are different approaches to the code – some are in the form of “best practice”, which are merely recommendations. Others are in a form which listed companies must follow or explain the reasons for their departure from the code as a condition of their listing on an exchange. Some countries give the impression of a genuine understanding of and appreciation for the value that improved corporate governance can bring; some give the impression that important parties have yet to be won over to the idea. Almost all the measures implemented are, at the time of press, very much work-in-progress. Signs are encouraging, however. Arguably the most recalcitrant of the type of organization surveyed, even Korea’s chaebols are changing – the restructuring of the LG Group has realized significant shareholder value – while China’s regulators have de-listed a number of companies since 2000 (CG Watch, 2002). The insights given by our contributors will, we hope, help the reader appreciate how the different regulatory, cultural and historical backgrounds of the countries surveyed have hampered or helped those efforts.

Notes 1. See the World Bank, The East Asian Miracle: World Bank Policy Research Report (Oxford: Oxford University Press, 1993) p. 7. 2. Warr, P. G. “Thailand” in Ross McCleod and Garnaut (eds), East Asia in Crisis: From Being a Miracle to Needing one (London: Routledge, 1998). 3. i.e., Hong Kong, Indonesia, Japan, South Korea, Singapore, Malaysia, Philippines, Taiwan, Thailand.

Ferdinand A. Gul and Judy S. L. Tsui 25 4. The PECC was founded in 1980 by government officials, academics, and business leaders as a forum to coordinate policy and promote cooperation among Pacific Region countries. Each member economy is represented by a Member Committee, composed of senior representatives from business, government and academic circles. Currently, there are 25 Member Committees, representing: Australia, Brunei Darussalam, Canada, Chile, China, Columbia, Ecuador, Hong Kong, Indonesia, Japan, Korea, Malaysia, Mexico, New Zealand, the Pacific Islands Forum, Peru, the Philippines, Russia, Singapore, Taiwan, Thailand, USA, Vietnam, France (Pacific Territories), and Mongolia. 5. At the time of writing, these documents can be accessed directly at http://www.oecd.org/dataoecd/47/50/4347646.pdf and http://www.fsa.gov. uk/pubs/ukla/lr_comcode3.pdf

References CG Watch (2002). February. Cheong, S. (1997). Bumiputera Entrepreneurs in the KLSE. Vol. 2. Corporate Research Services Sdn Bhd, Kuala Lumpur. Claessens, S., S. Djankov and L. H. P. Lang (2000). The separation of ownership and control in East Asian corporations. Journal of Financial Economics 58(1–2): 81–112. Far Eastern Review (2004). Reasons for optimism. January 29, pp. 38–47. German Code of Corporate Governance (GCCG) (2000). Jackson, K. D. (1999). Introduction: The roots of the crisis. In Asian Contagion: The Causes and Consequences of a Financial Crisis, (ed.) by K. D. Jackson. Colorado: Westview Press. Johnson, S., P. Boone, A. Breach and E. Friedman (2000). Corporate governance in the Asian financial crisis. Journal of Financial Economics 58: 141–186. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. W. Vishny (1998). Law and finance. Journal of Political Economy 106(6): 1113–1155. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. W. Vishny (1997). Legal determinants of external finance. Journal of Finance 52: 1131–1150. Rajan, R. G. and L. Zingales (1998). Which capitalism? Lessons from the East Asian crisis. Journal of Applied Corporate Finance 11(3): 40–48. Saldaña, C. G. (2001). The Philippines, Chapter 3 in Capulong, M., Edwards, D. and Zhuang, J., (eds), Corporate Governance and Finance in East Asia: A Study of Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand: Volume Two (Country Studies), Manila: Asian Development Bank. Shleifer, A. and R. Vishny (1997). A survey of corporate governance. Journal of Finance 5 (June): 737–783. The Economist (1997). March 1, London. Walker, G., and T. Reid (2002). Upgrading corporate governance in East Asia. Journal of International Banking Law 17(3): 59–66. Warr, P. G. (1998). Thailand. In Ross McCleod and Garnaut (eds). East Asia in Crisis: From Being a Miracle to Needing One. London: Routledge. World Bank (2001). Report on the Observance of Standards and Codes (ROSC) The Philippines Accounting and Auditing. Washington, D.C.: World Bank.

26 The Governance of East Asian Corporations World Bank (1993). The East Asian Miracle: World Bank Policy Research Report. Oxford: Oxford University Press. Yafeh, Y. (2000). Corporate governance in Japan: Past performance and future prospects. Oxford Review of Economic Policy 16(2): 74–84.

2 Shareholding Structures, Related Party Transactions and Corporate Governance in China Wei Guo Zhang

2.1

Introduction

The People’s Republic of China (PRC) is unique among the markets in our overview because of the changing pattern of ownership over the past 25 years, and in particular, the last decade. Under the communist system with a planned economy, companies were owned and controlled by the State, with all key decisions being made in accordance with State policy and objectives. The initial steps towards a western style securities market occurred in the late 1970s, with the State allowing enterprises to raise funds from employees. In the mid-80s, some enterprises began to issue stocks to the public, and in 1986 public trading of stocks was allowed. Commencing in 1992, the government allowed companies to raise capital by listing in Hong Kong and overseas. With the beginning of the trading in company stocks, the PRC had to implement a regulatory framework to oversee market activity, as well as develop policies for transforming state-owned enterprises (SOEs) into publicly traded companies. The PRC is not unlike other countries in terms of the potential for opportunistic behavior of managers, but the issue of transformation of SOEs causes unique problems that require alternative solutions. The PRC is in the position to learn from the history of older capital markets, but the lessons learned must be adapted to the particular circumstances present in the PRC today. Due to the characteristics of company ownership in the PRC at the time of the Asian Financial Crisis (AFC), companies were not affected as badly as in other countries. Instead of examining how the AFC affected the PRC, this chapter looks in detail at the development of the PRC’s capital market and how the relatively new regulatory and corporate governance frameworks have evolved. 27

28 The Governance of East Asian Corporations

2.2

Background

Enterprises in the PRC were transformed into SOEs after the Communist Party came into power in 1949. Enterprises were funded by the government and operated according to a unified business and production plan set by the State. All profits were submitted to the government and, in such circumstances, the securities market was abolished. Investment banking and the capital market, in effect, ceased to exist. In 1979, the PRC initiated the policy of opening-up and reform. In order to raise capital for economic growth, the State began to issue treasury bonds and at the same time enterprises were allowed to raise funds from employees. In 1984, certain enterprises in Beijing and Shanghai began to issue stocks to the public. At that time, regardless of whether they were private placements or public offerings, the stocks were not tradable in public. In 1986, the government permitted over-the-counter trading of corporate stocks. The commencement of operation of the Shanghai Stock Exchange and Shenzhen Stock Exchange in 1990 marked the establishment of a national centralized securities market in the PRC. In 1992, the government declared its commitment to establish a market-based economic system with Chinese characteristics. The securities market has grown rapidly since then, as evidenced by the soaring number of listed companies. With the development of the securities market, laws and regulations defining the legal framework for formulating rules and practices in the PRC with respect to corporate governance were promulgated, as shown in Table 2.1. In addition to allowing capital to be raised within the PRC by issuing corporate stocks to PRC residents (A shares), enterprises were also permitted to issue corporate stocks to overseas investors within the PRC (B shares). Furthermore, enterprises in the PRC were given the green light to raise capital by listing in Hong Kong or other overseas stock markets (H shares). As a result, the securities market in the PRC has progressed rapidly over the past 12 years. At the time of the commencement of operation of the Shanghai Stock Exchange and the Shenzhen Stock Exchange in 1990, there were only 10 listed companies. The number had grown to 1,224 by the end of 2002. These companies raised an accumulated capital of RMB 707.1 billion, with a total market capitalization of RMB 3.86 trillion. This market capitalization represents nearly 37% of the PRC’s Gross Domestic Product (GDP) (Table 2.2).

Wei Guo Zhang 29 Table 2.1 Development of PRC Stock Market and Promulgation of Laws and Regulations Related to Corporate Governance Year

Development of stock market

1979

• PRC government initiated reform and opening-up policy

1980

• PRC government began to issue treasury bonds and allowed enterprises to raise capital from employees

1984

• Enterprises in Beijing and Shanghai began to issue stocks to the public

1986

• Stocks traded publicly over the counter

1990

• Shanghai Stock Exchange and Shenzhen Stock Exchange commenced operations

1991

• First B shares company listed

1992

• First H shares company listed • Demonstration by more than one million shareholders and local residents in Shenzhen • China Securities Regulatory Commission (CSRC) established

1993

Promulgation of laws and regulations related to corporate governance

• State Council promulgated Provisional Regulations for Stock Issuance and Trade • Ministry of Finance (MOF) promulgated Basic Accounting Standards • CSRC promulgated Implementation Rules for Information Disclosure of Initial Public Offerings (IPOs) • The National People’s Congress promulgated Company Law

1994

• Implementation of Company Law

1995

• Severe case of manipulating the treasury bond future market in Shanghai

1997

• First fraudulent case of financial • CSRC promulgated Guidelines reporting for Articles of Association of • Establishment of regulatory Listed Companies system for the national • MOF began to promulgate centralized stock market Specific Accounting Standards • CSRC and MOF demanded • The Securities Committee Certified Public Accountant (CPA) under the State Council firm with securities business promulgated Rules on the qualification for transformation Administration of Securities Investment Funds

• MOF began to promulgate Auditing Standards

30 The Governance of East Asian Corporations Table 2.1 Development of PRC Stock Market and Promulgation of Laws and Regulations Related to Corporate Governance – continued Year

Development of stock market

Promulgation of laws and regulations related to corporate governance

1998

• Properly regulated funds investing in the securities market were issued

• The National People’s Congress promulgated Securities Law

2000

• Implementation of Securities Law

• Shanghai Stock Exchange promulgated Code of Corporate Governance for Listed Companies (draft) • CSRC promulgated The General Requirements Governing Shareholders’ General Meeting • CSRC promulgated Provisional Measures Governing Open Fund

2001

• PRC residents were allowed to • CSRC promulgated Guidelines invest in B shares for Introducing Independent • Several significant fraudulent Directors to the Board of Directors cases relating to IPO and financial (BOD) of Listed Companies reporting • De-listing of some companies with consecutive years of losses • Pilot scheme to reduce the proportion of state-owned shares in listed companies

2002

• Started to issue open-ended funds • CSRC promulgated Code of investing in securities Corporate Governance for Listed • Terminated the pilot scheme to Companies reduce the proportion of state • CSRC promulgated Regulations owned shares in listed companies on Mergers & Acquisitions of Listed Companies • CSRC promulgated Provisional Measures Governing Listed Companies to Sell State-owned Shares to Foreign Investors

2003

• The Supreme Court promulgated Rules On Hearing Cases Involving Civil Compensation Due to Insider Trading, Fraudulence And Market Manipulation On The Securities Market

Table 2.2

Stock Market Statistics in the PRC

No. of A share companies No. of B share companies No. of H share companies Capital raised in domestic market (RMB billion) Capital raised in overseas markets (RMB billion) Total market capitalization (RMB billion) Percentage of GDP represented by total market capitalization Stock trading volume (RMB billion)

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

177 40 6 28

287 58 13 10

311 70 18 9

514 85 25 29

720 101 42 86

825 106 43 78

923 108 46 90

1,060 114 52 150

1,133 112 61 118

1,224 ?? ?? 81

10

23

6

13

47

6

5

58

7

??

105

369

347

984

1,753

1,951

2,647

4,809

4,352

3,860

10% 68

8% 813

6% 404

15% 2,133

23% 3,072

25% 2,354

32% 3,132

54% 6,083

45% 3,831

37% 2,799

Source: CSRC, 2002a.

31

32 The Governance of East Asian Corporations

With respect to the development of its securities market, the PRC has achieved commendable progress in terms of market size, formulation of rules and regulations, regulatory capability and techniques, standards, etc. over the past 12 years. It had taken developed countries a much longer period to attain similar significant achievement and progress.

2.3 Main characteristics of joint stock company formation for IPO As shown in Table 2.2, there were altogether 1,224 listed companies in the PRC by the end of 2002. These listed companies previously existed in various other legal forms and undertook structural transformations into joint stock companies to prepare for an Initial Public Offering (IPO). In order to understand the features of shareholding structures and the problems encountered in corporate governance, it is necessary to understand the characteristics of the transformation process, the most significant of which are as follows:

2.3.1

Most listed companies are transformed from SOEs

Enterprises were largely state-owned in the planned economy. After the establishment of the securities market, depressed SOEs were expected to raise capital in the securities market. Therefore, most listed companies were transformed from SOEs and this chapter focuses on SOEs.

2.3.2

Enterprises often split and restructure

In preparing for an IPO, most enterprises in the PRC split their assets and businesses into several companies. The underlying reasons for the split are: (i)

In order to meet the requirements for an IPO as prescribed in the Company Law, SOEs have to spin-off their welfare oriented or administrative affiliated organizations, such as schools, hospitals or cinemas, as well as certain units with poor economic performance. (ii) In the early stages of the securities market development, fund raising capability was limited and the markets had insufficient liquidity to sustain the sizable offerings of large SOEs. These businesses therefore had to split parts of their business before they could go public so as to match the capacity of the market. (iii) In the early stages, the volume of stock for public offering was under the unified control of the State. There were quite a number

Wei Guo Zhang 33

of enterprises who desired listing, so in order to manage the demand for public offerings, the government authorities allocated the volume of stock to the local authority in each region.

2.3.3 Enterprises usually undergo rapid changes into joint stock companies In a developed market, listed companies often undergo a gradual process of change. They usually evolve from proprietorship or partnership to company. The method of raising capital is from private placement to public offering. The status of the company is then changed from non-listed company to listed company. In the PRC, however, most listed companies undergo a rapid change. Once an SOE is selected by the State to go public, the chosen enterprise, within a few months, has to change into a joint stock company. As such, a number of problems often occur: (i)

Many legal formalities of the split and restructuring of the business were not completed; (ii) The separation and split of the assets, operations, organization structure, personnel, finance, etc. of the listed company from the parent enterprise were not made in substance or completed; (iii) Enterprises did not make fundamental changes to their systems and operations even though they raised funds in the capital market and became a listed company. In other words, the SOE mode of operation still continued.

2.4 Main characteristics of the shareholding structure of listed companies in the PRC By restructuring into a joint stock company for an IPO, the shareholding structure possesses the following characteristics:

2.4.1

A low proportion of publicly traded stock

According to the regulations and policies which have been in place for many years in the PRC, the shares of the promoter cannot be publicly traded in the securities market. As a result, the proportion of publicly traded stock in issue has remained around 30%, as shown in Table 2.3.

2.4.2

A large number of state controlled shareholdings

The State owns shares in listed companies both directly and indirectly. State-owned shares are clearly defined to be under direct control of the

34

Table 2.3

Market Value of Publicly Traded Stock of Listed Companies in the PRC

Total market capitalization (RMB billion) Market value of publicly traded stock (RMB billion) Percentage Source: CSRC, 2002a.

1993

1994

1995

1996

1997

1998

1999

2000

2001

353

369

347

984

1,752

1,951

2,647

4,809

4,352

86

97

94

267

520

575

821

1,609

1,446

24%

26%

27%

27%

34%

33%

30%

29%

31%

Wei Guo Zhang 35

State after the IPO. State-owned legal person shares are controlled by the State through a legal person. The former category is easier to identify for statistical purposes and a summary of which is shown in Table 2.4. It is more difficult to estimate how many legal person shares are controlled either directly or indirectly by the State. If the non-state owned non-publicly traded legal person shares can be offset by the state-owned publicly traded stock, the stock directly or indirectly controlled by the State accounts for around 60% of the total amount. This is represented approximately by the sum of the first two rows in Table 2.4. According to a report prepared in December 2002 by Jiang Qiangui, vice director of the State Economic and Trade Commission, out of 1,051 controlling shareholders of listed companies, 813 of them are state-owned, representing 77% of all of the controlling shareholders (A breakdown is given in Table 2.4a). Furthermore, there are 390 companies, representing 36.8% of all listed companies in the PRC, with a single state-owned shareholder holding more than 50% of the shares. There are a further 387 companies, representing 36.5% of all listed companies in the PRC, with a single state-owned shareholder holding 20%–50% of the shares (Jiang, 2002).

2.4.3

The largest shareholder is often in a dominant position

The largest shareholder of a listed company often holds a remarkably high proportion of the total shares: 56.5% at the time of IPO and 52.1% after, according to Li’s (2001) study. The study by Wei (2003) also indicates the phenomenon described above. The average percentage held by the largest shareholder is 44.68%, and the highest holding by the largest shareholder is 88.58%.

2.4.4

Underdeveloped institutional investors

The size of institutional investors and their significance to the securities market in the PRC are difficult to estimate. They can generally be classified into three groups: securities investment funds; enterprises permitted to own corporate shares; and the so-called underground funds or hidden institutional investors, which use the names of individuals to purchase and hold shares. Our analysis will focus on the significance of securities investment funds. These are leading institutional investors in developed markets, however, despite the tremendous endeavors undertaken so far to promote their presence in the PRC, progress has been insignificant. The

36

Table 2.4

Percentage of State Owned Stocks in Listed Companies in the PRC 1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

State-owned stock Legal person owned stock Other non-publicly traded stock

41% 22% 6%

49% 20% 3%

43% 22% 2%

39% 23% 2%

35% 26% 4%

32% 30% 7%

34% 27% 5%

36% 25% 4%

39% 23% 2%

46% 18% 1%

Total non-publicly traded stock

69%

72%

67%

64%

65%

65%

66%

65%

64%

65%

Source: CSRC, 2002a.

Wei Guo Zhang 37 Table 2.4a Number

Breakdown of Controlling Shareholders Percentage

665 79

63 8

54 15 183 55

5 1 18 5

1051

100

Description SOE’s or state controlled enterprises State-owned asset management companies Government organizations Other state-owned units Non-state-owned Collectives

State-owned Yes Yes Yes Yes No No

trading volume contributed in 2001 by them accounted for only 6.68% of the total annual turnover. Without their participation, it is difficult to rectify or alleviate the impact of speculation and market manipulation in the PRC securities market. In addition, under-performing senior management comes under little pressure of being replaced.

2.5 Corporate governance problems arising from the above characteristics The characteristics of the equity structure of listed companies in the PRC resulting from IPO-driven transformations have caused the following major problems in corporate governance.

2.5.1 The co-existence of extremely strong and weak controls by the State make the primary objective of corporate governance, to maximize benefits for the company and the minority shareholders, impossible The State’s controlling position has led to the following problems: (i)

Corporate governance is characterized by the strong influence of the State. The government can exercise their control on listed companies, through various channels, to influence the major corporate decisions on personnel, investment, finance, business operations, etc. (ii) Contrary to the extremely strong control situation as described above, corporate governance may also be weakly controlled by the State. At present, the state-owned shares in listed companies in the PRC are usually entrusted by the government to certain assets management companies or groups. As a result, these listed companies are actually under the control of the agents of the

38 The Governance of East Asian Corporations

government. The performance of these listed companies’ operations has no obvious relationship with the interests of the agents, who are not likely to try their best to protect and increase the value of these state-owned assets, or to adopt active measures to encourage the board of directors (BOD) and management of the listed companies to make their contribution. The interests of minority shareholders are even more remote. (iii) Because extremely strong and weak controls co-exist, it is easy for the largest shareholder of the company to collaborate with internal management, increasing the possibility and feasibility of exploiting the financial resources of the listed company and expropriating the interests of the minority shareholders. (iv) Another negative aspect of the strong and weak controls by the State is the lack of motivation for restructuring the business in the case of a corporate crisis. The relevant government authority, being the representative of the state-owned shares, is not likely to handle the corporate restructuring entirely by itself, but will delegate the responsibility and power to the senior management of the listed company or other interested parties to carry it out. This might lead to the corporate restructuring being carried out in a way that is mainly in the interests of senior management or the company and the interests of the minority shareholders are ignored. The opposite extreme is where the government authority handles the corporate restructuring itself by forcing unsuitable enterprises to merge together leading to diseconomy of scale and wastage of resources. The rights and the interests of the minority shareholders are then gradually diminished.

2.5.2

The shareholders’ general meeting

In a shareholders’ general meeting, the shareholders should be able to protect their interests, while decision makers and management should demonstrate their capabilities by responding to questions from investors. However, the shareholders’ general meetings of listed companies in the PRC cannot attain these objectives: (i)

Shareholders’ rights to propose resolutions are often restricted. The Company Law has no prescription about the minority shareholders’ rights of proposition, although the Guidelines for Article of Association of Listed Companies prescribes that shareholders holding more than 5% of the equity should have the right of proposition. However, in reality it is not that easy for minority

Wei Guo Zhang 39

shareholders to propose a resolution for voting at the general meeting if the resolution is in conflict with the interests of the members of the BOD. The board often impedes or delays the proposition by requesting a review or scrutiny of the resolution. (ii) The Company Law prescribes that certain resolutions should be passed in shareholders’ general meetings and others in the meetings of the board of directors (BOD). The division of power is finely defined – many important resolutions, such as corporate asset restructuring, disposal of significant assets, or providing guarantees for others by using corporate assets as collateral, should be subject to voting in the shareholders’ general meeting – but, in practice, most of the power is often delegated to the BOD, which is in turn controlled by the largest shareholder or internal management. As such, the minority shareholders are deprived of their rights. (iii) The method of shareholder voting is also not properly regulated or standardized. Certain resolutions which require voting by poll are often voted on by a show of hands or other informal communication methods.

2.5.3 Board of directors has a weak awareness of responsibility for the interests of the company and all shareholders The Company, Securities and Criminal Laws have all clearly defined the rights, obligations and relevant civil and criminal responsibilities of directors. However, because of the over-centralized equity control of listed companies, the BOD has a weak awareness of its responsibilities for the interests of the company and all of the shareholders, allowing the largest shareholders and internal management to exploit the financial resources of the listed company or otherwise disregard the interests of the minority shareholders.

2.5.4

Limited function of board of supervisors

The Company Law in China prescribes the system of the board of supervisors which should be composed of representatives of shareholders and employees, an appropriate proportion which is specified in the company’s Articles of Association. Its duties are to monitor the BOD and the management. This is similar to the dual corporate governance models in Germany and Japan. However, in reality it is closer to the Japanese model in which the board of supervisors exists in form only. As the board of supervisors is only equipped with the right of supervision, without the

40 The Governance of East Asian Corporations

rights of control and strategic decision making, it has no ability to appoint or to remove any members of the BOD or management, nor to participate in or veto the decisions of the BOD and management. Furthermore, according to statistics prepared by Shanghai Stock Exchange in 1999, 73.4% of chairmen of the board of supervisors had been internally promoted from within the company and most of the vice chairmen and other members of the board of supervisors had also been internally promoted by the company. As a result, the board of supervisors is actually an organization controlled by the BOD, which itself acts according to the instruction of the largest shareholder or internal management. This means that the board of supervisors is only a “rubber stamp”, unable to effectively monitor senior management, and with little choice but to turn a blind eye on activities such as exploiting the company’s financial resources or infringing the interests of minority shareholders.

2.5.5

Lack of strong external monitoring mechanism

Effective corporate governance not only needs a sound internal monitoring mechanism but also requires a strong external monitoring mechanism. In order to make up for the deficiency of internal monitoring mechanisms, countries such as the U.K., the U.S. and France place a lot of emphasis on the importance of external monitoring mechanisms by the use of corporate takeovers, external recruitment of senior executives, bankruptcy, intermediary agencies, etc. In China however, external monitoring mechanisms have limited impact on internal management. (i)

Corporate takeovers – There have been a number of changes in the controlling shareholder of listed companies in the PRC, however, most takeovers are not through the purchase of publicly tradable shares in the securities market, but is by virtue of the transfer of state-owned shares and legal person owned shares. In other words, the securities market has little significance in the transfer of controlling rights. Also, the objective of some new controlling shareholders is not to improve the operating results and increase the value of the company, but to use the listed company as a “shell” to raise capital in the securities market or to profit from manipulating the securities market. This kind of takeover has a limited contribution towards the improvement of corporate governance of listed companies.

Wei Guo Zhang 41

(ii) External recruitment of senior executives – The State has absolute control of most listed companies in the PRC, and determines the appointment of senior management. This is usually selected from governmental officials or leaders of SOEs. In this situation, the market for the recruitment of senior executives does not function to monitor management. Additionally, the imperfection of the capital market further adversely affects the function and effectiveness of this monitoring mechanism because the company cannot use commensurate remuneration packages to attract or retain new talent. Without an effective senior executive recruitment mechanism, it is difficult to achieve the maximization of the interests of the company and its shareholders. (iii) Bankruptcy and the de-listing mechanism – SOEs, including state controlled listed companies, have a significant influence on the whole economy. Because of the large population in the PRC, the country faces a great deal of pressure to ensure adequate employment. Therefore, the government has great difficulty in allowing companies that have performed poorly to be de-listed or go bankrupt. As there is no sound exit mechanism, a company that has performed poorly can rely on the value of its listing status “shell” to substantiate its share price because this is a rare resource in the market. Shareholders therefore have no awareness of any risk or crisis relating to their shares. They are not concerned about the quality of corporate governance and have no strong demand for high quality financial information.

2.6

Issues highlighted by analyzing financial information

The study of problems in corporate governance of listed companies in the PRC would be facilitated by a comprehensive analysis of financial information.

2.6.1

Inadequate capital contribution by the controlling shareholder

The high ownership stake of the largest shareholder increases the likelihood of the shareholder infringing on the interests of the listed company and the minority shareholders. One of the more obvious cases is that the largest shareholder breaks its commitment to make a capital contribution. In 1998, when a Fujian based listed company sought a rights offering, its largest shareholder, the local bureau for State Assets Administration, committed itself to contributing RMB 50 million. However, it

42 The Governance of East Asian Corporations

was later discovered by the China Securities Regulatory Commission (CSRC) that the bureau had never contributed any capital in return for the rights issue, and subsequently only did so under pressure from the CSRC and the Ministry of Finance (MOF).

2.6.2 Financial resources of listed companies are dispossessed by the largest shareholders When a company goes public, the parent enterprise has to undergo restructuring to inject quality assets with significant profit contribution into the company to be listed, and to shoulder the heavy burden encumbered by the non-operating and under-performing assets. It is, therefore, very natural for the parent company to want to gain returns from the listed company after the IPO. This can be done by dispossessing the financial resources of the listed company through means such as defaulting on repayment of debt to the listed company and using the listed company as a guarantor for external borrowing. It is reported by the CSRC that among the 175 listed companies for which their auditors issued qualified audit opinions in 2000, 54 of the listed companies were dispossessed of financial resources totaling RMB 20.6 billion by their largest shareholders or their related parties. According to Jiang (2002), 20% of listed companies reported that they had provided guarantees for their largest shareholders or related parties. Yue Jinman used to be a company with outstanding performance, but gradually fell into financial difficulties. By the end of 1999 its total assets were RMB 900 million, whereas its accounts receivable due from its parent company and related parties amounted to nearly RMB 1 billion. As the receivables were unlikely to be recovered, it had to make an enormous bad debt provision and was forced to borrow. By the end of 1999, its short-term borrowings exceeded RMB 1 billion. Most were overdue and the company was de-listed in 2001.

2.6.3

Financially entangled with the largest shareholder

Most listed companies in the PRC were transformed and divested from SOEs in a hasty and incomplete way which has left them entangled with the largest shareholders in areas such as human resources, assets, finance, organizational structure, business operations, etc. The entanglement of finance can be illustrated by the following points: (i) No separate bank accounts. (ii) Assets, liabilities and expenses cannot be correctly recognized. (iii) Financial reports cannot be accurately prepared.

Wei Guo Zhang 43

2.6.4 Manipulation of financial information by related party and abnormal transactions The high degree of ownership concentration is not only due to the disproportionate control of the largest shareholder, but also due to the fact that some of the other significant shareholders are affiliated companies of the largest shareholder. Such organizational structure facilitates the manipulation of financial information by means of related party or abnormal transactions. For example, a listed company bought 10 million shares of related party A from related party B for the price of RMB 1 per share, sold them one month later to related party C at RMB 8 per share, so realizing a gain of RMB 70 million, representing 436.4% of its total profits for the year. Another listed company sold its land use right, with a net book value of RMB 69.26 million, to a related party for the price of RMB 219.26 million. It also earned RMB 79.6 million by disposing of a subsidiary, with a net book value of RMB 14.54 million, to a related party for the price of RMB 94.14 million. Without the RMB 229.6 million profit from these transactions, the company would have reported a loss of RMB 132.77 million. Transactions mentioned above can be characterized as follows: (i) They are abnormal transactions. (ii) Transaction prices are not at arm’s length. (iii) “The wool comes from sheep’s back after all”. Whatever the parent enterprise gives to the listed company would be returned to the parent enterprise in the future, ultimately, at the cost of the minority shareholders. (iv) They are numbers with no meaning. The transaction prices are set arbitrarily or the transactions are even fictitious. The motives for manipulation of profits by listed companies are as follows: (i)

Meeting the requirements for raising capital under the Company Law; (ii) Avoiding losses for three consecutive years which would result in de-listing; (iii) Creating profits for manipulating the share price. These factors indicate that, to a large extent, manipulation of profits by listed companies is policy induced: an allegation substantiated in several studies (Chen et al., 2000; Aharony et al., 2000).

44 The Governance of East Asian Corporations

2.6.5

Little or no dividend distribution

Given the high proportion of shares held by the largest shareholders, the minority shareholders have little influence on the management of listed companies. The serious manipulation of profits causes the disclosed profits or other financial information to be unreliable. The investors, consequently, are more concerned about the fluctuation of the share price rather than the operating results. The listed companies in the PRC take advantage of this phenomenon by distributing little or no dividend at all. Such irregularity prompted the CSRC to announce in 2000 that a listed company’s historical distribution will be taken into account when considering the listed company’s application for raising capital. Since then, more companies have committed to distributing dividends, but, compared to the share price paid by investors, the dividends paid out are negligible. The studies by Wei (1998a, 1998b, 2000a, 2000b), Yuan (1999), etc. provide evidence to substantiate the above allegation.

2.7 Adopted and proposed measures 2.7.1 Shareholding restructuring and independence of listed companies Reducing the portion of state-owned shares to address the shortcomings arising from the high proportion of shareholding owned by the largest shareholder It has been repeatedly emphasized in this Paper that many problems in the PRC securities market stem from the high proportion of stateowned shares in listed companies. Various measures should be taken to reduce the high proportion of state-owned shares and to address the associated shortcomings. The main measures should include: (i)

A steady reduction of state-owned shares. A policy to sell a portion of the state-owned shares in listed companies was announced in 2001, but raised much controversy and depressed the market. The sell-off of state-owned shares was subsequently called off in the summer of 2002 although its merits were re-affirmed by the relevant government authority. (ii) Allowing private enterprises to access the securities market. The PRC government has, since 2001, allowed private enterprises to have an IPO and the proportion of IPOs for private companies has significantly increased.

Wei Guo Zhang 45

(iii) Transfering state-owned shares to foreign investors. Joining the World Trade Organization (WTO) presents the PRC with unprecedented opportunities and, in November 2002 the CSRC, MOF and State Economic and Trade Commission (SETC) jointly issued the Circular on Issues Concerning Transfer of State-Owned and Legal Person Shares in Listed Company to Foreign Investors, giving the green light for overseas companies to acquire state-owned shares in PRC listed companies. The launch of the above three important policies, together with stateowned shareholders’ abandonment of subscribing for shares in the cases of rights issues in subsequent fund raising, and gradual disposals of state-owned shares to private companies, has contributed to an improved shareholding structure in listed companies. This is demonstrated by the gradual decrease in the proportion of state-owned shares. At the end of 1995, state controlled companies accounted for 99% of all listed companies, holding 54% of the total shares in issue. The numbers decreased to 75% and 48% respectively at the end of 2001 (Jiang, 2002). By the end of April 2002, there was a total of 126 private listed companies in the PRC, representing around 10% of all PRC listed companies; 44 collectively owned enterprises accounting for about 3%; while foreign investors or listed companies controlled by another entity accounted for around 6%. All these facts indicate that a diversified shareholding structure is taking shape (Cha, 2002). In summary, the plight caused by the highly concentrated shareholding of state shareholders is improving gradually and a diversified shareholding structure is steadily being put into place. It will facilitate the formation of a system of governance by shareholders, safeguarding the interests of minority shareholders and laying a solid foundation for enhanced corporate governance.

Policies and regulations which induce manipulation of operating results and other potential weaknesses should be amended One of the motives underlying the widespread manipulation of profits by listed companies is the criteria stipulated for an IPO and maintaining listing status after the IPO, as promulgated in Company Law in 1993. Companies applying for an IPO have to be profitable for three consecutive years during the track record period. The return on newly raised capital has to exceed the interest rate for bank savings accounts. Listed companies have to be able to distribute dividends after the IPO. Three consecutive years of losses would result in de-listing. To eradicate

46 The Governance of East Asian Corporations

the malpractices and manipulation of profits during the IPO process, it is necessary to amend the related provisions in Company Law and other rules and regulations issued by the State Council or the CSRC.

Assets and business of the listed company should be separated from the controlling shareholders Most listed companies in the PRC were split-off from parent enterprises, but remain closely related to their parent enterprise in human resources, assets, finance, organizational structure and business operations, exposing the company to malpractice and infringement, and facilitating the manipulation of profits. Relevant government authorities have taken various measures to tackle the problem. For example, appropriate rules and regulations, such as CSRC (1999, 2000a), requiring listed companies to undertake self-examination and imposing penalties for serious offences, have been implemented. After years of endeavor, a clear separation of listed companies from their controlling shareholders has gradually taken shape. Listed companies are gradually becoming independent from their controlling shareholders in terms of assets, finance, human resources, organizational structure and business operations. It is reported by Laura Cha, Vice Chairman of the CSRC (Cha, 2002) that: • 74% of listed companies have their own proprietary trademarks for their main products or services; • 88% of listed companies have complete supplementary manufacturing systems and facilities, without hiring facilities from shareholders or related parties; • 68% of listed companies have their own factory land use right for production; • 88% of listed companies can operate without a license for any industrial property rights or non-proprietary expertise; • Nearly all listed companies have their own bank accounts and independent finance department; • 96.5% of listed companies have total freedom to make financial decisions; • In 884 listed companies, the managers, chief financial officers, marketing executives and secretaries to the BOD hold no concurrent posts in the parent company or any other related party and the company is able to employ managers and employees at its own discretion;

Wei Guo Zhang 47

• 83% of listed companies are able to purchase raw materials or sell products without reporting to their controlling shareholders; • 88% of listed companies have prepared clear analysis reports for setting prices of related party transactions; and • 83% of related party transactions are at prices approximate to the market price. The endeavors undertaken by regulators and listed companies have contributed to this improvement. Although some companies are still associated with controlling shareholders in one or more aspects, the development is going in the right direction. With the on-going development of the securities market, the relationship between listed companies and controlling shareholders will become more clearly defined, and the independence of listed companies will be gradually strengthened. Finally, it is hoped that the listed company will become a legal person entity with the ability to operate independently and be accountable for its own operating results.

2.7.2

Internal disciplinary system

The corporate governance system in the PRC is established under the framework of continental law. With the development of the securities market, the system has exposed certain weaknesses. In recent years, academics, entrepreneurs and government authorities in the PRC have dedicated considerable efforts to the study of corporate governance, particularly in drawing relevant experiences from developed markets. To address deficiencies in the Company Law and problems exposed in practice, the CSRC promulgated a number of rules and regulations:

The improvement of procedures and rules for proposing resolutions at shareholders’ general meetings and the protection of shareholders’ rights The shareholders’ general meeting is an authoritative agency of the listed company, and the problems with it have been discussed. To tackle these the CSRC has prescribed a wide range of requirements in Guidelines for Articles of Association of Listed Companies (CSRC, 1997), the General Requirements Governing Shareholders’ General Meeting of Listed Companies (CSRC, 2000b), the Code of Corporate Governance for Listed Companies (CSRC, 2002b), etc. to ensure shareholders can realize their rights. These have resulted in the shareholders’ general meeting becoming an important means for minority shareholders to realize their rights and safeguard their interests (Cha, 2002).

48 The Governance of East Asian Corporations

A sound independent director system has to be established and enhanced to ensure proper supervision of the board of directors and management Over the past two years, remarkable progress has been made in the functioning of the independent director system in listed companies in the PRC. It is reported by Wei (2003), that by the end of 2001, 26% of listed companies had engaged independent directors. According to Laura Cha’s report, by June 30, 2002, 2,414 independent directors had been engaged by 1,124 listed companies. In practice, it was found that a number of independent directors had provided listed companies with suggestions on production, operations, investment, nomination of executives and determination of their remuneration, financial management, auditing, etc. One independent director of a listed company provided a 1,200-page report to disclose and reproach the malpractice of the controlling shareholder regarding exploitation of the listed company’s financial assets and sub-standard disclosure of information. He also presented five recommendations for improvement to the board (Li, 2002). Certain independent directors responded to the management’s refusal to accept sound suggestions by resigning. The independent director system is beginning to have a positive influence on the enhancement of corporate governance in listed companies.

A sound remuneration system has to be in place to encourage management’s commitment to the company and shareholders A reasonable incentive system is essential to improve corporate governance and many listed companies have sought to find positive and effective methods to address the issue. Over 300 listed companies have adopted a yearly salary system or performance based compensation method for senior management with 43 listed companies adopting the long-term stock based incentive mechanism for members of the BOD (Cha, 2002). These methods have encountered obstacles of a political and legal nature during implementation, but listed companies’ attempts to adopt this mechanism reveal the need for it.

A sound system of internal control evaluation and disclosure should be established to improve the internal controls of listed companies The new Accounting Law issued in 1999 (NPC, 1999) has prescriptions on the establishment of internal accounting controls, management’s responsibilities for such a system, and the legal liabilities arising

Wei Guo Zhang 49

from any non-compliance. The CSRC has similar requirements in its standards for IPOs and information disclosure of listed companies (CSRC, 2000c, 2000d, 2000e, 2000f, 2000g, 2001a, 2001b), including the requirement that listed companies should invite a Certified Public Accountant (CPA) to evaluate the completeness, reasonableness and effectiveness of internal controls, and that the listed company should disclose any serious deficiencies in internal controls reported by the CPA as well as the remedial measures taken by the management. All these requirements will help to improve the internal control level of listed companies in the PRC. But there are still a lot of difficulties in implementation, namely: • Listed companies have a weak awareness of internal control; • Internal control systems tend to be in form only; • There is a lack of standards concerning internal control rules and guidance; • Accounting firms lack specialists in evaluation of internal control systems; and • The company is reluctant to bear the fees for such evaluation, or there is insufficient time for evaluation. This indicates that there is still a lot of work to be done in the establishment and improvement of the internal control of listed companies in the PRC.

2.7.3

External monitoring mechanism

In order to promote the improvement of corporate governance of listed companies, the CSRC and other organizations have made efforts to strengthen the external monitoring mechanisms of listed companies. This includes the following:

Quality institutional investors have to be developed Experience of mature markets shows that institutional investors play an important role in the corporate governance of the company that they invest in. At the beginning, the securities market in the PRC basically consisted of private investors but, according to the report made in early 2003 by Laura Cha, vice chairman of the CSRC, there are now 17 fund management companies, with over RMB 108 billion of assets under their management. At the end of 2002, the CSRC and the People’s Bank of China (PBOC) jointly issued Provisional Rules on Qualified Foreign Institutional Investors (QFII) to invest in

50 The Governance of East Asian Corporations

Domestic Securities (CSRC, 2002c), which permits qualified institutional investors including fund management companies, securities companies and commercial banks to invest in the PRC A share market. Many organizations have submitted applications to become a QFII and the implementation of the policy will not only provide a large quantity of funds to listed companies in the PRC, but will also bring advanced concepts, facilitating the enhancement of corporate governance of listed companies in the PRC and driving their advancement (Zhou, 2002).

Merger and acquisition and the mechanism of de-listing can be used to force listed companies to improve operations and management The CSRC has formulated de-listing rules based on the prescription of the Company Law, which forced a few listed companies with poor management who were unable to turn around loss-making situations to be de-listed from the stock exchange. According to the recent report made by Laura Cha (Cha, 2003), by the end of 2002, ten listed companies had been de-listed. This policy helps to force the management of listed companies to improve operations and the level of management and encourages businesses to absorb new practices and ensures the survival of the fittest.

Measures have to be taken to prevent manipulation of financial results through related party transactions The specific environment in the PRC encourages listed companies to use abnormal or falsified related party transactions to manipulate financial results. To address the problem, the CSRC and the MOF made great efforts and, in particular, adopted a more steady approach than that adopted in other countries and by the International Accounting Principles Committee. This is reflected in the formulation and promulgation of the accounting principles related to profit recognition such as income, investment, non-monetary transactions, etc. Also, the CSRC set rules in 2001 requiring that profits from abnormal transactions should be excluded in determining whether the company has met the profit requirements. It also issued rules on how to calculate and disclose abnormal profits and losses. Under the facilitation of the CSRC, the MOF issued a special document at the end of 2002 prescribing that profits from abnormal transactions with related parties cannot be treated as current income. Instead, they are required to be recognized as a contribution to shareholders’ equity.

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The standards of independence, objectivity and impartiality of intermediary agencies have to be improved Investment banks, credit appraisal organizations, accounting firms, asset valuation firms, law firms and other intermediary agencies as well as their related systems and practices are generally regarded as important to the infrastructure of a securities market. The good quality service of intermediary agencies is helpful to promote the healthy development of the securities market, to force management to improve the level of corporate governance, and to optimize the allocation of social resources. In the CPA industry, the major effective measures adopted include: (a) A license system for CPAs. (b) Accounting firms are pushed to separate from their original parent organization. (c) Standards and guidelines on auditing, professional ethics, quality controls and continuous professional education have been set and issued. (d) The CPA industry in the PRC has opened. In the coming years, the biggest problem facing the intermediary agencies in the PRC is how to further open-up the intermediary service market pursuant to commitments made to the WTO.

2.7.4

Law enforcement

Since the establishment of the securities market in the PRC, the CSRC and other government bodies have attached importance to the investigation and punishment of activities contrary to the laws and regulations or infringing the rights and interests of minority shareholders. For instance, over the past seven years, 41 listed companies had been investigated and punished by the CSRC for infringements of laws and regulations. Also, numerous listed companies received public censure or private reprimand from the CSRC and the stock exchanges. However, we have to recognize that the strength and scope of investigation and punishment is not sufficient in light of the quantity and severity of activities against the laws and regulations or infringing the rights and interests of minority shareholders. Several recent judicial interpretations by the Supreme People’s Court on civil compensation in the securities market have facilitated investors and other victims to instigate compensation claims. This will enhance the awareness of the

52 The Governance of East Asian Corporations

responsibility of corporate management and intermediary agencies such as accounting firms, and promote the improvement of corporate governance.

References Aharony, J., J. Lee, and T. J. Wong (2000). Financial packaging of IPO firms in China. Journal of Accounting Research 38 (Spring): 103–126. Cha, L. M. (2002). Summarize experience, innovate with boldness, and promote the establishment of modern enterprise system among listed companies. A Seminar of Experience Exchange and Summary for Building Modern Enterprise System in Listed Companies, Shanghai, Dec. 27. Sponsored by CSRC, SETC. Cha, L. M. (2003). Corporate Governance Reform in China: Progress and Prospects, Global Corporate Governance Reform: Challenges and Opportunities, Shanghai, Jan. 21. Chen, C., S. Chen and X. Su (2000). Profitability regulation, earnings management and modified audit opinions: Evidence from China. Working paper, City University of Hong Kong. CSRC (1997). Guidelines for Articles of Association of Listed Companies. CSRC (1999). The Notice of General Manager and Senior Management of Listed Company Can not Hold Concurrent Positions in Holding Companies. CSRC (2000a) The Notice of Listed Company Offering Guarantee to the Others. CSRC (2000b). The General Requirements Governing Shareholders’ General Meeting of Listed Companies. CSRC (2000c). Reporting and Disclosure Requirements for Companies with Securities Issued to the Public #1 – Specific Regulations for the form and content of prospectus of commercial banks. CSRC (2000d). Reporting and Disclosure Requirements for Companies with Securities Issued to the Public #3 – Specific Regulations for the form and content of prospectus of insurance companies. CSRC. (2000e). Reporting and Disclosure Requirements for Companies with Securities Issued to the Public #5 – Specific Regulations for the form and content of prospectus of stock companies. CSRC (2000f). Reporting and Disclosure Requirements for Companies with Securities Issued to the Public #7 – Specific Regulations for the form and content of annual reports of commercial banks. CSRC (2000g). Reporting and Disclosure Requirements for Companies with Securities Issued to the Public #8 – Specific Regulations for the form and content of annual reports of stock companies. CSRC (2001a). The Standard for the Form and Content of Information for Disclosure by Companies with Securities Issued to the Public #1 – Prospectus. CSRC (2001b). The Standard for the Form and Content of Information for Disclosure by Companies with Securities Issued to the Public #11 – Prospectus for issuing new shares by listed companies. CSRC (2002a) China Securities and Futures Statistical Yearbook, Beijing, Baijia Publisher House. CSRC (2002b). Code of Corporate Governance for Listed Companies.

Wei Guo Zhang 53 CSRC (2002c). Provisional Rules on Qualified Foreign Institutional Investors (QFII) to Invest in Domestic Securities. Jiang, Q. (2002). Deepening Reform and Operating Legally, Become Earnest and Responsible Shareholders of Listed Company, A Seminar of Experience Exchange and Summary for Building Modern Enterprise System in Listed Companies, Shanghai, Dec. 27. Li, B. (2002). Promoting Corporate Governance, Strengthening Interior Management, China Securities, Dec. 23. Li, D. (2001) Majority Share Control, Earnings Management and underperformance of listed Companies, PhD Dissertation, Shanghai University of Finance & Economics. National People’s Congress (NPC), (1999), Accounting Law. Wei, G. (1998a). Case study of no-dividend issued by China listed company. Securities Market Herald, Issue 5. Wei, G. (1998b). Case study of dividend policy carrying out by China listed company. Economic Research, Issue 6. Wei, G. (2000a). Case study of stock dividend issued by China listed company. Securities Market Herald, Issue 11. Wei, G. (2000b). Case Study of Cash Dividend Issued by China Listed Company, Securities Times, November 24. Wei, G. (2003). Independent directors; corporate performance and earnings management. PhD dissertation, Shanghai University of Finance & Economics. Yuan, H. (1999). Provisional measures governing IPO and Trading. PhD Dissertation, Shanghai University of Finance & Economics. Zhou, X. (2002). Keeping Pace With the Times, to Create A New Situation in Promoting Listed Companies Development, A Seminar of Experience Exchange and Summary for Building Modern Enterprise System in Listed Companies, Shanghai, Dec. 27.

3 Governance in Family-Owned Hong Kong Corporations Judy S. L. Tsui and Vanessa Stott

3.1

Introduction

In 1997, Hong Kong’s sovereignty reverted to the People’s Republic of China (PRC), but the Hong Kong Special Administrative Region (SAR) has retained its common law system.1 As such, and following La Porta et al.’s (1998) empirical findings, Hong Kong should offer relatively better investor protection than the jurisdictions in this book which have civil law systems. Further, a key characteristic in Hong Kong is that most of the large companies are family-owned. SCMP (2000) has argued that family owned firms in Hong Kong are subject to fewer typical agency problems than non-family firms. The challenge for Hong Kong’s regulators, as pointed out by Tsui and Shieh (2004), is to implement effective corporate governance measures which recognize the importance of concentrated ownership and yet balance the interests of controlling and minority shareholders. In this chapter we outline Hong Kong’s position in terms of ownership, regulatory provisions and various corporate governance reforms that the government has instituted.

3.1.1

Ownership

As reported by Claessens et al. (2000), Hong Kong ranks third among nine East Asian countries2 in terms of concentration of cash-flow rights (with an average of 24.3%) and ranks fourth in terms of concentration of control rights in the hands of large blockholders (28.08%). The average number of firms controlled by a single family is 2.36, and the percentage of total value of listed corporate assets controlled by the largest ten family groups reaches 32.1%. Perhaps surprisingly, it was also found that the largest separation of ownership and control in Hong Kong occurs in relatively small firms. 54

Judy S. L. Tsui and Vanessa Stott 55

3.1.2

Legal and regulatory requirements

The main legal requirements concerning corporate governance are found in the Companies Ordinance (Cap 32) and the Securities and Futures Ordinance (Cap 571). The fiduciary duties and the duties of care and skill applying to all directors are not however contained in either of these ordinances – they remain as common law principles. The Rules governing the listing of securities on the Hong Kong Stock Exchange also impose significant corporate governance requirements but these rules lack statutory backing and are devoid of effective sanctions.3

Companies Ordinance (CO) Historically, the development of Hong Kong’s company law has tended to follow developments in the U.K. Since the return of the sovereignty of Hong Kong to China, it is noticeable that the Standing Committee on Company Law Reform (SCCLR) increasingly looks to a range of jurisdictions, but mostly common law jurisdictions, before making recommendations for reform. The CO provides some requirements relating to corporate governance: these include matters concerning the appointment of a director of a company and the need for a director to declare direct or indirect interest in a contract with the company. The CO also requires a report by the directors to be attached to every balance sheet in the annual report. Every company must keep proper books of accounts and those accounts must give a true and fair view of the company’s financial statements and must be audited. The Ordinance contains certain provisions that aim to ensure that the rights of the shareholders of the company are adequately protected. There are a number of provisions in the Ordinance that are specifically designed to protect minority shareholders. For example, the holders of 5% of the paid up share capital of the company which carries the right to vote may demand the directors to call a general meeting; if the directors fail to do so, the shareholders may convene a general meeting themselves. If minority shareholders feel there is a need for a formal inquiry into the affairs of the company, they may petition the Financial Secretary to appoint an inspector and order an investigation.

Securities and Futures Ordinance (SFO) The SFO applies to all companies that list their securities in Hong Kong. The SFO took more than a decade in coming to fruition but was

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finally enacted in March 2002 and came into effect on the 1st of April 2003. Its purpose was not only to consolidate Hong Kong’s securities laws, bringing into one piece of legislation ten former ordinances including the Securities (Disclosure of Interests) Ordinance, the Securities (Insider Dealing) Ordinance and the Protection of Investors Ordinance,4 but also to modernize and improve the effectiveness of the regulatory regime. The investigative and disciplinary power of the Securities and Futures Commission (SFC) was widened, and its regulatory objectives, functions, powers and duties include: • listed companies and listing applicants are now required to file copies of their disclosures and applications for listing respectively to the public and, not only with the Hong Kong Exchanges and Clearing Co Ltd (HKEx) but also with the SFC.5 • all forms of market misconduct, including insider dealing, are punishable with a term of imprisonment.6 • in respect of substantial shareholders being required to disclose their holdings, the disclosure threshold is lowered from 10% to 5% and the time limit for disclosure reduced from five days to three business days so as to provide investors with timely and accurate information for their investment decisions. • investors who suffer losses as a result of market misconduct are granted a clear statutory right to take civil actions and claim compensation for loss. The above measures are expected to enhance the effectiveness of the regulatory framework to protect investors, reduce market misconduct, and promote better corporate governance in Hong Kong.

Banking Ordinance (BO) BO governs the activities of banks, restricted license banks and deposit taking companies operating in Hong Kong, generally described as “authorized institutions” (AIs). The BO gives the authority to the Hong Kong Monetary Authority (HKMA) to promote the stability and effective working of Hong Kong’s banking system and ensure proper standards of conduct and sound and prudent business practices amongst AIs and money brokers. In this regard, the HKMA (2001) has issued statutory guidelines that set out the minimum corporate governance standards for locally incorporated AIs. These guidelines include a recommendation that at least three independent directors be appointed to the board of directors (BOD) in

Judy S. L. Tsui and Vanessa Stott 57

order to provide a sufficient pool of resources for quality independent monitoring.

3.1.3

Regulatory framework and requirements

Since the 1987 stock market crash, Hong Kong has established a three tier securities regulatory framework comprising the Financial Services and Treasury Bureau and the Companies Registry (representing the Hong Kong SAR government), the SFC and the HKEx. A review of the markets was then undertaken7 with a view to identifying the changes desirable to ensure their integrity and to protect investors. Besides making recommendations for the stock and futures exchange, it was recommended that the market be regulated by an independent statutory body. This ultimately led, in 1992, to the creation of the SFC. In essence, the government sets the policy, the SFC regulates the daily operation of brokers and the SFC together with HKEx regulates listed companies.

Stock exchanges Companies which trade on Hong Kong’s stock and futures exchanges are also subject to additional rules as laid down by the two exchanges: the Stock Exchange of Hong Kong Ltd (SEHK) and the Futures Exchange of Hong Kong Ltd. In 2000, these two exchange companies, together with the Hong Kong Securities Clearing Company Ltd (HKSCC) became wholly owned subsidiaries of the HKEx. Shortly after its creation, HKEx was itself listed on Hong Kong’s Stock Exchange. The HKEx operates the Main Board and the Growth Enterprise Market (GEM), the latter a secondary board which was introduced in 1999 for companies with higher risk but higher growth potential. The HKEx is the thus generally accepted as the “front line” regulator of listed companies.

Main board listing rules Companies listed on the Main Board of the Stock Exchange of Hong Kong are required to follow the Listing Rules. The Exchange has also published a Code of Best Practice, which although not mandatory, is incorporated in Appendix 14 of the Listing Rules. The Code is intended to be a guideline and, while it does not have to be strictly adhered to, companies listed on the Main Board are encouraged to comply with the provisions. The Code outlines the best practices in corporate governance in terms of board composition, directors’ access to information, appointment and re-appointment of directors and the establishment of

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audit committee among others. The SCCLR proposed extensive change to this Code (see below). With respect to directors, the Listing Rules reiterate directors’ common law fiduciary duties, which include requirements to act honestly and in good faith for the company, to avoid conflicts of interest and duty, and apply the skill, care, and diligence that would be reasonably expected of directors. The Listing Rules also require that the board of every listed company have at least two independent non-executive directors (INEDs). The Exchange may require more than two INEDs if they consider the size of the board or other circumstances justify it. The Listing Rules also define an independent director as a director holding not more than 1% of the total issued share capital, having no past or present financial interest in the company (other than shareholding, subject to 1% limit), and fulfilling no management function in the group. Directors are also encouraged to follow the “Model Code for Securities Transactions by Directors” which is found in Appendix 10 of the Listing Rules. While not mandatory, the Code is expressed in the form of guidelines which set minimum standards of good practice with respect to buying and selling securities of the company on whose board they sit.

Growth Enterprise Market (GEM) listing rules The HKEx also operates a secondary exchange, known as the GEM, for high growth and high risk companies which normally do not meet the criteria of the Main Board. It is described as “a buyers beware market for informed investors”. To compensate somewhat for the increased inherent risks in these listed companies, GEM rules are in certain respects more stringent than those required in the Main Board Listing Rules. Similar to the Main Board rules, the GEM Listing Rules reiterate the common law fiduciary duties of directors, and require a minimum of two INEDs to be on the board at all times. Similarly, the company concerned must appoint a ‘qualified’ company secretary with an additional requirement to employ a qualified8 accountant. One executive director is required to be appointed as the company’s compliance officer, who will act as the liaison between the company and the Exchange and will be responsible for all matters of compliance with the Listing Rules and Ordinances and other laws and regulations. GEM listed companies are required to establish audit committees. The audit committee must have a minimum of two members, the

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majority (all if the committee has only two members) of which are INEDs, and it must be chaired by an INED. The Rules also refer to the Hong Kong Society of Accountants’ Guide to the Formation of Audit Committees (discussed later) for further guidance. The GEM Listing Rules incorporate the “Model Code for Securities Transactions by Directors” from Main Board Listing Rules (Appendix 10) as guidelines.

Securities and Futures Commission (SFC) The SFC is also the primary regulator for Exchange Participants (brokers) and has oversight of all the HKEx’s, and its subsidiary’s operations. The SFC’s statutory duty to supervise and monitor the stock market in addition to the HKEx inevitably gives rise to some confusion amongst the investing public. For these reasons, since 1991, a memorandum of understanding has sought to ensure that the HKEx deals with the day-to-day administration of listing related matters.9

Hong Kong Monetary Authority (HKMA) Another source of corporate governance legislation is the BO, enforced by the HKMA whose role is largely to regulate banks and financial institutions. The HKMA was praised in the CLSA (2001) survey on corporate governance in emerging markets for setting the lead in Hong Kong for issuing corporate governance guidelines to all banks and financial institutions operating in Hong Kong.

Accounting standards and disclosure The CO, the Statements of Standard Accounting Practice (SSAPs) issued by the Hong Kong Society of Accountants (HKSA), and the Rules Governing the Listing of Securities issued by the HKEx, are the major sources that prescribe the mandatory accounting principles and disclosures for companies listed in Hong Kong. The HKSA has issued Interpretations to provide authoritative guidance on the application of the SSAPs. In addition to the SSAPs and Interpretations, the HKSA also issues Accounting Guidelines and Technical Bulletins. The HKSA has adopted a policy to converge with the International Accounting Standards (IAS). For the most part, the HKSA’s standards are in line with IAS in terms of measurement, recognition and disclosure. It is worthwhile noting that Hong Kong SSAPs do not have statutory backing, but they are the most authoritative source of Hong Kong Generally Accepted Accounting Principles (GAAP).

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Apart from the regulatory requirements that govern corporate governance practices in Hong Kong, there are additional recommendations on corporate governance practices from professional institutes/ organizations such as the HKSA and Hong Kong Institute of Directors (HKIoD). Since 1995, the Corporate Governance Committee of the HKSA has responded to the debate on corporate governance in Hong Kong with a number of guidelines and publications. They include recommendations on the roles and responsibilities of BOD, financial reporting and audit, and other additional disclosures such as the inclusion of a statement on internal control in the annual reports. Several of the publications dealt specifically with the establishment and function of effective audit committees, directors’ remuneration and board structure and functions. The HKIoD also issued guidelines summarizing the existing laws governing directors’ duties and recommending good practice for directors in areas where the law is vague or unclear.10 The above reviews the regulatory framework and requirements as well as the financial reporting and disclosures environment governing the existing corporate governance regime and its review process in Hong Kong. The following analyzes some of the recent developments in the corporate governance reform process.

3.2 3.2.1

Recent corporate governance developments Corporate governance reforms

The government’s major initiative in corporate governance reforms was the setting up of the SCCLR 11 which was entrusted with the task of conducting a Corporate Governance Review to promote and strengthen Hong Kong’s position as an international financial center in the Region. The Consultation Paper on proposals made in Phase I of the Corporate Governance Review was published in July 2001 with Phase II due to be completed. Some of the recommendations concerning shareholder remedies may be dealt with by a Companies (Amendment) Bill. The final recommendations arising from Phases I and II of the Review are to be submitted to the government. The Review will likely take four years to complete, in part because consultation processes are inevitably time consuming, but also because of the scope of corporate governance issues. It was also determined at the outset that the Review would extend to public unlisted companies

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and private companies. The SCCLR offers two points to justify this extension: • First, the law does not require a company issuing shares to the public to list on any exchange and that investors in publicly held but not listed companies need as much, if not more, protection than investors in listed companies because they do not have the protection of the securities regulators, • Second, private companies comprise the majority of Hong Kong’s registered companies12 and play a very significant economic role because they contribute (together with unincorporated businesses) “roughly 40%” to Hong Kong’s GDP and employ “about 60%” of the work force. The SCCLR adds a further point – that shareholders in a public company usually have the option of selling their shares, whereas “no such remedy is available to shareholders in private companies”. Thus many of the SCCLR’s proposals concern revisions and additions to the CO which will apply to all companies.

3.2.2

Corporate governance review – phase I

The SCCLR’s major proposals in Phase I concerned the following: • Directors’ duties: non-statutory guidelines are proposed summarizing the principles of law in relation to directors’ fiduciary duties and duties of care and skill.13 The SCCLR gives a number of reasons for not proposing to enact directors’ duties; they include the impossibility of properly encapsulating all duties in the law, the regard of a statutory enactment as exclusive, the inflexibility of laws and the lack of accommodation of judicial developments to take into account changing standards. The SCCLR explains that in proposing a guideline, their intent is to make the principles of the common law and equity more accessible. In relation to the duty of care and skill, the SCCLR also explains their view is based on the assumption that it is open for case law to demand higher standards, as evidenced by international developments. • The process of electing directors: the SCCLR proposes that the rights of shareholders to elect directors should be set out in the Ordinance and give shareholders a reasonable period of time within which to nominate directors for election. The manner of selecting candidates and the biographical details of candidates should be

62 The Governance of East Asian Corporations

disclosed to shareholders. The reasons why a person has resigned as a director or declined to be reappointed should also be disclosed. In relation to the rights of the shareholders to nominate directors for election, the SCCLR has not reached a firm decision on whether there should be any limit on, criteria for, or the percentage of shareholding required, for such nominations. • Directors/controlling shareholders voting on transactions in which they have an interest (self-dealing): the SCCLR proposes to strengthen existing laws by prohibiting a director from voting at a board meeting on a matter on which he has a material interest, except in limited circumstances as laid down in the Ordinance and by requiring disclosure of such matters to shareholders. Also, if the selfdealing is above a certain value, the transaction should be approved by the shareholders in a general meeting. They also propose providing civil consequences in the event of breach of the Ordinance, and widening the provision to include “transactions”, “arrangements” and “connected persons”. The SCCLR also proposes extending these requirements to controlling shareholders. • Connected transactions: the SCCLR proposes the introduction of a statutory provision to require disclosure of transactions potentially benefiting a director or a person connected with a director. They propose that the persons connected with a director should include their children or step children, spouse, trustee of any trust in which the director or his family are beneficiaries, and any company associated with the director. The transactions to be disclosed include the acquisition and disposal of all types of assets, and all other arrangements potentially benefiting the director or connected person. Above a certain value, such transactions would require the approval of disinterested shareholders. But what that value should be remains a point for debate. The SCCLR also proposes extending these requirements to controlling shareholders, and persons connected with controlling shareholders. The definition of “controlling shareholder” remains a matter for debate but one option is to adopt the HKEx’s definition, namely a person controlling 10% or more of the voting power at any general meeting. • Transactions between directors or connected parties with an associated company: the SCCLR proposes revision of the HKEx’s listing rules to

Judy S. L. Tsui and Vanessa Stott 63

extend connected party transactions to associated companies (the rules presently apply only to the listed company itself and its subsidiaries). The SCCLR proposes that an “associate company” should be defined as one in which a listed company controls the exercise of 20% or more of the voting rights of the equity capital. As in the case of connected transactions, disinterested shareholder approval and the extension of these requirements to controlling shareholders, and persons connected with controlling shareholders, is proposed. • Chief Executive Officer(CEO)/chairman: the SCCLR concludes that in Hong Kong, it would be difficult to separate the roles and functions of the Chairman and CEO. • Shareholder remedies: the SCCLR’s proposals in this regard include the introduction of a statutory derivative action, amendments to the remedies which may be granted by the court in the event of “unfairly prejudicial” conduct (s 168A), clarification of the rights granted to individual members to enforce the company’s memorandum and articles, the introduction of a statutory right to obtain access to company records and, an extension of the powers of the court to grant an injunction against any contravention of the CO or any breach of fiduciary duties. The SCCLR also considers the powers of regulators in relation to enforcing standards of corporate behavior and proposes that the SFC should be allowed to bring derivative actions, on behalf of a listed company, in relation to breaches of duty. This proposal has proved to be controversial. • Corporate reporting: the SCCLR proposes that private companies with limited liability should be required to file their financial statements with the Registrar of Companies for public inspection. The SCCLR also proposes that auditors should be required to report on inconsistencies between audited financial statements and other information contained in the directors’ report. Whether auditors should also be required to report in respect to inconsistencies in other sections of a listed company’s annual report will require a definition of an “annual report” and the public’s view is being sought on this extension. It is also proposed that listed companies be required to provide more qualitative and forward looking management discussion and analysis.14 • Standards setting/monitoring of corporate reports: the SCCLR proposes that the standard setting function should continue to be vested in

64 The Governance of East Asian Corporations

the HKSA but that the composition of committees concerned be widened to cater for more involvement of the public.15 This proposal was made on the basis that HKSA adopts a policy of benchmarking local standards against IASs and International Standards on Auditing (ISAs), which already provide a substantial element of independence and objectivity in the standard setting process. It is also proposed, with a view to improving financial reporting practices, that a body be set up to investigate financial statements with the power to order companies to revise their financial statements and that further improvement be made to the HKSA’s Practice Reviews undertaken with respect to both listed and private companies. In relation to the revision of audited financial statements, the SCCLR proposes that when it comes to the attention of the directors that there are material misstatements in the financial statements that have been laid before the company in the general meeting and filed (in the case of a public company), they should file a warning statement with Companies Registry to prevent further reliance on that statements and meanwhile to work with the auditors on a set of revised financial statements. Also, if the auditors find such a misstatement, they should report this to the directors. These proposals are made as a means to ensure that the financial statements give a true and fair view as required by the CO. The above summarizes the major proposals made by the SCCLR in its Phase I recommendations relating to directors’ duties, connected transactions, shareholders’ remedies, and corporate reporting. These are attempts to further enhance corporate governance in accordance with international benchmarks.

3.2.3 Proposals for listing rules amendments by Hong Kong Exchanges and Clearing Co Limited (HKEx) In January 2002, the HKEx published the Consultation Paper on Proposed Amendments to the Listing Rules Relating to Corporate Governance Issues to raise the standard of corporate governance of Hong Kong to an international standard. The amendments cover directors and board practices, corporate transactions and shareholders’ rights, and corporate reporting and disclosure of information. One of the proposals concerns the designation of an executive director, with appropriate qualifications, to be responsible for accounting and financial reporting; and the appointment of an executive director with appropriate qualifications who should be appointed as com-

Judy S. L. Tsui and Vanessa Stott 65

pliance officer. These recommendations parallel the existing GEM Listing Rules. The proposals also include more explicit statements of the duties and responsibilities of non-executive directors including their attendance at board meetings, the protection of minority interests, and their participation in audit and other committees. It is also suggested that separation of the roles of chairman and CEO should be observed as good practice. The proposal includes stricter definitions for independence in the case of INEDs, as well as recommending that not less than one-third of the board should be INEDs. It is proposed that audit committees be mandatory, comprised of at least three INEDs, with the majority being INEDs. Remuneration committees and nomination committees are also recommended. In the case of non-compliance, disclosure of such a fact would be required. With respect to reporting, quarterly reports are proposed with a requirement for review by audit committees and publication within 45 days of their quarter-end. For the half-year and annual reports, the time limits of publishing these reports are proposed to be shortened to two months and three months after the relevant period ends respectively. It is also proposed that the annual report contain a statement on corporate governance practices, and disclosure of directors’ remuneration. The above summarizes the recent developments of corporate governance reforms initiated by the SCCLR and HKEx. Both proposals are being considered as part of the overall corporate governance reform in the legal and regulatory framework in Hong Kong. Since Hong Kong has been successful as a laissez-faire economy, any further enactment of laws and/or regulations to its existing legal and regulatory infrastructure would have to be taken with extreme caution.

3.3 Challenges for corporate governance reform in Hong Kong The relationship-based corporate governance regime which leads to less transparency and accountability is born out of the concentrated ownership structure found throughout East Asia. One of the common yet important agency problems that occur in countries with concentrated ownership is minority shareholder expropriations (Shleifer and Vishny, 1997). La Porta et al.’s (1998) study showed that countries with concentrated share ownership have poor investor protection. In Hong Kong, we can infer that the highly concentrated share ownership by families is associated with relatively poorer protection for minority shareholders. The prevalence of about 66% of family owned

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firms in Hong Kong could be an obstacle to enhanced corporate governance (Claessens et al., 2000). However, other academics have argued that family ownership can be considered an effective corporate governance device in its own right since agency conflicts arising from the separation of ownership from control between shareholders and management are reduced (SCMP, 2000). Family shareholders who are actively involved in management are likely to pursue long-term value maximization objectives. Tricker (1998) suggested that shareholders in Hong Kong might be seen as part of the family business where the owner manager was the center of the family business, surrounded by “concentric rings”, first of the immediate family members of the owner manager, then those related parties in the business, and finally “the shareholders in the outer ring of this extended family”. In this case, no agency problem would arise as the directors, who are family members, could be trusted to pursue the interests of the shareholders. Though the typical agency problem arising from the separation of ownership from control may not be an issue for family owned firms, others have argued that the nature of the agency problem could be different since the controlling shareholders in family-owned firms can expropriate funds from the minority shareholders through a pyramidal structure whereby a private holding company sits at the top, with a second tier company holding the most valuable assets and the listed company at the third tier of the overall structure. In addition, the fact that the controlling family members or their nominees would occupy senior management positions would also exacerbate the corporate governance problem (Tsui and Lynn, 2001). It is also not uncommon that the CEO and chairman are one and the same person, who represents the controlling family as well. Therefore, family domination and entrenchment resulting from the shareholding ownership structure in Hong Kong could give rise to allegations of minority shareholder expropriations. Related to the issue above, it is argued that more shareholder activism can improve corporate governance practices. In particular, research findings show that institutional investors such as insurance companies, pension funds and mutual funds, due to their relatively large shareholding in firms, have both the interest and the power to push companies towards better governance (e.g., Daily et al., 1996; Hirschmann, 1970; La Porta et al., 1998), and some studies find that active participation in corporate governance by institutional shareholders will lead to better firm performance (Agarwal and Rao, 1990;

Judy S. L. Tsui and Vanessa Stott 67

McConnell and Servaes, 1990). Although Hong Kong has witnessed significant growth in the institutional shareholding, including a rise in the number of authorized unit trusts and mutual funds from 77 in 1981 to 1,701 in 2000 (HKIFA, 2000), shareholder activism is generally not common in Hong Kong. This may be partly attributed to the prevalence of family ownership in Hong Kong (Doe, 1998). Recently, the Asian Corporate Governance Association (ACGA) formed an investor discussion group for institutional investors to address this problem, and tried to create a platform to allow them to discuss issues about corporate governance on a regular basis (HKSA, forthcoming). One shareholder activist was recently elected to be an INED for the HKEx. Another major challenge to the enhancement of corporate governance in Hong Kong is the availability of “truly independent” INEDs, both in terms of quantity and quality. In a small business dominated by family-controlled companies, it is very difficult for Hong Kong to have truly independent INEDs and so INEDs, who are well qualified in terms of business expertise and experience, are usually connected to the company’s chairman or CEO. In times of economic downturn, such as that being experienced in Hong Kong in early 2000, it may be even more difficult for companies to offer sufficiently attractive compensation packages to attract qualified and experienced executives outside of Hong Kong. In addition to the above two challenges, the enforcement of the rules and regulations relating to corporate governance is also an issue. Only the CO and the SFO have statutory power; the Listing Rules and the Code of Best Practice on corporate governance do not. The Listing Rules require directors of a listed company to adhere to the fiduciary duties of skill and diligence to the standard established by common law in Hong Kong. In cases where there is a wilful or persistent failure by the director to discharge his responsibilities under the Listing Rules, the HKEx may state publicly that the retention of the director is not in the best interests of investors. If that director remains in office after HKEx’s public statement, the trading of that company’s shares may be suspended. The Code of Best Practice is not intended to be rigidly followed. Instead, each listed company is encouraged to implement the code of practice that best suits it. Therefore, the impediment to effective corporate governance lies not only in the corporate governance reform but also in the associated enforcement. The continuous reforms that Hong Kong needs are an ongoing process.

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3.4 Conclusion Over the past several years, the Hong Kong SAR government has been committed to major corporate governance reform in terms of legal and regulatory changes, accompanied by more attention on effective implementation of the reform measures through better enforcement. This is already a significant step forward to encourage listed companies to enhance their corporate governance practices and related disclosures. The improvement can be witnessed from the fact that Hong Kong is ranked number two (second to Singapore) for its macro corporate governance environment among ten Asian countries, according to a survey done by Corporate Governance Watch in its 2003 report (HKSA, forthcoming). In order to ride out the economic downturn in Hong Kong and be ready for an upward swing, it is imperative that institutional investors and individual minority investors alike have better investor protection through enhanced corporate governance practices, related disclosures and effective enforcement.

Notes 1. Under the Joint Declaration and Basic Law, which took effect on the 1st of July 1997, it was agreed that the common law system will be maintained in the Hong Kong SAR (Article 8) and that the capitalist system and way of life will remain unchanged for 50 years affirming the “One Country, Two Systems” concept (Article 5). 2. The nine East Asian countries examined in the study include Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines, Singapore, Taiwan and Thailand. 3. The SCCLR explained in Phase II of their Review at para 23.11 that the only sanction with teeth is delisting which is a “nuclear” option which has been used very rarely. 4. Cap 335. The other ordinances subsumed and repealed by the SFO are: the Securities Ordinance (Cap 333), the Securities and Futures Commission Ordinance (Cap 24), the Commodities Trading Ordinance (Cap 250); the Stock Exchange Unification Ordinance (Cap 361), Securities and Futures (Clearing Houses) Ordinance (Cap 420), Leveraged Foreign Exchange Trading Ordinance (Cap 451), Exchanges and Clearing Houses (Merger) Ordinance (Cap 555). 5. This dual filing regime is established under the Securities and Futures (Stock Market Listing) Rules made under the SFO. 6. Ibid s 303. The maximum penalties for conviction on indictment are a fine of $10 million and ten years’ imprisonment and on summary conviction a fine of $1 million and three years’ imprisonment. 7. The Governor appointed a committee, chaired by Ian Hay Davidson, to conduct the review. The Committee’s report was published in 1988.

Judy S. L. Tsui and Vanessa Stott 69 8. A qualified accountant who is a member or fellow of the HKSA or similar body of accountants. 9. The current “Memorandum of Understanding Governing Listing Matters” was signed in January 2003. 10. The Guideline reflects the law of Hong Kong as at 31st March 1995. 11. The SCCLR was established in 1984 to advise the Financial Secretary on amendments of the CO and other related ordinances. The Corporate Governance Review process over the past four years was chaired by the Hon Mr Justice Rogers, V-P, JP. 12. The number of local companies incorporated as at the end of 2002 was 503,111 of which 496,189 (98.6%) are private companies. 13. See Chapter 2, part 6, of the Consultation Paper on proposals made in Phase I of the SCCLR’s Corporate Governance Review. 14. Ibid Phase I, chapter 4, Section 23.08. This proposal is being followed up by the HKEx. 15. Ibid Phase I, chapter 4, Section 26.13. The committees concerned are the Financial Accounting Standards Committee (FASC) and Auditing Standards Committee (Au SC). This proposal has already been followed up by HKSA.

References Agarwal, R. and R. P. Rao (1990). Institutional ownership and distribution of equity returns. The Financial Review 25: 211–229. Claessens, S., S. Djankov and L. H. P. Lang (2000). The separation of ownership and control in East Asian corporations. Journal of Financial Economics 58(1–2): 81–112. Credit Lyonnais Securities Asia (CLSA) Emerging Market (2001). CG Watch: Corporate governance in emerging markets (April). Research & Sales Offices, CLSA Ltd. Daily, C. M., J. L. Johnson, A. E. Ellstrand and D. R. Dalton (1996). Institutional investor activism: follow the leaders. Working paper, Purdue University, Indiana University and California State University. Doe, J. (1998). Corporate governance in Hong Kong. International Company and Commercial Law Review 9(10): 281–290. Hirschmann, A. O. (1970) Exit, Voice, and Loyalty. Cambridge, MA: Harvard University Press. Hong Kong Investment Funds Association (HKIFA) (2000) The Hong Kong Investment Funds Yearbook 2000. Hong Kong Monetary Authority (HKMA) (2001). Corporate governance of locally incorporated authorized institutions. Supervisory Pending Manual, CG-1 (September). Hong Kong Society of Accountants (HKSA). Staying ahead, but it’s a long road. The Hong Kong Accountant, forthcoming La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. W. Vishny (1998). Law and finance. Journal of Political Economy 106(6): 1113–1155. McConnell, J. J. and H. Servaes (1990). Additional evidence on equity ownership and corporate value. Journal of Financial Economics 27: 595–612. Shleifer, A. and R. Vishny (1997). A survey of corporate governance, Journal of Finance (June): 737–783.

70 The Governance of East Asian Corporations South China Morning Post (SCMP) (2000). Family control and the Asian crisis. Business Post (September 20). Tricker, B. (1998). Editorial: The role of institutional investor in corporate governance. Corporate Governance 6 (4): 213–216. Tsui, J. and T. Shieh (2004). Corporate governance in emerging markets: an Asian perspective, a chapter in “International Accounting and Finance Handbook”, Third Edition, Edited by Frederick D. S. Choi, New York University. Tsui, J. and S. Lynn (2001). Family control, CEO dominance and firm performance in Hong Kong. Working paper, City University of Hong Kong.

4 Political Patronage, Cross-Holdings and Corporate Governance in Indonesia Etty R. Wulandari and Asheq R. Rahman

4.1

Introduction

This chapter describes and evaluates both the macro and micro aspects of corporate governance of private sector and public sector enterprises in Indonesia. The analysis is based on the corporate governance literature resulting from Williamson (1988), Hart (1995), Shleifer and Vishny (1997), La Porta et al. (1998) and Licht, Goldschmidt and Schwartz (2001). This literature suggests that corporate governance practices of firms evolve from the influences of culture, institutions, markets, contractual arrangements and the rationality and opportunism of human actors. Corporate governance is indeed a product of a web of interacting variables that are too numerous to be analyzed in any single research effort and we simply cover a few within the context of Indonesia. Consistent with Shleifer and Vishny (1997), we see corporate governance as a set of monitoring arrangements associated with the financial contracts of firms. These monitoring arrangements exist within firms, in the capital markets or are imposed by regulatory institutions. The analysis, therefore, starts from the examination of broader contextual issues of corporate governance in Indonesia and narrows down to the more firm specific monitoring issues.

4.2

Background

Indonesia declared its independence from The Netherlands in 1945. Under the 1945 constitution, the president possessed executive responsibility as well as ceremonial functions as head of state. As the first president, Sukarno’s main objectives were the preservation of national unity and the restoration of a sense of national identity. He pursued 71

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these objectives through an increasingly flamboyant style, which led to serious economic decline and inflation (Encyclopedia Britannica, 2001). Political upheaval followed and in March 1968 General Suharto was appointed to the presidency. His three decades of uninterrupted rule gave Indonesia much-needed political stability and sustained economic growth. Suharto instituted a policy he called the New Order where Western investment and foreign aid were encouraged. Indonesia’s domestic oil production was greatly expanded, with the resulting revenues used to fund infrastructure and development projects. By 1972, Suharto had succeeded in restoring steady economic growth, while also reducing the annual rate of inflation from its high of 630% in 1966, to less than 9% (Encyclopedia Britannica, 2001). During Suharto’s regime, Indonesia’s economy grew an average of 7% annually, and living standards rose substantially for the bulk of the population. In 1997, however, Indonesia became caught up in the Asian crisis. The value of the Indonesian national currency, the Rupiah, plummeted, exposing deep flaws in the national economy. Suharto resisted demands for structural reforms even while the economy went into recession, inflation skyrocketed, and living standards collapsed for the poor. Suharto lost the support of the military, and resigned the presidency on May 21. He was succeeded in office by the vice president, B. J. Habibie (Encyclopedia Britannica, 2001). Since his downfall, Indonesia has experienced a rapid transformation towards democratization of politics and business, and corporate governance has come under the spotlight.

4.2.1

Awareness of corporate governance

The key reasons for the crisis that hit Indonesia were intergroup business funding, the centralized ownership of corporations, lack of accountability on the part of the directors and commissioners, low levels of information disclosure, inadequate enforcement of regulations, collusion, corruption, and nepotism (Husnan, 2001). These examples reflect the lack of good corporate governance practices on the part of both the government and the business sector. In an effort to correct this weakness, the government established the National Committee for Corporate Governance (NCCG) on August 19, 1999, (State Coordinating Minister for Economy, Finance, and Industry, Decree no. Kep-10/M.EKUIN/08/1999). This committee was given the task of formulating, designing, and recommending national policies regarding corporate governance including the preparation of a code for

Etty R. Wulandari and Asheq R. Rahman 73

good corporate governance. Additionally, the committee was responsible for performing regular and continuous inspections on the reform efforts in the area of corporate governance. The NCCG has 22 members who are drawn from the private and public sectors.1 The NCCG outlined implementation guidelines for good corporate governance practices in the “Code for Good Corporate Governance (GCG)”, with the intention that they become a reference point for good corporate governance for the entire Indonesian business community. They describe corporate governance with respect to shareholders, the board of commissioners (BOC), the board of directors (BOD), the audit system, the corporate secretary, other stakeholders, disclosure, confidentiality, insider information, business ethics and corruption, donations, regulatory compliance, and equal employment opportunity.2 The NCCG expects that public companies, state-owned enterprises (SOEs) and companies utilizing public funds or engaged in the business of managing public funds will be the first to implement recommendations of the Code. The extent to which these companies embrace fair business practices, and principles of transparency and accountability will dictate the extent to which other business entities will. Before turning to the specifics of the Code, a brief overview of the legal framework, that is, its background will be given.

4.3

Business regulatory framework

Business activities in every country must be carried out within the regulatory framework in that country. The following is a brief description of the regulatory framework in Indonesia.

4.3.1

The Company Law

Previously, limited liability companies were regulated by the Dutch Commercial Code Wetboek van Koophandel, Staatsblad (1847:23). However, to meet the needs of companies in the modern business environment, a new code (Law No. 1 of 1995, hereinafter referred to as “the Company Law”) was promulgated in March 1995. The Company Law regulates all aspects of the limited liability company, including BOD and BOC.

4.3.2

Bankruptcy Law

During the 1997 crisis, a massive outflow of funds and termination of credit facilities occurred. This made many Indonesian businesses realize for the first time that the bankruptcy law and the courts had

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insufficient capacity to address disputes arising from bankruptcies. In order to provide for fair settlement, a strong legal framework was needed. On September 9, 1998, a new law (Law No. 4 of 1998) was issued to amend the bankruptcy law and establish a commercial court. According to Article 1 of the “new” Bankruptcy Law, a debtor who has two or more creditors and has failed to pay at least one debt which is due and payable, shall be declared bankrupt by the decision of a competent court, either upon his own petition, or upon petition of one or more of his creditors. The intention of the bankruptcy law is the distribution of all the assets of the debtor among all his creditors with due observance of their respective rights.3

4.3.3

Securities market regulations

On December 14, 1912, Indonesia’s first stock exchange was set up in Batavia under the auspices of the Dutch colonial government. After that, the Indonesian capital market was closed and opened again several times due to economic and political instability. When the capital market was most recently reactivated in 1977, the Capital Market Executive Agency (hereinafter to be referred to as Bapepam (Badan Pengawas Pasar Modal)) was established. Bapepam is led by a chairman assigned by the President and is responsible to the Minister of Finance. In its earlier stages, Bapepam acted both as an organizer and as a supervisor, but this dual task was eliminated in 1990. Bapepam maintained its acronym but changed its function from Capital Market Executive Agency to Capital Market Supervisory Agency, leaving supervision of the capital market as its sole function (Indonesian Capital Market Supervisory Agency, 1999). From 1977 to 1987 development of the capital market was sluggish. Only 24 companies were publicly listed during those years. However, in 1988 banking was liberalized and capital markets reformed, the market started to grow. In 1995, realizing that the capital market has a strategic role as a source of funding for business and as a vehicle for public investment, a new law was enacted (Capital Market Law No. 8) which provided the Indonesian capital market with sound legal foundation and extended Bapepam’s authority in the fields of regulation, development, supervision, and law enforcement. It also clarified the authority and responsibilities of self-regulatory organizations, capital market institutions and professionals, and firms doing business in the capital market (Indonesian Capital Market Supervisory Agency, 1999). Figure 4.1 shows the details of the Indonesian capital market structure. It shows that Bapepam is the highest regulatory agency within the Indonesian capital market regulatory structure.

Etty R. Wulandari and Asheq R. Rahman 75

Figure 4.1

The Indonesian Capital Market Structure

Source: Indonesian Capital Market Supervisory Agency (1999).

The Jakarta Stock Exchange (JSX) The JSX has been operating since the reactivation of the capital market in 1977. Located in Jakarta, it is one of two privately operated stock exchanges in Indonesia, the other being the Surabaya Stock Exchange. The JSX is the larger of the two stock exchanges, with a market capitalization of Rp. 451.8 trillion in 1999 (JSX, 2000a). The instruments traded on the JSX include shares, rights certificates, warrants, bonds and convertible bonds. Investors who want to trade have to do so through a securities company which is a member of the JSX. Currently, there are 197 shareholders in the JSX. Also, 188 securities companies are acting as JSX members.4 The Composite Stock Price Index (CSPI), introduced in 1983, is used as the main indicator of stock price movements in the JSX. The JSX listing requirements and periodic companies’ disclosure requirements affect financial reporting practices for listed companies.

76 The Governance of East Asian Corporations

Currently, listing at the JSX is classified on two listing boards, namely the Main Board and the Development Board, each with its own requirements.

4.4

Corporate governance

There are numerous governance mechanisms in Indonesia. Some important ones are described here to highlight the state of Indonesian corporate governance. Due to the specific nature of listed companies and SOEs, the explanations for each of these two types of firms will be provided separately.

4.4.1 Listed companies Board of Directors (BOD) and board of commissioners (BOC) Indonesia follows a two-tier board system, which is comprised of the BOC and BOD. The BOD is what is commonly called “management”, while the BOC would be called “the Board of Directors” in a unitary board (one-tier) system. The commissioners have the responsibility to supervise the directors and to advise them in the running of the company. The directors have full responsibility for the management of the company in accordance with the interest and goals of the company, and to represent the company both in and out of court. The shareholders’ meeting is the highest authority in the company. It has the authority to elect both the commissioners and the directors, determine the use of profit, determine the remuneration of directors and commissioners, set the key policies of the corporation, approve the Articles of Association and define the duties of directors. The directors have full responsibility to define and manage the company’s activities: in effect, the BOD in an Indonesian corporation conducts almost all tasks and obligations of the BOD and the management in corporations with single boards. There is a clear separation between the BOD and the BOC. The directors cannot be members or the chairmen of the BOC. The BOC, however, mostly represents the majority shareholders. A recent listing rule of the JSX (2000b) (JSX No. 1-A regarding General Provisions of Equity Securities Listing Rules in JSX, effective July 1, 2000) lays out the obligation of independent commissioners. The number of independent commissioners is required to be proportionate to the number of shares owned by non-controlling shareholders, and inde-

Etty R. Wulandari and Asheq R. Rahman 77

pendent commissioners constitute at least 30% of the membership of the BOC. These arrangements were put in place to protect minority shareholders.

Audit committee The Corporate Governance Framework proposed by the NCCG recommends that the BOC of a corporation establish an audit committee consisting of members of the BOC. The BOC may invite outsiders to join the committee to achieve the requisite mixture of skills, experience and other qualities necessary for achieving the objectives of the audit committee. The audit committee is expected to be independent of the BOD and the external auditors, and hence should report solely to the BOC. It is also expected that the removal of a member of the audit committee should require the approval of more than 50% of the members of the BOC (NCCG, 2001). Bapepam released Circular Letter No. SE-03/PM/2000 concerning audit committees on May 5, 2000. This contained recommendations to form an audit committee as a measure to improve accountability of independent commissioners. The Letter also recommends that audit committees have at least three members, one of whom should be an independent commissioner. The member of the audit committee who comes from the BOC would act as the chairman of the audit committee. The audit committee has the responsibility to give an opinion to the BOC regarding statements or anything submitted by the BOD to the BOC. It may review: • financial information to be disclosed by the company, e.g., financial statements or projections; • the company’s compliance with the regulations of the capital market and other relevant regulations; and • the adequacy of the audit conducted by the external auditor to ensure that all significant risks have been considered. (NCCG, 2001) Subsequently, Securities Listing Rules No. 1-A regarding the General Provisions of Equity Securities Listing Rules in JSX specifically required the establishment of an audit committee, appointment of independent commissioners and the improvement of the corporate secretary’s function in publicly listed companies. Previously, banks were also required to have audit committees. Now, in place of an audit committee, Bank Indonesia requires banks to have

78 The Governance of East Asian Corporations

a compliance director, whose main responsibility is to ensure that the banks meet prevailing rules and regulations. Since the compliance director is responsible to the president director, rather than to the BOC as the audit committee was, it may be argued that the compliance director cannot maintain independence. Furthermore, the scope of responsibility of the compliance director is more limited than that of the audit committee. The compliance director mostly deals with compliance issues while the audit committee not only deals with compliance but also with internal audit, external audit and organizational performance effectiveness. Therefore, it is felt that the compliance director is not a suitable substitute for an audit committee. Currently, there is no regulation that requires an Indonesian company to have a remuneration committee or an appointment committee.

Share ownership According to Article 7 of Law No. 1 of 1995 (Company Law), a limited liability company (not a listed company) should have at least two shareholders. Consequently, investors can own up to 99.99% of issued shares of an unlisted limited liability company, so long as there are at least two shareholders. The Capital Market Law stipulates that a public company is a company that has at least 300 shareholders and a paid-in capital of at least 3 billion Rupiahs.5 To be listed on the Main Board of the JSX, a company should have shares owned by minority shareholders after public offering or be listed on another stock exchange with a minimum of 100 million shares or a minimum of 35% of paid-in capital, whichever is lower.6 Bapepam requires publicly listed companies to disclose significant ownership in the company. Bapepam Rule No. VIII.G.7 states that the names of shareholders that own 5% or more of the company’s shares and the names of directors and commissioners that own shares in the company should be disclosed in the financial statements. In addition, each director or commissioner of an issuer should report changes of ownership no later than ten working days from the transaction date to Bapepam. (Rule No. X.M.1) Ministry of Finance Decree No. 90/KMK.010/2001 regarding Share Ownership of Securities Companies by Foreign Investors allows foreign investors to own shares of securities companies. Shares of a joint venture securities company can be owned by foreign entities involved in the finance sector up to a maximum of 85% of paid-in capital. A maximum of 99% of paid-in capital of a joint venture securities

Etty R. Wulandari and Asheq R. Rahman 79

company can be owned by foreign entities involved in the securities industry. These entities should have a license from or be under the supervision of a capital market regulator in their own country. If either a national securities company or a joint venture securities company conducts an initial public offering, its shares can be owned wholly by domestic or foreign investors. Foreign investors can purchase up to 99% of a commercial bank’s shares directly or indirectly through the stock exchange (Government Regulation No. 29 of 1999, May 7, 1999, regarding Shares Purchased by a Commercial Bank).

4.4.2

State-owned enterprises (SOEs)

SOEs are those companies in which the government has at least a 51% equity interest, and represent a very large part of Indonesia’s productive sector. Currently, there are 188 SOEs, which are under the control of the Directorate General of SOEs in the Ministry of Finance (hereinafter referred to as MoF). 7 Like private companies, SOEs are involved in a wide range of industries, such as trade, construction service, telecommunications, tourism, finance, pharmaceuticals, airlines, shipping, mining, plantations, fisheries, fertilizer, and forestry. Since July 2001, SOEs (previously controlled by Directorate General of SOEs – MoF) and banks under restructuring (previously controlled by Indonesia Bank Restructuring Agency (IBRA)) are now under the control of the State Ministry of SOEs. The minister is responsible directly to the President of Indonesia. As this change has not yet been formalized at the time of writing, the following discussion will explain the structure of SOE governance according to the existing regulations. The MoF has been granted necessary powers by the Indonesian Parliament to represent the people of Indonesia, who are the legal owners of SOEs. It appoints all directors and commissioners, and has the responsibility of ensuring that the return on the investment in a SOE is in line with the SOE’s assigned social objectives. For operational purposes, SOEs are under the supervision of “technical” (line) ministries. A line ministry’s role is to set and enforce the regulations applicable to the respective SOE. All line ministers are responsible directly to the President of Indonesia. The Parliament sets broad policies and supervision requirements for the SOEs. The significance of SOEs to the Indonesian economy can be viewed from the comparison of the total assets of SOEs with the total assets of

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listed companies (under the JSX) and banks under restructuring (under the control of IBRA). This comparison is shown in Table 4.1. Despite their enormous total assets, the performance of SOEs is far from satisfactory. The total income after tax of all SOEs put together was negative in 1998, 1999, and 2000; with the biggest loss being in 1998 (Return on Assets (ROA) = –24.02% and Return on Equity (ROE) =–503.73%). The Indonesian government began to rectify this in the late 1980s by means of business restructuring, mergers, and private participation including public share offering and strategic sales. Transparency is also on the agenda. The government sees good corporate governance as the key issue and, on May 31, 2000, the Ministry of Investment and SOEs issued a Decree (No. KEP-23/M-PM.PBUMN/2000) regarding the Development of Good Corporate Governance Practice in SOEs. These included enhancement of the role and responsibility of the BOC, the formation of an audit committee, and a “fit and proper test” to recruit professional managers. It is expected that the SOE managers will not be chosen because of their relationship with key decision-makers. Nevertheless, the recommendation on the implementation of corporate governance should take into account the heterogeneous state of the SOEs. Indonesian SOEs currently are at various phases of corporate governance development. Business results and profitability, as well as ongoing restructuring efforts, greatly differ between SOEs. Some SOEs that have been privatized had to go through a substantial amount of reform for improvement of management and accounting practices. By the end of 2000, eight SOEs had been privatized. These SOEs are involved in the telecommunication, banking, seaport, tin, cement, and mining industries.8 Meanwhile, some SOEs are still struggling to restructure their debt and corporate structure. Making all of these SOEs, at different states of change, achieve the same corporate governance goals will be difficult.

Table 4.1

Comparison of Total Assets (in Rp. trillion)

Total assets SOEs Listed companies Banks under restructuring

1999 607 696.5 249.8

Sources: Directorate General of SOEs, the JSX, IBRA.

2000 861.5 (prognosis) 940.76 557.2 (prognosis)

Etty R. Wulandari and Asheq R. Rahman 81

4.5 4.5.1

Disclosure rules and regulations Legal foundation of disclosure in Indonesia

The key regulations pertaining to disclosures by Indonesian companies are in Law No. 3 of 1982 on Company Registration, Government Regulation No. 64 of 1999 concerning Company’s Annual Financial Information, and the Bapepam rules (for publicly listed companies) (Kurniawan and Indriantoro, 2000). The Company Registration Law 1982 requires all companies incorporated in Indonesia to file reports with the Registration Office, which is under the jurisdiction of the Ministry of Industry and Trade. Its objective is to create a publicly available listing of companies in Indonesia. However, there is a lack of monitoring and enforcement to ensure that the companies report in an appropriate and timely manner. A new company registration law is under consideration to make company registration and reporting more efficient and effective. Government Regulation No. 64 of 1999 regarding Company’s Annual Financial Information is a significant step in promoting transparency and accountability in Indonesia. This regulation not only broadens requirements for audited financial statements but also aligns the components of the required financial statements with the requirements of the current standards of financial accounting issued by the accounting profession. Previously, only listed companies published audited financial statements. Under the new rules, companies which are required to file audited financial statements will include those public companies, others that acquire funds from the public, issue a debt instrument, have total assets or net assets in excess of 50 billion Rupiahs, or are required by a bank to have audited financial statements (Government Regulation No. 64 of 1999). In 2000, the requirement for total assets or net assets was decreased to a minimum amount of 25 billion Rupiahs.9 Article 58 of the Indonesian Company Law states that “the annual accounting shall be done in accordance with the Standards of Financial Accounting.” Standards of Financial Accounting are the principles of accounting that are issued by the Indonesian Institute of Accountants (hereinafter to be referred to as IAI: Ikatan Akuntan Indonesia), as well as by the responsible agency of the government. Article 59 of the Company Law requires the BOD to deliver the company’s annual audited financial statements if the company acquires funds from the public through capital and debt instruments.

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The Capital Market Law of 1995 gave Bapepam powers to further stipulate reporting requirements and accounting standards for companies involved in the capital market. As stated in Article 69 of this Law, financial reports that are submitted to Bapepam must be prepared in accordance with generally accepted accounting principles, i.e. the accounting standards issued by IAI. Bapepam may also establish additional accounting rules with respect to the needs of the capital market.

4.5.2

Development of accounting standards in Indonesia

The development of accounting standards in Indonesia cannot be separated from the development of its accounting professional organization, the IAI. In 1973 a committee was formed by IAI to gather and codify generally accepted accounting principles. This step provided a foundation for corporate reporting to support the development of the capital market, which was being activated by the government. In 1974, three sets of standards were introduced: Indonesian Accounting Principles, Generally Accepted Auditing Standards, and Code of Professional Ethics of Indonesian Accountants. All three were basically adopted from the American Institute of Certified Public Accountants standards (Kurniawan and Indriantoro, 2000). In 1984 and 1994, the Accounting Principles Committee of IAI conducted major revisions by incorporating more recent U.S. standards in 1984 and the International Accounting Standards (IAS) in 1994. These revisions made the regulatory infrastructure of the capital markets more suitable for the evolving global conditions. The 1994 codification consisted of 35 Statements of Financial Accounting Standards, known as Pernyataan Standar Akuntansi Keuangan (PSAK), which were mostly adaptations of the IASs. The IASs were adopted as a means to meet the needs of globalization of the accounting profession and to harmonize accounting rules with those of neighboring countries, who were also adopting IASs. However, adjustments were made to accommodate the unique legal, social and political environment existing in Indonesia and at the time of writing this chapter there were 59 PSAKs. A number of these standards regulate transactions or events that have not been tackled by the International Accounting Standards Board (IASB), for instance, cooperatives, land, mutual funds, and joint operating activities other than joint ventures.

Etty R. Wulandari and Asheq R. Rahman 83

4.5.3

Enforcement of accounting disclosure rules

There is a premise that the best way to protect investors is to insist on full disclosure of material information by companies, while presuming that investors will make prudent use of this information. Accordingly, there are two sides to the disclosure issue: transparency on the part of companies, and due diligence on the part of investors. A study in 1999 conducted by Bapepam, comparing the The Organization for Economic Cooperation and Development (OECD) Principles of Corporate Governance with the regulatory framework in Indonesia, concludes that almost all of the principles of corporate governance have already been covered in the Indonesian regulatory framework.10 Therefore, Indonesian law and regulations with respect to corporate disclosure are essentially in line with OECD recommendations regarding transparency. Moreover, research in 1999 done by the Asian Development Bank in Bapepam, based on a review of the 1998 financial statements of 100 listed companies on the JSX, showed that Indonesian accounting standards are, subject to certain exceptions, substantially equivalent to IAS.11 Accordingly, any deficiency in transparency or lack of disclosure is not the result of insufficient standards but instead was perhaps due to insufficient compliance with established standards and rules. A corporate governance survey by PricewaterhouseCoopers in 1999, however, employed institutional investors in Singapore as respondents, and showed that the perceived level of corporate disclosure in Indonesia was very low compared with other principal markets in the Asia–Australia region. This was evidenced by lack of disclosure of material information in a timely manner, avoidance of disclosure during meetings with major investors, and lack of broad market disclosure to transnational investors. According to the Company Law, the directors and commissioners must submit financial statements to the shareholders and in the event these documents are untrue or misleading, the directors and commissioners are jointly and severally liable for any person’s loss.12 In addition to civil liability for misleading information, under certain condition directors, commissioners, accountants and others associated with a public company may be subject to severe criminal penalties for false or misleading statements. The Capital Market Law also requires reporting and publication of material events by public companies within 48 hours, which is a stricter standard than that of the U.S. Public companies are required to submit semi-annual and annual financial statements to Bapepam and quarterly reports to stock exchanges, and Bapepam has consistently fined companies for failure to comply, while the JSX has suspended trading in securities for the same

84 The Governance of East Asian Corporations

reason. An issuer is subject to a fine of one million Rupiah for each day of delay in submitting a report, up to a maximum fine of five hundred million Rupiah13 (US$50,000, by assuming US$1 = Rp. 10,000). Violation of the Capital Market Law may result in Bapepam imposing other sanctions, such as requiring issuers to hold an independent shareholders meeting, public disclosure of the violation, or payment of fines to state treasury. The JSX also suspends trading in the case of sudden, unexplained price changes or other unusual behavior in trading. As public demand for better law enforcement increased, Bapepam, as capital market regulator, has been more proactive in dealing with Capital Market Law violation. This effort is reflected in the increased number of investigations as well as higher levels of disclosure in reporting investigation results to both market participants and the public. The number of sanctions imposed on issuers in 2000 and 1999 can be seen in Table 4.2. During 2000, the number of alleged disclosure violations was 16, a significant increase compared to the number of cases in 1999 (three cases). The number of cases of misleading information in 2000 was two, compared to none in 1999.14 In conjunction with the implementation of GCG practices, the JSX asked listed companies to submit their financial reports on time. If necessary, it conducts public disclosures. During the year 2000, JSX invited 45 listed companies to publicly disclose actions, compared to only six in 1999.15

4.5.4

Auditing standards and practices

Indonesian auditors have to comply with the Professional Standards for Public Accountant issued by IAI. These standards are adapted Table 4.2

Enforcement Actions in the Capital Market

Sanctions on issuers Issuers fined for late reporting on: • Annual financial statements • Semi-annual financial statements • Material events • Realization of public offering proceed • Audit on allotment and tender offer • Annual report Fines imposed on issuers (Rp. Billion) Issuers suspended for failure to submit financial statements to the JSX Sources: Bapepam, Annual Report 2000; the JSX press release.

2000

1999

164 92 14 – 29 2 96 13,236 6

295 84 55 1 34 5 116 796 4

Etty R. Wulandari and Asheq R. Rahman 85

from the Statements on Auditing Standards issued by the American Institute of Certified Public Accountants (AICPA) as of June 1993. For topics on which AICPA has not issued a statement, IAI refers to the International Standards on Auditing issued by the International Federation of Accountants (Kurniawan and Indriantoro, 2000). In addition to the auditing standards, Indonesian auditors must comply with the Code of Ethics for Public Accountants of the IAI, which is based on AICPA Ethical Conduct. As a professional organization for accountants, IAI has to ensure that all auditors implement the professional standards and follow the code of ethical conduct. The Judiciary Council for Public Accountants within the IAI has the responsibility of reviewing complaints made by the public concerning the auditor’s implementation of the professional standards and the code of ethical conduct. Other institutions that are involved in supervising the accounting profession include: the Directorate General of Financial Institutions of the MoF, the Supervisory Body for Finance and Development (Badan Pengawas Keuangan dan Pembangunan – BPKP) and Bapepam. The Directorate General of Financial Institution of the MoF is responsible for the issuance of licenses and administrative requirements of accounting firms, while BPKP is responsible for conducting limited peer reviews of accounting firms. Bapepam requires that a public accounting firm and its partners be registered with Bapepam before they can audit any firm involved in the capital market. Accountants that audit financial reports of issuers, stocks exchanges, and other parties engaged in capital market activities must report to Bapepam within three working days of discovery of any violation of the Capital Market Law or any matters that may jeopardize the financial condition of these institutions or their clients. The number of accounting firms and partners registered with Bapepam were 137 and 236 respectively in 1999 and 153 and 256 respectively in year 2000. Indonesian accounting standards are substantially equivalent to IAS’s, however the lack of an effective and efficient enforcement mechanism may result in low quality financial reports. In this regard, the economic crisis that hit the Indonesian economy since mid-1997, brought up concerns relating to the credibility of financial statements of Indonesian listed companies (Rahman, 1998). Prior to the crisis, many companies’ financial statements had received unqualified opinions from their auditors, but during the crisis they were found to be bankrupt. Auditors were subsequently blamed for this situation.

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Several reasons may account for why auditors failed to follow accounting and auditing standards: • Auditor’s lack of understanding and awareness of accounting and auditing standards; • Auditors’ judgment depends on the work of other professionals, such as appraisers, in valuing company’s assets (Kurniawan and Indriantoro, 2000). Auditors do not have control over any asset mark-up practices adopted by companies; and, • Too much reliance on management representation (Rahman, 2000). There is a tendency for auditors to rely on management representation without further seeking corroborative audit evidence to support their opinions.

4.6

Corporate governance of the top 100 listed companies

To examine some features of the corporate governance in Indonesian firms, we conducted a survey of the top 100 public companies listed in the JSX as at December 31, 1999. Information on corporate governance mechanisms is mostly taken from 1999 annual reports. The BOC size in the top 100 companies ranged from two (five companies) to 12 persons (one company), while BOD size ranged from two (seven companies) to 11 persons (one company). In only 25 companies did BOC members own shares, and the maximum percentage owned was 29.24%. There were 18 companies whose BOD members owned shares, with maximum percentage of shares owned being 17.31%. So, in total, there are 31 companies that had BOC or BOD members owning their company’s shares. Tenure of BOD chairmen ranged from one year to 35 years, however not all companies disclosed this information in their annual reports.

4.6.1

Ownership structures

The percentage of shares held by public shareholders is 30.92%, while institutional investors held, on average, 62.39%. The institutional investors included holding companies. Prior research has shown that there are 15 families that control about 62% of the market capitalization of the JSX (Husnan, 2001). The ownership of corporate shares by banks was at an average of 27.75% in only four companies. Of the 12 companies with high government shareholdings that are reported in Table 4.3, six were listed SOEs and the remaining six were under

Table 4.3

Ownership Structures

No.

Variables

1. 2. 3. 4. 5.

Total % of shares held by individual owners ≥ 5% Total % of shares owned by institutional investors Total % of shares owned by banks Total % of shares owned by government Total % of shares owned by public

Number of reporting companies 4 93 4 12 100

Minimum

Maximum

Average

5 0.21 2.10 25.73 0.21

14.01 99.59 96.60 99.58 78.49

8.12 62.39 27.75 66.39 30.92

Median

6.74 64.49 6.15 65 32.73

87

88 The Governance of East Asian Corporations

restructuring with IBRA. In our sample only four companies had ownership by individuals owning 5% or more shares. A lot of indirect control through subsidiaries exists, but it is difficult to identify such control from annual reports.

4.6.2 Audit committee, remuneration committee, and appointment committee The requirements from JSX for public companies to have an audit committee took effect on July 1, 2000. On December 31, 1999, no public company had an audit committee in place, except for banks. However, of the 13 banks in the top 100 companies, only eight had audit committees. Also, no public company had a remuneration committee or an appointment committee. There is no such regulation requiring the establishment of these committees.

4.7

Discussion

Our discussion of corporate governance in Indonesia suggests that several exogenous factors influence the way corporate governance is conducted. In this Section we analyze the state of corporate governance in Indonesia from several viewpoints. Discussion in this respect is shown below:

4.7.1 Country level Socioeconomic Issues As a nation Indonesia has many major challenges. Development of a capital market is one of these challenges and an essential component of that is an adequate system of corporate governance. Corporate governance in modern-day Indonesia is undergoing rapid change. Not many Indonesian BOCs have representatives from stakeholders other than the majority shareholders, whereas the whole purpose of a two-tiered board is to include stakeholders such as bankers and employee representatives. More recently, the Anglo-American form has influenced Indonesian corporate governance, where transparency and independent director representation is seen as necessary for achieving adequate governance. Indonesia has many natural resources and a young population. The people are attaining literacy, and the recent democratization process has shown that they are eager to move forward in the development process that began 30 years earlier. Key to this development will be the development of the capacity to organize economic systems that can

Etty R. Wulandari and Asheq R. Rahman 89

promote and sustain large-scale development. Indonesia has to move from the current system of corporate governance to a system that will be transparent and friendly enough to attract capital providers. It also has to be effective enough to promote efficient allocation of capital.

Regulatory issues The regulatory framework in Indonesia has already covered many aspects of corporate governance. The limited liability company, bankruptcy, and capital market laws, and stock exchange regulation cover corporate governance elements in detail. The problem seems to lie in the fledgling enforcement system. Until the fall of Suharto most corporate conglomerates were directly or indirectly associated with the officials in government who were responsible for the enforcement of laws and regulations. Although Suharto has been replaced it is too early to tell whether the regulators will seriously enforce the rules. Akin to the elements of corporate governance, disclosure rules in Indonesia are also very robust and of international levels. However, since private debt is the main source of financing followed by high ownership concentration and control, disclosure alone may not be an effective mechanism for capital market efficiency. Bankruptcy law enforcement should also be a priority for improving corporate governance in Indonesia. In this respect, the new Bankruptcy Law and the commercial court system are constructive developments.

4.7.2 Firm level Publicly listed companies a. Two-tier Board System vs. Single Board System The issue of two boards versus a one board system is a significant unresolved issue (La Porta et al., 1998). The two-tiered board system has been used in countries such as Germany to allow broad representation of stakeholders in the management of the firm through the BOC, while keeping the control of the operational activities in the hands of the directors in the BOD. However, in Indonesia both the BOC and the BOD represent the interests of the 15 groups (Husnan, 2001) which control a majority of the market capitalization, and these boards are tools of control of these family groupings. Unlike Germany, where banks monitor firms through BOCs for their debt funding, banks in Indonesia do not have much monitoring capacity through the BOC. Furthermore, many banks in Indonesia are controlled by the same families that control the companies that borrow funds from these banks.

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Coupled with a weak legal enforcement system, this dual control over banks and companies makes debt contracts ineffective. b. Company’s Structure Currently, most Indonesian companies are part of complex economic groups with interlocking directorships, reciprocal ownership arrangements, and excessive cross-ownership of companies. As long as such complex groups are not discouraged, there will be problems with transparency of company operations. Not even good accounting standards are suited to provide transparency in such a complex environment. Bapepam already requires disclosure of related party transactions in financial statements.16 PSAK No.7 regarding Related Party Disclosures requires a company to disclose transactions with its related parties. Monitoring of related party transactions is difficult since most groups have complex ownership structures. Prohibiting publicly listed companies from having cross-holdings with other companies is one way that has been used by Bapepam to prevent the formation of such overly complex company groups. However, the system of indirect controls developed by controlling families defies the law enforcement arrangements. c. Heavy Reliance on Banks The average ratio of total debt to total equity of the 100 listed companies surveyed is very high. Firms rely on debt financing from banks. A lot of the financing comes from banks that are in the same group of companies. There are no rules in Indonesia prohibiting interlocking directorships between banks and borrowing companies. Borrowing companies or their parents often control banks and can secure perpetual loan rollovers for their loans, thereby limiting the need to sell equities and long-term bonds. This shows that the weakness of corporate governance practice lies primarily in the governance practices of banks and in the lack of enforcement of debt contracts. Until bank ownership is separated from their borrowers and the debt contracts are effectively enforced, the governance of companies will remain weak. d. Board of Directors (BOD) and Board of Commissioners (BOC) There have been many criticisms about the effectiveness of the BOD as well as of the BOC of Indonesian corporations. Absence of the required competence and failure to maintain independence are some of the problems that are commonly found with BOC members. In addition, there is

Etty R. Wulandari and Asheq R. Rahman 91

a cultural issue: board members do not feel comfortable if their decisions are discussed or challenged openly. This could be because the members of the board are usually chosen because of their share ownership, their close relationship with the major shareholders, or due to their previous position in the government bureaucracy. The existence of capable independent commissioners in the BOC could help ease this problem.

State-Owned Enterprises (SOEs) a. Role of Government The government plays a strategic role in introducing and promoting corporate governance within the SOEs management. The government could enhance its role by requiring SOEs to adopt a more transparent decision-making process. With their large total assets and government protection and support, SOEs could potentially generate enormous profit. However, there is a tendency to use SOEs as a means to support government political interest, which undermines the effectiveness of the SOEs’ management. There is also a tendency for the MoF to act as a back-up entity whenever creditors become too demanding or profitability turns negative. This happens when creditors exert pressure on SOEs with the purpose of obtaining unequivocal government support or requiring the government’s intervention in financial negotiations to strengthen the creditworthiness of an SOE as a borrower. b. Management of SOEs SOEs are responsible to the MoF and to line ministries. This duality of responsibilities creates difficulty for SOEs to conduct their business effectively because both ministries would like to supervise the SOEs. Further, SOEs also have to fulfill two roles: generating a return on government investment and achieving social objectives. To be able to conduct these tasks, SOEs have to be given the freedom to manage their own resources. The government should create incentives for SOEs to align their activities with their objectives. In this regard, improvement in the accountability of SOEs is also relevant. Clear responsibility of the BOD and the BOC of SOEs and strong supervision from the government will force SOEs to achieve better performance.

4.7.3

Disclosure level

Many surveys have evidenced low levels of disclosure by Indonesian corporations. This is not due to the insufficiency of the disclosure

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standard itself, rather it is due to the lack of compliance with the existing standards and regulations regarding disclosure. There are many reasons for this problem. Awareness of the companies with regard to transparency and full disclosure is still doubtful. Since ownership of many Indonesian companies is heavily concentrated, there is no incentive for them to be transparent. Moreover, the business law enforcement arrangements have not been sufficiently used to enforce the transparency requirements. Since the Capital Market Law was enacted in 1996, investors have brought no case against the issuers or their directors for lack of company disclosure. This may be due to the lack of investor awareness of the law, investors’ lack of ability to understand the financial reports, or the ambiguity of the law procedures. Furthermore, auditing also needs to be revamped. Lack of understanding of accounting and auditing standards, lack of effective judgment of asset appraisals and over-dependence on management representations have been seen as common weaknesses in auditing. These weaknesses need immediate attention to ensure reliability of financial statements.

4.8

Conclusions

The Indonesian account of corporate governance is a case of disjointedness between economic development and governance. The pace of economic development over the ten years prior to 1997 was phenomenally fast. In the absence of a well-organized market and regulatory system the family form of governance with government patronage was perhaps essential to get economic development started. However, once development had gathered speed, it was necessary to align the ownership structure with the needs of a capital market to sustain large-scale development. The new form of ownership would likely be dispersed shareholding with less family control and more professional manager control. The capital market desired would be a more equity-based, liquidity-oriented capital market rather than a market for private debts. Enhanced forms of corporate governance perhaps would naturally follow or could be easily encouraged. The term “corporate governance” became known in Indonesia only in the economic crisis of 1997. The contention of the commentators that corporate governance was the main reason for the crisis is obvious from the earlier inference that corporate governance practices in Indonesia were not properly aligned with the needs of a large-scale economic set-up. In spite of a late start, the corporate regulators are now appreciating the concept of corporate governance. Currently,

Etty R. Wulandari and Asheq R. Rahman 93

the corporate governance considerations have moved from “what is corporate governance” to “how to implement corporate governance” (Tjager, 2001). Corporations, however, are yet to follow suit in a large scale. They may take greater interest once they find that debt financing from friendly banks has dried up or is not the right form of financing for long-term assets, and that they have to compete for funds from the stock market investors. Since corporate governance is a function of the nature of financing arrangements (Shleifer and Vishny, 1997), widespread public ownership is perhaps going to be the main motivator of good corporate governance. Other than that, it will be seen as a costly managerial exercise and will not be appreciated by corporate managers and owners. Therefore, regulators should not only institute and implement corporate governance arrangements, but also ensure that corporate conglomerates’ control over the markets is reduced and corporate shareholding is made more dispersed and transferable. Once dispersion and transferability is achieved, the market itself may become a disciplining mechanism for firms through mergers and acquisitions. As for SOEs, the government, being the main financing source, has the ability to establish corporate governance requirements. Success, in this respect, will depend on whether the government has the will to separate the SOEs from the political purposes they have been expected to serve.

Notes 1. I Nyoman Tjager, Recent Development on Corporate Governance in Indonesia, May 2001, paper presented on ACORN Project Workshop II, Jakarta, May 25, 2001. 2. The National Committee for Corporate Governance, Code for Good Corporate Governance Ref. 4.0., March 2001. 3. Fred B. G. Tumbuan, Main features of the Bankruptcy Law as amended by Perpu No. 1 of 1998, Indonesian Law and Administration Review, Vol. IV No. 1, 1998. 4. The Jakarta Stock Exchange, Fact Book 2000. (JSX, 2000a) 5. See Article 1 of Law No. 8 of 1995. 6. See listing rule of JSX No. 1-B. (JSX, 2000c) 7. Directorate General of SOE – Ministry of Finance, Report on Performance Development of SOEs, April 2001. 8. Directorate General of SOE – Ministry of Finance, Report on Performance Development of SOEs, April 2001. 9. Decree of Ministry of Industry and Trade No. 234/MPP/Kep/6/2000 dated June 26, 2000. 10. Bapepam: A Study on the Implementation of Corporate Governance in Indonesia, June 1999. 11. Bapepam and ADB: Accounting Disclosures in Indonesia: Review of the Published Financial Statements of 100 Listed Companies, December 1999.

94 The Governance of East Asian Corporations 12. See article 60 Law No. 1 of 1995. 13. See article 63 of Government Regulation No. 45 of 1995 concerning Capital Market Organization. 14. Bapepam: Annual Report 2000. 15. The JSX: Press release on “JSX and its performance in 2000”, http://www.jsx.co.id. 16. See Bapepam’s Rule No. VIII.G.7 regarding Guidelines for Presentation of Financial Statements.

References Bapepam (2000) Annual Report 2000. Bapepam (1999). A Study on the Implementation of Corporate Governance in Indonesia, June. Bapepam (2000). Rule No. VIII.G.7: Guidelines for the Presentation of Financial Statements, March. Bapepam (1996). Rule No. X.M.1: Disclosure requirements for certain shareholders, January. Bapepam (2000). Circular Letter No. SE-03/PM/2000 regarding Audit Committee. Bapepam and ADB (1999). Accounting Disclosures in Indonesia: Review of the Published Financial Statements of 100 Listed Companies, December. Directorate General of SOE – Ministry of Finance (2001). Report on Performance Development of SOEs, April. Directorate General of SOEs – Ministry of Finance (2001). Master Plan 2001 – Reformation of SOEs, February. Encyclopedia Britannica (2001). http://www.britannica.com. Government Regulation (1999). No. 29: Shares Purchased by a Commercial Bank. Government Regulation (1995). No. 45: Capital Market Organization. Government Regulation (1999). No. 64: Annual Financial Statements of a Company. Hart, O. (1995). Corporate governance: Some theory and implications. The Economic Journal 105 (May): 678–689. Husnan, S. (2001). Indonesia, Corporate Governance and Finance in East Asia, Country Studies, Vol. 2, (ed.) Zhuang J., Edwards, D., and Capulong, M. V. A., Asian Development Bank. Indonesian Capital Market Supervisory Agency (1999). Indonesian Capital Market Blueprint 2000–2004, Jakarta, November. Indonesian Institute of Accountants (1996). PSAK (Statement of Financial Accounting Standards) No. 7: Related Party Disclosures. Jakarta Stock Exchange (2000a) Fact Book 2000. Jakarta Stock Exchange (2000b). Securities Listing Rules No. 1-A: General Provisions of Equity Securities Listing in JSX, June. Jakarta Stock Exchange (2000c). Securities Listing Rules No. 1-B: Requirements and Share Listing Procedures in the Exchange, June. Kurniawan, M. and Indriantoro, N. (2000). The Role of Disclosure in Strengthening Corporate Governance and Accountablity, The Second Asian Roundtable on Corporate Governance, Hong Kong, China, 31 May–2 June 2000.

Etty R. Wulandari and Asheq R. Rahman 95 La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (1998). Law and finance. Journal of Political Economy 106(6): 1113–1155. Law No. 1 of 1995, Company Law. Law No. 3 of 1982, Company Registration Law. Law No. 8 of 1995, Capital Market Law. Licht, A., C. Goldschmidt and S. Schwartz (2001). Law and finance: Cultural dimensions of corporate governance laws. SSRN working paper series. Ministry of Finance (2001). Share Ownership of Securities Companies by Foreign Investors (Decree No. 90/KMK.010/2001). Ministry of Investment and SOEs (May 31, 2000). Development of Good Corporate Governance Practice in SOEs, (Decree No. KEP-23/M-PM. PBUMN/2000). Ministry of Industry and Trade (2000). Decree No. 234/MPP/Kep/6/2000: Registration of Company’s Annual Financial Statements, June. OECD (1999). Ad Hoc Task Force on Corporate Governance, OECD Principles of Corporate Governance, April, http://www.oecd.org/daf/governance/ principles.htm. PricewaterhouseCoopers (2000). Corporate Governance 1999 Survey of Institutional Investors, March. Rahman, M. Z. (1998). The Role of Accounting in the East Asian Financial Crisis: Lessons Learned?, Transnational Corporations, published by UNCTAD, Geneva, Vol. 7, No. 3, December. Rahman, M. Z. (2000). Accounting Standards in the East Asia Region, paper presented to the Second Asian Roundtable on Corporate Governance, Hong Kong, May–June. Shleifer, A. and R. W. Vishny (1997). A survey of corporate governance. The Journal of Finance 52(2): 737–83. The National Committee for Corporate Governance (NCCG) (2001). Code for Good Corporate Governance Ref. 4.0., March. Tjager, I. N. (2001). Recent Development on Corporate Governance in Indonesia. Paper presented on ACORN Project Workshop II, Jakarta, May 25, 2001. Tumbuan, F. B. G. (1998). Main Features of the Bankruptcy Law as amended by Perpu No. 1 of 1998, Indonesian Law and Administration Review, Vol. IV, No. 1. Williamson, O. E. (1988). Corporate finance and corporate governance. Journal of Finance XLIII(3): 567–590.

5 Corporate Governance in Japan: Role of Banks, Keiretsus and Japanese Traditions Huong N. Higgins

5.1

Introduction

Japan’s economy is the second largest in the world. The country’s productivity ranks among the top dozen advanced economies. Its level of industry is at or near the top rank in the advanced products, materials and production processes that define the world’s technology frontier. Despite its lack of natural resources, Japan transformed itself from a war-torn country to an economic giant within one generation. Between the 1950s and the 1973–74 oil embargo, Japan averaged 10% real Gross National Product (GNP) growth a year. That high level of economic growth slowed to an average rate of 5% between 1975 and 1990, however, the last ten years in Japan have been characterized by financial crisis and prolonged recession, and she is now showing signs of serious difficulties in obtaining any growth at all. Japan’s corporate environment since the 1950s has been tightly shaped by government regulators who institute industrial policies for the private sector. In light of its legal framework and industrial policies, traditional corporate governance in Japan is characterized by five aspects: bank-centered capital markets, keiretsu cross-holdings, administrative guidance, insider-dominated boards of directors (BOD), and weak external monitoring of corporate management. The challenges of globalization, the lessons learned from the 1997 financial crisis, and stagnant economic performance triggered the government and businesses to adopt a wide range of schemes to reinvigorate the economy. Because sound corporate governance is essential for international competition, both the public and private sectors in Japan are seeking to reform the corporate governance system, particularly through revising Japan’s Commercial Code. The efforts and their 96

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results are the subject of frequent debates for a broad cross-section of disciplines within and outside Japan. This chapter aims to provide some insight into Japan’s corporate governance system, particularly the recent developments in light of revisions to Japan’s Commercial Code.

5.2 The legal framework and traditional characteristics of Japan’s corporate governance environment 5.2.1

Legal framework

The legal framework for Japanese corporations is defined by Japan’s Commercial Code and the Securities and Exchange Law. The Ministry of Justice is responsible for the Commercial Code, and the Ministry of Finance (MOF) is responsible for the Securities and Exchange Law. Japan’s Commercial Code takes root in the German code law tradition, which provides protection to investors and creditors more effectively than the French code law tradition, but less effectively than the Anglo-American common law tradition (La Porta et al., 1998). The Commercial Code was enacted in 1890 based on a draft by a German scholar named K. F. H. Roesler (1834–1894) and defines major types of corporate entities and their liabilities to creditors. For large, publicly traded corporations, the Commercial Code stipulates unconditional transfer of shares, and individual establishment of corporate organizations, including a board of directors (BOD), representative directors, and auditors. Japan’s Securities and Exchange Law was introduced in 1948 and modeled after the U.S. Securities Act of 1933 and the Securities Exchange Act of 1934. It regulates listed companies for the purpose of protecting private investors. This Law has provisions concerning disclosures relevant to securities values, take-over-bid regulations, fraudulent conduct, and market manipulation. It purports to achieve sound domestic economy and market liquidity by ensuring fairness in securities transactions. Finally, there is Corporate Income Tax Law. Income reported on the financial statements and approved at the general meeting of shareholders is computed in accordance with the Commercial Code. This income is the basis for computing taxable income under the Corporate Income Tax Law, and agrees with net income reported on the income statement for the Securities and Exchange Law. In essence, the three laws are tied together with the Commercial Code at the apex of the triangle.

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5.2.2

Industrial policies

The Japanese corporate environment is tightly shaped by government regulators who institute industrial policies for the private sector (Katz, 1998). Traditionally, good relations with bureaucrats were the necessary and often sufficient condition for pursuing business. The government chose the industries that the private sector should pursue for rapid growth, and set up the incentives to ensure that the private sector would follow through. The Ministry of International Trade and Industry (MITI), for example, formulated “visions” for the Japanese economy and chose the industries to realize such visions. The Ministry of Postal Savings in turn allocated the appropriate postal funds to finance the chosen industries. The MOF issued its own directives to private banks to supplement the financing of the chosen industries and stood ready to rescue them. This meant the Japanese government’s intervention was felt in the daily governance of banks and corporations. The active intervention of government regulators in corporate governance continued well after Japan transformed into an advanced developed country. Until recently, a variety of organizations in Japan operated in the so-called convoy system, where businesses were protected by the government as are a convoy of ships by a warship.

5.2.3 Traditional characteristics of Japan’s corporate governance Bank-centered capital markets The Japanese financial system is often classified as bank-centered due to its reliance on keiretsu main banks. The bank-centered classification is due to the historical predominance of corporate borrowings from commercial banks and a lack of reliance on public markets for financing (Anderson and Makhija, 1999). High economic growth fueled a steady demand for bank loans at a time when the domestic capital market was not yet developed. The practice of mutual cross-holding (keiretsu) further hampered capital mobilization, making the role of bank lending crucial. Governance role provided by banks Corporate governance of industrial firms in Japan was traditionally strongly influenced by banks. Holding up to 5% of a firm’s total shares, as allowed by Section 65 of the Japanese Securities and Exchange Law, banks had tight relationships with firms. Besides equity ownership, Japanese banks acted as principal long-term lenders to specific corporations and their affiliates (Field, 1997).

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Many studies highlighted the governance role of banks on industrial firms, based on the argument that banks reduced agency costs due to information asymmetries and potential conflicts between shareholders and creditors (Gilson and Roe, 1993). As an agent in the collection, evaluation, and transmission of information about firms and their management, banks internalized the monitoring and control functions of the external capital markets, therefore substituting them (Sheard, 1989). Banks monitored borrowers without imposing excessive hold-up costs, i.e., they did fund growth projects (Anderson and Makhija, 1999). The governance role of banks was especially strong for keiretsu firms, where banks acted in the broader interests of a range of stakeholders (Morck and Nakamura, 1999).

Keiretsu cross-holdings Cross-holding of shares is one of the underlying tenets of corporate Japan. Keiretsu, Kigyo Shudan, and Kigyo Group are interchangeable Japanese words used to describe Japan’s system of interlocking banks and industrial companies. Traditionally, the majority of Japanese firms belonged to keiretsu, or “industrial” groups (Nakatani, 1984). At the center of these were banks, which lent to group members, held their shares within the legal limit, and sent their former employees to sit on the boards of member companies. Individual members of each group were connected through cross-holdings of shares, mutual appointment of directors, financing and intra-group transactions. In such traditional industrial groups, about 64% of corporations’ listed shares were controlled by main banks while one third of listed shares were in crossholdings (Jacobson and Aaker, 1993). Main banks and cross-holders rarely sold their holdings because their ownership was motivated by trading relationships rather than share price appreciation. Although group companies competed against each other for better performance, if a keiretsu company fell into financial trouble, group companies provided help. In part because of this support, member companies could not drop out of competition or be acquired. The keiretsu structure has been a controversial issue. On the one hand, it can be argued that the keiretsu structure is but loosely coordinated by minority cross-holdings, informal communication among top executives, and general cooperation for mutual benefits. Groups do not have central strategy, and each member firm remains independent in its decision-making and its management’s responsibility (Teramoto, 1999). On the other hand, keiretsus have raised enough concerns among Westerners to be included in trade talks. In 1989–1990, the U.S.

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Structural Impediments Initiative (SII) viewed cross-holdings as an exclusionary and anti-competitive device (Gilson and Roe, 1993). In Europe in the early 1980s, members of the EC Commission criticized the system as unfair trade practices in violation of the principles of free trade under the General Agreement on Tariffs and Trade (Cooke, 1996). Keiretsu governance may be understood as contractual governance, aimed at facilitating relational investments, of which investment in financial capital is only one. Many studies viewed governance through keiretsu cross-holdings as alleviating agency costs associated with the separation of ownership and control (Gilson and Roe, 1993). First, it lowered the costs of information transfer by allowing other parties to acquire information, for example suppliers as well as stockholders. Second, it increased the incentives to intervene when a firm was in trouble in order to save a stock investment and to assist a supplier. And third, it provided added means of intervention since stockholders were both buyers of products and owners of stock, and thus could exercise voice as well as exit. Similarly, some studies argued that Keiretsu membership resulted in lower costs of capital. Specifically, monitoring costs and risk premia were reduced by stressing common group goals (Johnson and Neave, 1993). Furthermore, mutual trust experienced by member firms resulted in favorable transactions among them. The lower cost of capital offered advantages in mustering high capability governance structures to administer deals under a relatively high degree of uncertainty, and allowed Japanese managers to embrace more risks (Johnson and Neave, 1993). Other studies showed that the keiretsu system did not work for the interests of shareholders. Group firms did not necessarily pursue profits, had lower profitability and growth rates, lower dividend per paid capital, but higher workers’ average income, than independent firms (Nakatani, 1984). The lack of focus on shareholder interest was a serious governance problem, which manifested itself in the unproductive management of cash and unrelated diversification pursued by Japanese corporations (Kester, 1997). In the name of long-term growth, companies made investments that earned low returns (Watanabe and Yamamoto, 1992). The governance of Keiretsu firms was influenced by banks; however, bank monitoring no longer worked, because banks had their own governance problems (Watanabe and Yamamoto, 1992). Overall, the keiretsu system was unable to create and support the openness that allowed firms to lever high specialization. Instead, it created a walled city that shut members from outside distraction, and in so doing, it shut out opportunities as well (Okubo et al., 1996). The flaws

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of the keiretsu structure became more obvious as economic conditions worsened in Japan.

Administrative guidance Traditionally, bureaucratic control worked through the system of “gyosei shido”, or administrative guidance (Sherman and Babcock, 1997). In this system, bureaucratic authority was asserted through several layers. The first layer of control was regulation. Products or processes were simply not approved or were delayed if the MOF or some other bureaucracy did not support the project. The second layer was group pressure. The MOF applied pressure through affiliated companies, suppliers, and acquaintances. The last and most severe layer of control was the control of credit. By tightly controlling banks, the MOF could force a cut of credit to a company or its group if the company insisted on a non-sanctioned course of action. Administrative guidance occurred as a natural consequence of daily contact between regulators and company management. Similarly, the practice of “Amakudari”, or “descent from heaven”, also impacted relations between bureaucrats and financial institutions. This refers to officials retiring from the government, especially the MOF and the Bank of Japan, to accept new positions in the private sector (Horiuchi and Shimizu, 2001). It could be argued that Amakudari was a form of collusion between the regulators and banks at the expense of taxpayers and, consistent with this view, data on regional banks showed that those banks accepting post-retirement officials from the MOF had reduced capital adequacy levels and increased nonperforming loans (Horiuchi and Shimizu, 2001).

Insider-dominated board of directors Whereas the basic framework for corporate governance by the board in the U.S. is the separation of supervision and oversight, resulting in a predominance of outside directors, traditionally most directors in Japan were executive directors cumulating both functions of policy decision and execution. Furthermore Japanese boards were typically large and dominated by insiders who had developed their whole careers from within. Board structure A traditional Japanese BOD could be divided into a hierarchical structure based on promotion from within the company (Hattori, 1978). The first group consisted of directors with overall responsibility,

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including the chairman and president, and sometimes other representative directors. The second group consisted of divisional directors, who doubled as division managers or heads of major functional departments such as marketing, accounting, and personnel. They were responsible for contributing their divisional interests to board decisions. The third group consisted of adviser and honorary chairman, responsible for supervising the top management, and usually past chairmen or presidents of the same corporation. Though no longer active, they formed another level that might be placed above the active chairman and president. The presence of divisional directors connected the board to the lower executive system and tended to form an internally cohesive corporate community with a psychological boundary to shut off outsiders. For the same reason, decision-making in Japanese corporations was centered on middle-management, not top management (Hattori, 1978). Thus the traditional BOD of a Japanese company was composed of corporate “insiders”. It was in fact quite common for large Japanese firms to have boards that did not contain any “outsiders”, nor even representatives of large shareholders, except for representatives of the main banks.1 Directors’ career incentives The traditional system of promotion and remuneration in Japan helped motivate employees to develop their careers through long-term, if not life-time, association with the firm (Aoki, 1988). Management jobs were assigned to those who were promoted through the ranking hierarchy for white-collar employees. While management compensation was relatively flat, the primary incentive device in Japanese firms was employee competition to achieve higher status within their hierarchies of rank (Kato and Taylor, 1994). A prolonged promotion tournament for management positions resulted in competition among employees, accumulation of firm-specific human capital and thus overall competitiveness for the Japanese firm (Kato and Taylor, 1994). One important incentive for lifetime service was the lump-sum compensation paid at the time of separation, which rose sharply with directors’ years of service. This lump-sum was disclosed collectively for all retiring directors in annual reports.

5.2.4

Weak external monitoring of corporate management

External monitoring through the market for corporate control was traditionally weak in Japan. Large mergers rarely happened through the

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early 1990s (Anderson and Campbell, 2000). Most acquisitions that occurred were friendly and involved acquisitions of very small corporations. Acquisitions often were to rescue companies in financial trouble by companies belonging to the same industrial groups. Others involved the acquisitions of financially sound but small family enterprises. The much rarer, larger-scale acquisitions were generally sanctioned by the government. Commentators advanced four reasons for the low level of Mergers and Acquisitions (M&A) activity in Japan: (1) weak shareholders, (2) cross-holdings, (3) culture, and (4) regulatory barriers. First, the weak position of shareholders relative to other stakeholders precluded shareholders’ action for corporate control (Sibbitt, 1998). The lack of focus on current performance meant large stockholding institutions only picked new managers in crises (Gilson and Roe, 1993), and the relationship between managers and stakeholders was maintained for a long time (Shleifer and Vishny, 1997). Such governance system created less scope for disciplinary action by shareholders. Second, cross-holdings among group firms left fewer shares to be freely traded, and therefore hampered share mobility on the market (Sibbitt, 1998). Concentration on a small number of large shareholders that rarely sold their holdings to maintain trading relationships reinforced this (Allen and Gale, 2000) and essentially precluded hostile takeovers and deterred outside control threats. Third, the cultural tradition of Japan limited the frequency of M&A. Lifetime employment, restricted labor mobility, seniority-based wages, and company unions caused M&A to be avoided as employment risks to managers and employees. A third party was required to arrange a deal, a role usually played by the main bank or the government (Saywell, 1994; Cooke, 1991). The acquiring firm rarely took the initiative and unsolicited acquisitions were socially not well-perceived. Because Japanese considered acquisition to be failure by the seller, there was an attitude in Japan against M&A (Abegglen, 1983). And fourth, the ultimate barrier to M&A activity in Japan was restrictions imposed by the Foreign Exchange and Foreign Trade Control Law (Sibbitt, 1998; Saywell, 1994). Tender offer bids were first permitted in 1972 under a tightly regulated system following an amendment to the Securities Exchange Law. The rationale for the tight regulation was the widespread feeling at the time that Japanese companies might not be able to protect themselves from foreign takeovers and so the mechanics of the legislation were not userfriendly. The offeror had to file notification with the MOF under a

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prior notification system impeding his ability to time the market, and risking information leakage. The bid further had to be published in the daily newspapers right after notification became valid, revealing the offeror’s strategies to competitors, with no guarantee that sufficient acceptances would be received for the tender offer to succeed. As a result, tender offer bids were extremely rare and on no occasion had hostile intention.

5.3 5.3.1.

Economic pressures and corporate governance reforms Economic crisis

During the 1990s, Japan’s industrial policies became counter-productive and its cheap capital evaporated. Industrial policies, which had helped build Japan’s industrial miracle in the 1950–1960s, became counter-productive beyond the 1970s (Katz, 1998). Protectionism had built Japan’s infant industries into export stars, but at the very point in the country’s evolution when the “developmentalist” policies should have been loosened, they were reinforced. By the 1970s, when Japan had matured economically, its industrial policies shifted from promoting winners to protecting losers, therefore stifling efficiency and growth. Japanese businesses increasingly faced larger cost of capital as previously passive shareholders demanded greater returns (Sherman and Babcock, 1997). Pressure for greater returns was aggravated by unacceptably low yields on Japan’s pension assets, the aging population, and competition from foreign investment firms (Field, 1997). Deregulation and financial reform helped intensify competition from abroad (Alexander, 1997). The cost of labor also increased substantially faster than sales and Gross Domestic Product (GDP) growth (Levy, 2000). The hollowing out of Japan’s productive potential led economic growth to slow down. Japan’s major manufacturing corporations experienced a substantial downtrend in profitability, yielding the lowest returns on investment in the post-war era (Watanabe and Yamamoto, 1992). The earnings drought for Japanese companies became the longest since the 1950s (Sherman and Babcock, 1997). Poor prospects of profits led to persistent decreases in Japanese equity prices (Levy, 2000). During the Asian crisis of 1997, Japan experienced large exchange rate depreciation and stock market declines, which further exacerbated the country’s economic turmoil. The number and size of corporate bankruptcies rose steeply to record levels (Levy, 2000). Large bad debts

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resulting from the burst in asset values pushed the banking sector into crisis and stressed the corporate sector (Arayama and Mourdoukoutas, 2000). In the past, firms belonging to industrial groups could count on the support of their main banks when facing distress, and bureaucratic efforts prevented banks from failing. However, persistent slowdown, the deteriorated financial standing of banks, and the weakening of corporate balance sheets changed this pattern. Many banks failed, and the rate of bankruptcies soared. Japan’s current recession was not only one of the country’s worst and potentially longest lasting recessions in the post-war era (Sherman and Babcock, 1997), but had a depth and duration virtually unprecedented for a major industrial country since World War II (Bayoumi and Collyns, 2000).

5.3.2

Corporate governance reforms

During Japan’s economic downturns, flaws in corporate governance of Japanese corporations have become obvious. Several scandals involving large firms have also played their part in pushing for changes. Recognizing that corporate governance is essential for Japanese corporations to compete internationally, Japan has turned to large scale measures to reform corporate governance. One major effort is revisions to the Commercial Code, which aim at improving mechanisms to enforce management accountability. The Commercial Code has been revised numerous times, however the current reform is the most thorough (Poe et al., 2002). The major players are the Ministry of Justice, the Ministry of Economics, Trade, and Industry, the MOF, the Japan Federation of Economic Organizations (Keidanren), the American Chamber of Commerce in Japan (ACCJ) (Poe et al., 2002), and the Japan Corporate Governance Forum. Among the many proposals for revisions to the Commercial Code that bear on corporate governance, the following six proposals are highlighted: (1) to facilitate mergers and corporate restructurings; (2) to reduce the level of cross-shareholdings; (3) to liberalize stock options; (4) to liberalize shareholders litigation; (5) to change the composition of the BOD; and (6) to strengthen the role of corporate auditors (kansayaku). The first four proposals are intended for governance through market discipline, while the last two purport to revamp internal governance mechanisms.

M&A The proposal to facilitate mergers and corporate restructurings is based on the belief that M&A activity allows corporations to jettison

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enterprises that are not performing well and to concentrate on their core businesses. In essence, managers would be subject to disciplinary actions from the external market if they fail to allocate corporate resources efficiently. Many major roadblocks were resolved over the past decade. Japan had long banned pure holding companies, fearing anti-competitive business practices. As a result of recent legislative changes, the number of reported deals in Japan has increased dramatically in recent years (Yoost et al., 2001; The Economist, June 9, 2001; Yamashita and Kamiyama, 2000; Spindle, April 13, 1997). According to Japan External Trade Organization (JETRO), the number of mergers by listed companies in Japan grew to 72 in 1998 and 152 in 1999, compared with between 30 and 50 before 1997. There were 49 stock swaps and seven stock transfers from October 1999 to November 2000. The number of Management Buy-Out (MBO) deals grew to nine in 1998 and 15 in 1999. The aggregate amount of MBO in 1999 reached 29.7 billion yen. However, the overall M&A trend somewhat flattened more recently, perhaps in response to promises by the Japanese government to stabilize the financial sector (Statement by the Minister of Finance, August 21, 1998).

Cross-holdings The proposal to reduce cross-holdings is expected to have positive effects both on M&A mechanisms and on internal governance. On the one hand, M&A will become easier when corporate shares are more available for trading. On the other hand, directors will need to be more attentive to shareholders because they cannot count on support from cross-holdings. Beginning in 2002, new corporate accounting rules will require that cross-held shares be assessed at their market values rather than their book value. Because market values are more volatile, and because these assets have decreased values, banks and corporations have incentives to divest their cross-holdings. Furthermore, in June 2001, regulators from Japan’s Financial Services Agency proposed that banks’ shareholdings be less than the value of their capital holdings. This would require banks to sell all excess equity shares over a three-year period, further dismantling the banks’ roles and the cross-holding system itself. According to a report from NLI Research Institute (as reported by Poe et al., 2002), at the end of fiscal 1999, cross-holding and long-term holding ratios reached new lows, indicating that cross-holdings continued to unwind at a rapid pace. The cross-holding ratio of all large

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keiretsus declined significantly, except for Mitsui, which would have declined if excluding the extraordinary factor of change in major shareholders of group companies.

Liberalization of stock options A revision to the Commercial Code significantly liberalized the ability of Japanese corporations to issue stock options as of June 1, 1997. The revision effectively legalized stock options and stock option warrants by giving directors and employees the right to buy company shares at predetermined prices.

Shareholder litigation Traditionally, the Japanese civil, criminal, and social schemes for enforcing directors’ duties appeared relatively weak. Japan’s legal environment was said to be pro-defendant, and litigation was rare (Field, 1997). First, since the Japanese discovery rules made it difficult for plaintiffs to compel defendants to turn over evidence, it was not easy for individual plaintiffs to win cases against large corporations. Second, punitive damages were not available, and plaintiffs could not expect the large awards common in some other countries. Third, the country has few lawyers, and they do not ordinarily become involved in routine domestic financial transactions. Given this background, litigants normally sought informal negotiations outside the legal system and settled before commencing legal action: shareholders in Japan filed fewer than 20 derivative suits against directors from 1950 to 1990 (Milhaupt and West, 2001). The relevant provisions of the Commercial Code were amended, and came into effect as of October 1, 1993. Following the amendment, any shareholder who has held shares continuously for at least the previous 6 months in a limited liability company can commence a shareholder derivative suit on behalf of the company against any directors or statutory auditors. In a derivative suit, the shareholder’s right to sue “derives from” his or her shareholding, and any damages paid by the defendant are paid not to the shareholder, but to the corporation. The derivative suit mechanism, transplanted from the U.S. model in 1950, may only be brought against directors and similar actors in Japan. Japan has no class action mechanism, so derivative suits account for almost all shareholder litigation. The amendment allows shareholders to pay a fixed court fee of 8,200 Yen (about US$82) instead of the previous sliding scale amount. In addition, where the shareholder prevails in the suit, he may also demand that

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the company pay his reasonable expenses incurred in the suit, including his reasonable legal expenses. The requirement for fixed court fees has increased litigation activity. According to the JETRO, there were 256 derivative lawsuits in 1999, compared to 93 in 1993. Additionally, courts order corporate directions to pay large compensation more frequently. For instance, on September 20, 2000, 11 directors were ordered to pay their company large amounts equivalent to between $70 million and $775 million US dollars. In this case, the court also granted an extraordinarily high damage award, stressing that the company was obliged to establish an internal control system sufficient to prevent directors from engaging in illegal activity. Corporate Japan was not thrilled with the increase in litigation, and many managers complained that the suits were nuisance suits of groundless claims. However, plaintiffs and shareholder activists and the media proclaimed a new age of corporate governance in which managers were responsible to shareholders.

Board independence Various groups, notably the Japan Corporate Governance Forum (JCGF), a research group composed of academicians and practitioners, proposed to add independent directors to the board. Insiders appointed to BODs tended to be more loyal to employees and group interests than to shareholders while independent or outside directors, it was felt, would be more representative of shareholders in board decision-making. The issue of board independence was controversial due to vested interests by the involved parties, with the JCGF on one end, and Keidanren representing incumbent managers on the other end. The JCGF recommended that independent directors comprise a majority of the Board. The ACCJ further proposed that companies be allowed to eliminate the corporate auditor system if they add outside directors that total one-third of a board’s membership. However, Keidanren staunchly opposed the idea of allowing outsiders to meddle with a company’s strategic planning, and proposed it be implemented on an optional basis. In the end, the Ministry of Justice proposed that all large companies have just one independent director on the board. That independent director was duly defined as somebody who has never been a full-time director, executive, or employee of the company or its parent, subsidiaries, or affiliates. Inter-locking directors were viewed as lacking independence.

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Board structure Corporate governance principles as set forth by the JCGF called for a clear separation of management and oversight. Boards should be positioned as the supervisory body of a company’s management on the premise that managerial decisions will be evaluated by the securities market with shareholders’ interests at its core. The decisions of the board should be limited to matters such as approval of high level strategic decisions, nomination of candidates for director and executive position, appointment and removal of the CEO, setting of management salaries, and general control of accounting and auditing. The JCGF further recommended that boards establish committees to limit the discretion of company presidents to act arbitrarily. When directors are appointed and dismissed exclusively by company presidents, the board lacks independence and their supervisory role can be undermined. Therefore, a nomination committee should exist to select candidate directors and executives, and propose the appointment or dismissal of key management. A compensation committee should review executive compensation and incentive programs in accordance with pre-set compensation principles. An audit committee should organize the overall accounting and audit functions, and assess the audits performed by certified public accountants (CPA). Special committees should be established to deal with serious matters affecting shareholders, such as derivative lawsuits and takeover bids. To enhance the efficiency of company presidents in their conduct of business, an executive management committee should be set up for their assistance. A related issue was the large size of the traditional Japanese board. The large size was due to the consensus-based culture in decisionmaking, and to the practice of appointing seniors to the board as a reward for life-time service. However, the number of board members should be set so as to allow for meaningful discussion and accurate and prompt decision-making. Therefore, it was generally agreed by all parties that the number of directors should be reduced.

Corporate auditors The proposal to strengthen the role of the corporate auditor (kansayaku) was an alternative to adding independent directors to corporate boards. A corporate auditor is a statutory office required by the Commercial Code of Japan. The role of a corporate auditor is to oversee the execution of the directors’ duties. The oversight is divided

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into a business (also called compliance) audit and a financial audit. A business audit determines whether directors are observing the statutes and articles of incorporation of the company. A financial audit is conducted based on the business results of the year and the financial statements prepared by the company’s accounting department and being audited by the external auditor. Corporate auditors are not required to be CPAs. From a shareholder’s perspective, the corporate auditor system was viewed as inadequate governance for Japanese corporations because corporate auditors were often former staff of the company or of group companies, and therefore not powerful enough to prevent presidents from wrong-doing. Further undermining the whole audit system in Japan was a weak internal auditing system and, until recently, a lack of requirement for external auditors. CPA audits were enforced in 1974 to strengthen the internal auditing of major corporations, however, due to a lack of competition and protection from the MOF, CPA audits proved to be failures. External auditors were not required until April 2002 for large corporations. An amendment to the Commercial Code in 1994 required at least three corporate auditors, one of whom must be full-time, and at least one from outside for large corporations. The independence of corporate auditors was upheld through the requirement that corporate auditors could not at the same time be a director. Another amendment to the Commercial Code effective April 2002 required that half the company’s corporate auditors be appointed from outside the company. Recognizing the usefulness of a stronger oversight function, an amendment effective April 2003 allowed an audit committee system on an optional basis. Members of the audit committees must be appointed as members of the BODs at the shareholders’ meeting, and the majority of the members of the audit committee must consist of independent directors. Overall, the current Japanese laws allow the corporate auditor system and audit committee system on an optional basis. It should be noted that these provisions are in conflict with Section 301 of the U.S. Sarbanes-Oxley Act of 2002, rendering it impossible for Japanese firms to comply with this legislation to list in the U.S. Although Nippon Keidanren, the successor to Keidanren, is lobbying for a home-country exemption for Japanese firms, auditor systems for Japanese corporations will probably undergo more changes. For one thing, as the idea of independent directors gains support, the corporate auditors system will likely fade away.

Huong N. Higgins 111

5.4

Conclusion

Efforts to reform corporate governance in Japan may be loosely grouped into two categories, those that address corporate governance through market discipline, and those that address internal governance through management organization. The first category includes legislation that facilitates corporate restructurings and deal mechanics, for example through increasing M&A activity, reducing corporate crossholdings, liberalizing stock options, and facilitating shareholders’ litigation. The second category includes changes in the board room of Japanese corporations, for example through size reduction and introduction of independent directors. Reform efforts addressing market discipline face major obstacles despite a good number of revisions to the Commercial Code. For market forces to play a disciplinary role, the bureaucracies of Japan must be willing to dismantle the developmentalist regulations that protect Japanese firms from competition. However, while professing that non-performing institutions should be allowed to fail, politicians still continue their practice of bailing them out, most ostensibly for banks (Anderson and Campbell 2000). For this reason, commentators have criticized the Japanese political system for repeatedly compromising reforms in ways that limit their market-freeing impacts (Carlile and Tilton, 1998). The impact of new legislation on M&A activity, for example, was significantly dampened when Japan’s MOF promised not to let major banks fail. With regards to M&A, national protectionism persists in the form of complicated rules for cross-border share exchanges, limiting transactions for international corporations. It appears that developmentalist ideology prevails not only among political leaders, but also among business leaders and intellectual circles in Japan due to a concern for the country’s international competitiveness (Tilton, 1998). Guided by this concern rather than by shareholders’ benefits, business leaders are comfortable with the power of bureaucracy to order markets. As a result, the introduction of market discipline in Japan has been done in gradual and limited ways (Tilton, 1998). This developmentalism hurts bank governance because the government’s tendency to intervene and rescue will make banks content with merely masking their bad loan problems. The lack of bank governance will in turn hurt corporate governance of corporations due to a lack of sound bank monitoring and a lack of healthy competition for bank funds.

112 The Governance of East Asian Corporations

Furthermore, as Japan moves towards an Anglo-American style of corporate governance, it will encounter phenomena inherent to market settings, such as intense competition and stock price swings. However, there seems to be an inclination in Japan to avoid excessive competition on the grounds that it is too costly (Tilton, 1998), and because it is deemed to benefit only greedy short-term shareholders (Japan Corporate Governance Committee, 2001). Perhaps as a consequence, domestic shareholder activists are conspicuously absent from reform debates over corporate governance in Japan. Because market discipline requires true competition and a true respect for shareholders, these inclinations may dampen the intended effects of some reform measures. The second category of reform efforts, which addresses internal governance, requires changes in individual attitudes, especially among management teams. First, as opponents to independent directors insist, it would be difficult for outsiders to have sufficient expertise and understanding of the business to make important decisions for the firm. Therefore, a culture of transparency should be cultivated to allow important information to be disclosed concisely for decision-making by outsiders. Open disclosures are not easy to achieve in corporate Japan’s atmosphere of secrecy, where many believe that corporate affairs should best be kept within close insiders’ circles. Further, for outside directors to be effective, true psychological independence must exist among directors and auditors. Japanese social relationships are based on interdependence rather than on arms-length relationships, and this cultural trait may affect directors’ and auditors’ work despite the presence of outsiders on the board. Finally, members of the board should actively review company financial statements rather than passively endorse them. This requires due diligence and familiarity with financial affairs, which Japanese managers seem to lack in comparison with their operational insight. To foster the new corporate governance environment, Japan needs, but is missing, a larger pool of managerial talent. Directors and corporate auditors are rarely independent, because they are traditionally promoted from inside their companies and tend to have only company-specific knowledge. According to Craig (1998), Japan had about 12,000 CPAs and 710 bank examiners, in contrast with half a million and 7,000, respectively, in the U.S, although Japan is half the size of the U.S. in population. As the business environment becomes more litigious, Japan also needs more lawyers. According to Field (1997), the Japanese legal profession is currently based on only

Huong N. Higgins 113

17,000 licensed attorneys (versus 800,000 in the U.S.). Without new blood, it will be difficult for Japanese corporations to recruit their executives and take full advantage of the new atmosphere of market economy. Because the reform efforts are based on governance principles similar to those in Anglo-American systems, and because of the strong voice of the ACCJ in related debates, the trend of corporate governance reform in Japan seems to be towards the Anglo-American style. However, it is unclear that convergence will happen. Internal governance is difficult to change, as has been observed from multinational corporations (Pauly and Reich, 1997). Furthermore, durable national institutions and distinctive ideological traditions for business management, both of which are distinctive in Japan, will continue to shape crucial corporate decisions. Globalization will force governance systems closer together, however, even globalization will not be strong enough to overcome local vested interests (Palepu et al., 2002). In Japan, traditional relationships will undoubtedly remain, and the evolution of corporate governance in Japan will probably follow a path that is more or less dependent on the country’s past institutions.

Notes 1. The BOD of all firms with 1,000 employees or more had on average 21.2 directors. This average consisted of 1 CEO, 0.9 vice CEO, 1.9 Senmu (senior managing directors), 4.4 Jomu (managing directors), 7.8 Torishimari (junior directors), 1.9 Kansa (statutory auditors), 0.4 Kaicho (retired CEO remaining on the boards as chairman), 0.9 other full time directors, and 2 part time directors (Kato, 1997). Kaplan (1994) also reported that, based on 119 large Japanese firms, a typical board consisted of 21 directors, while the median number of outside directors was zero.

References Abegglen, J. C. (1983). Why Japan mistrusts mergers. Mergers and Acquisitions 17 (Winter): 16–19. Alexander, A. J. (1997). U.S.–Japan relations and the Japanese economy. Japan Economic Institute Report. No. 25A, July 4. Allen, F. and D. Gale (2000). Comparing Financial Systems. MIT Press, Cambridge Mass. Anderson, C. W. and T. L. Campbell (2000). Restructuring the Japanese banking system: Has Japan gone far enough? International Review of Financial Analysis 9 (2): 197–218. Anderson, C. W. and A. K. Makhija (1999). Deregulation, disintermediation, and agency costs of debt: Evidence from Japan. Journal of Financial Economics 51 (February): 309–339.

114 The Governance of East Asian Corporations Aoki, M. (1988). Information, Incentives, and Bargaining in the Japanese Economy. Cambridge University Press, New York and Cambridge. Arayama, Y. and P. Mourdoukoutas (2000). The Rise and Fall of Abacus Banking in Japan and China. Westport, CT: Quorum Books. Bayoumi, T. and C. Collyns (2000). Post-Bubble Blues – How Japan Responded to Asset Price Collapse. Washington D. C.: International Monetary Fund. Carlile, L. E. and M. C. Tilton (1998). Is Japan really changing? In Is Japan Really Changing Its Way edited by Carlile and Tilton, Brookings Institution Press, Washington D. C. Cooke, T. E. (1991). Environmental factors influencing mergers and acquisitions in Japan. Journal of International Financial Management and Accounting 3: 160–188. Cooke, T. (1996). The influence of the keiretsu on Japanese corporate disclosure. Journal of International Financial Management & Accounting 7 (Autumn): 191–216. Craig, V. V. (1998). Financial deregulation in Japan. FDIC Banking Review 11: 1–11. Field, G. (1997). Japan’s Financial System Restoration and Reform. London: Euromoney Publications PLC. Gilson, R. J. and M. J. Roe (1993). Understanding the Japanese keiretsu: Overlaps between corporate governance and industrial organization. Yale Law Journal 102 (January): 871–906. Hattori, I. (1978). A proposition on efficient decision-making in the Japanese corporation. Columbia Journal of World Business 23 (Summer): 7. Horiuchi A. and K. Shimizu (2001). Did amakudari undermine the effectiveness of regulator monitoring in Japan? Journal of Banking & Finance 25 (March): 573–596. Jacobson, R. and D. Aaker (1993). Myopic management behavior with efficient, but imperfect, financial markets: A comparison of information asymmetries in the U.S. and Japan. Journal of Accounting and Economics 16 (October): 383–405. Japan Corporate Governance Committee (2001). Revised corporate governance principles (October 26). Japan Corporate Governance Forum. Japan External Trade Organization (JETRO). http://www3.jetro.go.jp/examples/servlet/Qa2to3Servlet?class=2 Johnson, L. and E. H. Neave (1993). Governance and competitive advantage. Managerial Finance 20 (8): 54–70. Kaplan, S. N. (1994). Top executive rewards and firm performance: A comparison of Japan and the United States. The Journal of Political Economy 102 (June): 510–548. Kato, T. (1997). Chief executive compensation and corporate groups in Japan: New evidence from micro data. International Journal of Industrial Organization 15 (July): 455–467. Kato, T. and L. Taylor (1994). The timing of promotion to top management in the U.S. and Japan: A duration analysis. Mimeo. Katz, R. (1998). Japan, the System that Soured – The Rise and Fall of the Japanese Economic Miracle. Armonk, New York: M. E. Sharpe, Inc. Kester, W. Carl (1997). The hidden costs of Japanese success. Studies in International Corporate Finance and Governance Systems – A Comparison of the U.S., Japan, and Europe. Edited by Donald H. Chew. New York: Oxford University Press.

Huong N. Higgins 115 La Porta, R., F. Lopez-de-Silanes, A., Shleifer, and R. Vishny (1998). Law and finance. Journal of Political Economy 106 (December): 1131–1155. Levy, J. (2000). Financial reorganization and corporate restructuring in Japan. In: Bayoumi and Collyns (eds), Post-Bubble Blues – How Japan Responded to Asset Price Collapse. Washington, D. C.: International Monetary Fund. Milhaupt, C. and M. West (2001). Why shareholders sue: The evidence from Japan. Journal of Legal Studies 30 (June). Morck, R. and M. Nakamura (1999). Banks and corporate control in Japan. Journal of Finance 54 (February): 319–339. Nakatani, I. (1984). The economic role of financial corporate groupings. In The Economic Analysis of the Japanese Firm, M. Aoki, ed. Amsterdam: NorthHolland 1984. Okubo, S., W. Brown, F. Yu, and K. Borghese (1996). Prospects for growth in Japan in the 21st century. United States Department of Commerce. Palepu, K., T. Khanna, and J. Kogan (2002). Globalization and similarities in corporate governance: A cross-country analysis. Working paper, Harvard University. Pauly, L. W. and S. Reich (1997). National structures and multinational corporate behavior: enduring differences in the age of globalization. International Organization 51 (Winter): 1–30. Poe, M., K. Shimizu, and J. Simpson (2002). Revising the Japanese Commercial Code: A summary and evaluation of the reform effort. Stanford Journal of East Asian Affairs 2 (Spring): 71–95. Saywell, M. (1994). The ultimate barrier revisited: Mergers and acquisitions in Japan. In Japanese Commercial Law in an Era of Internationalization, edited by Hiroshi Oda. Graham & Trotman Limited. Sheard, P. (1989). The main bank system and corporate monitoring and control in Japan. Journal of Economic Behavior & Organization 11 (May): 399–323. Sherman, H. D. and B. A. Babcock (1997). Redressing structural imbalances in Japanese corporate governance. Studies in International Corporate Finance and Governance Systems – A Comparison of the U.S., Japan, and Europe. Edited by Donald H. Chew. New York, Oxford University Press. Shleifer, A. and R. W. Vishny (1997). A survey of corporate governance. Journal of Finance 52 (June): 737–783. Sibbitt, E. C. (1998). A brave new world for M&A of financial institutions in Japan: Big bang financial deregulation and the new environment for corporate combinations of financial institutions. University of Pennsylvania Journal of International Economic Law 19: 965–1027. Spindle. 1997. April 13. Teramoto, Y. (1999). Changes in interorganizational networks of Japanese corporate groups: from parenting to partnering. In Business Networks in Asia – Promises, Doubts, and Perspectives 1999, edited by Frank-Jurgen Richter. Quorum Books, Westport, Connecticut. The Economist (2001). Business: Japan Inc. on the treadmill. The Economist 359(June): 63–64. Tilton, M. C. (1998). Regulatory reform and market opening in Japan. In Is Japan Really Changing Its Way edited by Carlile and Tilton, Brookings Institution Press, Washington D. C. Watanabe, S. and I. Yamamoto (1992). Corporate governance in Japan: Ways to improve low profitability. NRI Quarterly, 3: 28–45.

Yamashita, A. and T. Kamiyama (2000). Energetic M&A in Japan. Corporate Finance Supplement (November): 39–40. Yoost, D., T. Tagai, and A. Zencak (2001). Japan paves the way for more M&A. International Tax Review 12 (March): 13–18.

6 Paradoxes of Governance: Ownership and Control of Corporate Malaysia Edmund T. Gomez

6.1

Introduction

Even though this country’s corporate history is replete with cases of business scandals, the issue of corporate governance in Malaysia only began to gain prominence in the late 1990s as a consequence of the 1997 financial crisis. Among the most prominent cases are the Bank Rakyat scandal1 in the 1970s and the Bank Bumiputra/BMF2 and PanEl/Multi-Purpose Holdings3 scandals in the early 1980s. The most serious cases of poor corporate governance exposed in the late 1990s involved two government-owned institutions, Perwaja Steel and Bank Bumiputra, which were allegedly brought to the brink of bankruptcy due to fraud and mismanagement. When the financial crisis occurred, a number of Malaysia’s largest publicly-listed companies nearly collapsed, mainly because of debt accumulation and poor due diligence when acquiring firms; the best example of this was the politicallylinked conglomerate, Renong. The owners of some well-run government-owned institutions which had been privatized, like Malaysia Airlines (MAS), had also allegedly managed to destroy shareholder value due to unwise – and incompetent – management (see Asian Wall Street Journal, 2001, July 26). MAS was eventually re-nationalized at great public expense. The near collapse and bailout of companies like Renong, MAS and Bank Bumiputra, to name a few, are no longer remote issues to ordinary Malaysians for two reasons. First, in the 1990s, with the rise of the middle class, the number of retail investors increased phenomenally. Many of these investors found that the value of their investments had declined appreciably due to poor governance by directors, as well as by public institutions. Second, the ostensible need to deal with the debt 117

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crises created by these poorly governed companies justified huge bailouts with public funds. This crisis, in effect, drew public attention to the rampant and unaccountable use of power by people with influence over corporate enterprises and government. This chapter will first describe some specific concepts of corporate governance that are relevant to the Malaysian situation. Key attention will be drawn to the concept of public governance because of the close links between politics and business in Malaysia, the huge interests that government-owned institutions have in the stock market, and the impact of key public policies on the corporate sector. This will be followed by a brief history of the rise of capital in Malaysia as well as some highlights from an analysis of the top 100 companies listed on the Kuala Lumpur Stock Exchange (KLSE). In the analysis of the development of the corporate sector, the concepts of ownership and control, interlocking stock ownership and interlocking directorships will be used. The focus will be on events that occurred between 1970 and 2000, for during this period the New Economic Policy (NEP), a major redistribution initiative, was implemented which had a major impact on corporate ownership patterns.

6.2

Defining corporate governance

Blair (1995) argues for the need to adopt a broader understanding of corporate governance than the mere monitoring of the activities of the management of companies and the protection of minority shareholders and funding institutions. For Blair (1995, p. 3), an analysis of corporate governance should encompass a review of legal and institutional arrangements to “determine what publicly traded corporations can do, who controls them, how that control is exercised, and how the risks and returns from the activities they undertake are allocated.” Put differently, public governance of the corporate sector is crucial, through the creation of a legal and institutional environment that monitors and supports the efficient use of resources, to ensure wealth creation that will benefit society (Blair, 1995, p. 235). Almost all studies on corporate governance focus on similar issues, that is the selection and remuneration of directors, whether banks or institutional investors should be active in the management of firms in which they have investments, and forms of control over corporate activities like mergers and takeovers. These were the key questions that formed the debate4 in Malaysia when new regulations and institutions were introduced to enforce greater governance over the corporate

Edmund T. Gomez 119

sector. The focus of this study, however, goes beyond merely dealing with these issues. In Malaysia, the state – or people in control of the executive – has overwhelming influence over the corporate sector, and the close ties between the state and business have influenced the nature of public governance. This, in turn, has affected the performance of corporations and their ability to generate wealth. Politicians with hegemony over the state can, for example, determine which companies secure privatized concessions, whether their activities can be funded by the financial sector and through stock market activities, and who gains, through various government policies, control of key economic sectors, like the banking industry. The manner of policy implementation has had a major impact on the issue of property rights, which has had a crucial bearing on the form of development of the corporate sector, which has in turn affected domestic and foreign – as well as retail and institutional – investment patterns. There are other reasons for the focus on public governance. The strength of the state in Malaysia is such that it has the capacity to relieve owners, even majority shareholders, of their ownership and control of their corporations if it so desires, or if it feels this is necessary. This is reinforced by the government’s vast ownership of major quoted enterprises. In the absence of direct ownership, a number of the top 100 publicly-listed firms are owned or controlled by businessmen with close ties to government leaders. Given this variety of links between the state and capital, government leaders have been able to influence the development of these firms. To explain how the state controls capital and to understand the form of corporate governance in Malaysia, these key questions will be dealt with here: what ownership and control patterns exist in the top 100 publicly-listed companies? What is the extent of interlocking stock ownership and directorships among these 100 companies, and to what extent do such ties contribute to control over corporate activities? Is there much competition within the economy or are monopolistic ownership patterns emerging in key economic sectors? What is the nature of the relationship between political leaders and corporate captains, and how does this relationship influence business activities? Finally, what is the nature of the ties between financial institutions and the corporate sector? These questions are important because corporate failures, specifically those that emerged following the 1997 financial crisis, affected politically well-connected companies, necessitating bailouts with public

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funds, partly to prevent the collapse of key financial institutions. There were also many allegations of abuse of power by owner-directors and of corruption in the manner of development of the firms – and banks – that required bailouts. Most of the corporations that were highly leveraged were indebted to banks that were either government-owned or controlled by politically well-connected businessmen. These bailouts have brought into question the capacity of government regulatory institutions to govern independently and the extent of their accountability to the public, in general, and company shareholders in particular. This chapter will deal with the issue of corporate and public governance primarily from the point of view of how it has affected the performance of corporations, their ability to generate wealth, and the impact of close ties between the state and capital on the rights of investors and the Malaysian economy.

6.3

The state of capital: corporate development 1970–2000

A review of the list of the top 100 publicly-listed companies in Malaysia in the year 2000 highlighted one key point: the emergence of enterprises owned by the government and Bumiputera5 – ethnic Malays – that had a conspicuous presence in the corporate sector. This was a notable achievement for the Malaysian government for it had introduced in 1970 a positive discrimination policy meant partly to nurture the development of Bumiputera capital. In 1969, before this affirmative action policy was introduced, Bumiputera ownership and control over the Malaysian economy was a meager 1.5% (see Table 6.1). By 1990, when the then 20-year old NEP came to an end, corporate wealth attributable to Bumiputera individuals and trust agencies had risen to 19.2%. During the 10 years of the National Development Policy (NDP, 1990–2000), which was introduced to replace the NEP, Bumiputera equity ownership rose to 20.6% in 1995 (see Table 6.1). Table 6.1 also indicates that, in spite of the NEP between 1970 and 1990, Chinese equity ownership continued to rise, increasing almost two-fold from 27.2% to 45.5%, though the volume of their equity ownership declined to 40.9% by 1995. The most significant change in corporate ownership patterns was the appreciable decline in foreign ownership of Malaysian corporate equity – from 63.4% in 1970 to 25.4% in 1990, though it increased to 27.7% in 1995. As impressive and profound these changes in equity ownership patterns may have been, these figures do not reveal the extent to which state control and influence over the corporate sector has increased over three short decades.

Edmund T. Gomez 121 Table 6.1 Malaysia: Ownership of Share Capital (at par value) of Limited Companies, 1969–2000 (percentages)

Bumiputera individuals and trust agencies Chinese Indians Nominee companies Locally-controlled firms Foreigners

1969

1970

1975

1980 1985

1.5

2.4

9.2

12.5

22.8 0.9 2.1 10.1 62.1

27.2 1.1 6.0 – 63.4

n.a. n.a. n.a. – 53.3

n.a. n.a. n.a. – 42.9

1990

1995

19.1

19.2

20.6

33.4 1.2 1.3 7.2 26.0

45.5 1.0 8.5 0.3 25.4

40.9 1.5 8.3 1.0 27.7

n.a.: Not available Source: Seventh Malaysia Plan, 1996–2000.

In his pioneering study of ownership and control of major firms in preIndependence Malaya, Puthucheary (1960) revealed the overwhelming dominance that foreign, especially British, enterprises had over the local economy in the early 1950s. Lim (1981) revealed that from 1957, when independence was attained, until the watershed events of 13 May 1969, ownership and control of the Malaysian corporate sector, particularly of the largest publicly-listed companies, remained in the hands of foreign enterprises. Although Chinese capital had had a ubiquitous presence in the Malaysian economy in the pre- and postIndependence period, in terms of ownership and control of influential firms operating in the domestic sector, their strength paled in comparison to foreign capital. Lim’s (1981) analysis of the top 100 quoted firms in the late 1970s indicated a number of other important points. First, there was significant interlocking stock ownership among a number of prominent corporate groupings indicating concentration of control over the economy; this control was primarily in the hands of a few large corporations. Lim’s (1981, p. 114) study revealed that of the 100,000 shareholders in Malaysia’s 62 large corporations, 797 of them – a mere 0.8% – owned 69% of RM1.4 billion worth of equity. Within this group, the top 1% owned 29%, while the top 50% owned 97% and the bottom 20% only 0.4%. Second, Lim (1981, pp. 52–70) noted extensive interlocking directorships, identifying three important types of directorates: owner directors, executive-professional directors and functional directors. Owner directors were equity owners who served as directors. Executive-professional directors were high ranking employees who did not own a substantial stake in the firm. Functional directors were those usually appointed to perform “extra-economic functions”;

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these directors were usually former senior bureaucrats who could perform “advisory and brokerage functions” (Lim, 1981, p. 69). Lim (1981, p. 115) suggests that directorate interlocks were used “to strengthen control over corporations in which one has ownership interests.” Third, although the government had attempted to develop domestic Bumiputera capital, more than a decade after Independence had been achieved, no ethnic Malay had emerged with a significant presence in the corporate sector. During the colonial period, Malay involvement in the emerging capitalist economy was not encouraged by the British. When Malay peasants tried to venture into capitalist sectors of the economy, the British imposed restrictive cultivation conditions thus blocking their efforts. These early discriminatory policies in favor of British plantation interests severely limited the development of indigenous capital and shackled Malays to traditional economic activities. Since the British had hindered the development of Malay capital in the colonial period, this reason was used to justify the post-1969 policies that positively discriminated in favor of the Bumiputeras. The continued dominance of foreign capital over the Malaysian economy after Independence was due to political factors. The leaders of the United Malays’ National Organization (UMNO), the dominant party in the ruling tripartite coalition, the Alliance, did not want to act to limit the influence of foreign firms mainly because they felt that only these companies could stem the rise of Chinese capital. Chinese capitalists had managed to secure a strong presence in the postcolonial government through their formation of the Malayan Chinese Association (MCA), hoping that effective political representation in government would enable them to protect their economic interests. The MCA, along with UMNO, formed the Alliance to help them secure control of the government. This coalition would later come to include the Malayan Indian Congress (MIC), another ethnically-based party. The basis for the cooperation between the MCA and UMNO was an agreement, popularly referred to as the ‘bargain’. The bargain involved an understanding among the multi-racial elite that Malays would dominate politics, leaving Chinese capital relatively unfettered by the state. This bargain was to prove unsustainable. Increasing Malay frustration over insignificant changes in ethnic ownership patterns and the inequitable distribution of wealth among ethnic communities partly contributed to the May 1969 race riots. Within the political domain, UMNO responded by enlarging its tripartite alliance into a multi-party coalition called the Barisan Nasional

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(National Front), comprising more than a dozen parties and reducing the MCA’s influence in government. In the economic domain, the government introduced the NEP, an ambitious 20-year social engineering plan. The NEP hoped to achieve national unity by eradicating poverty, irrespective of race, and restructuring society so as to achieve inter-ethnic economic parity, specifically between the Malays and the Chinese. The NEP entailed partial abandonment of the laissez-faire style of economic management in favor of ethnic affirmative action, including the accelerated expansion of the Malay middle class, capital accumulation on behalf of the Malays, and the creation of Malay capitalists. This was to be attained by increasing Bumiputera corporate equity ownership to 30% and by reducing the poverty level to 15% by 1990. To achieve the former goal, between 1971 and 1981, the number of state-owned enterprises (SOEs) that were incorporated grew phenomenally; inevitably, the presence of the state in the corporate sector increased appreciably during this decade. Chinese capital continued to grow during the NEP period, but there was an increasing need for them to accommodate the state. A signifying moment for the development of Bumiputera capital occurred when Mahathir Mohamad was appointed Prime Minister in 1981. From the outset of his premiership, Mahathir voiced his intention to create an ensemble of dynamic, entrepreneurial Malay capitalists. Mahathir’s argument for the need to hasten the development of Malay capital was that by 1981, ten years after implementation of the NEP, although the government had managed to increase the amount of corporate holdings held in the name Bumiputeras to 12.5%, little progress had been made in developing Malay businessmen in control of large corporations. In fact, as Lim’s (1981) list of top 100 corporations in the mid-1970s indicates, not one firm was owned by the Malaysian government or Bumiputera individuals. It was this situation that Mahathir sought to rectify.

6.3.1

The Mahathir-Daim factor

To aid his vision of creating of huge companies of international repute led by Malay capitalists, Mahathir appointed his close ally, prominent businessman Daim Zainuddin, as Finance Minister in 1984. Both men appeared obsessed with developing the stock market, and making it one avenue to help create domestic capitalists. Within just over a decade of Mahathir’s tenure as prime minister, Malaysia’s stock market capitalization relative to gross domestic product (GDP) had emerged as

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the highest in Southeast Asia. Between 1989 and 1993, for example, equity market capitalization as a percentage of GDP increased from 105% to 342.1%. By 1997, the KLSE had emerged as the 15th largest in the world in terms of market capitalization.6 By the mid-1990s, a number of huge publicly-listed conglomerates, controlled primarily by politically well-connected Malays, had emerged in the corporate sector. The high degree of autonomy that the Prime Minister had within the state had allowed him to selectively distribute government-created concessions to this select group of businessmen to help them swiftly develop their corporate base. Mahathir justified this form of patronage by arguing that the best way to create Malay capitalists was to distribute concessions to those most capable of generating wealth.7 These men, supposedly representative of the dynamic and entrepreneurial business class that Mahathir was trying to create, managed to develop huge conglomerates within a short time and, unlike some prominent Chinese businessmen who operated through unlisted firms,8 all politically well-connected businessmen developed their corporate assets through the use of one or more publicly-listed companies. By the mid-1990s, almost all of these Bumiputera-led companies were politically well-connected to one of the then three most powerful politicians in Malaysia – Prime Minister Mahathir, then Deputy Prime Minister and Finance Minister Anwar Ibrahim and then Economic Advisor Daim Zainuddin. A number of non-Bumiputera businessmen who were also politically well-connected quickly developed huge enterprises with government patronage.9

6.3.2

State power, patronage and the rise of the conglomerates

The manner of implementation of privatization, involving the selective distribution of concessions,10 reflects an important aspect of Malaysia’s political economy. The institutional and organizational structure of the government and ruling party has had a major bearing on the form of development of the corporate sector. An analysis of institutional control of government in Malaysia would indicate the enormous control that ruling politicians had come to have over the state. One party, UMNO, has hegemony over the Barisan Nasional, and by extension the government. Within government, through amendments to the Federal Constitution and through systematic undermining of the other arms of government – the judiciary, the legislature and the bureaucracy – power has come to be concentrated in the office of the executive.11 In Malaysia, the president of UMNO also serves as

Edmund T. Gomez 125

Prime Minister. This concentration of power in the office of the executive has enabled ruling politicians to distribute concessions at will to select businessmen. With growing political hegemony over the state, Malaysian politics subsequently became more personalized. When Anwar was appointed Finance Minister in 1991, he began developing his power base in UMNO by creating a new and large breed of politicians-cum-businessmen. The use of money in politics intensified and the creation of a corporate base became an important avenue to raise funds to finance political ascendance. The politician with the most influence over the corporate sector was, however, former Finance Minister Daim, who had little grassroots support and owed all his political appointments – as UMNO Treasurer and Government Economic Advisor and then again as Finance Minister – to Mahathir. Daim had come under heavy criticism from UMNO members for continuing to develop his corporate influence – and base – during his appointment as Finance Minister between 1984 and 1991. Following his appointment to the Treasury in 1984, Daim announced that he had divested his vast business interests, which included shares in companies involved in virtually all key sectors of the economy – banking, plantations, manufacturing, wholesaling and retailing, property development and media. Despite this, in 1992, one year after he had stepped down as Finance Minister, the total value of Daim’s assets was reportedly RM1 billion, which included assets in Australia, Britain, Mauritius and the U.S. (see The Star, 1992, May 19). While holding public office, Daim claimed that he had no active interest in business, even though he was still widely regarded as the most powerful figure in the Malaysian corporate scene. This was because his closest business associates had quickly emerged as major corporate figures controlling enterprises that had been owned by Daim or UMNO.12 By the early 1990s, although Mahathir, Anwar and Daim had an overwhelming influence over distribution of government concessions, there were different reasons why these political leaders channeled these concessions to businessmen. Anwar appeared to use his influence in government to develop his political base in UMNO, leading to the rise of a large group of businessmen whose primary motive was to use their corporate base as a means to secure ascendancy in UMNO. Their style of business was rather unproductive, many showing little capacity to build on the concessions they secured from the government. None of the Malay businessmen closely linked to Anwar has yet to emerge as

126 The Governance of East Asian Corporations

a major corporate figure. Mahathir, on the other hand, was much more selective in how he distributed concessions. The Prime Minister had a genuine belief in his ability to pick “winners” who could help him fulfill his vision of creating large Malay enterprises with the capacity to venture abroad and compete in an international environment. Such capitalists would later include a number of non-Malays. Daim-linked businessmen present a situation which is slightly more difficult to analyze since it is not clear whether the corporate assets held by these businessmen belong to them and/or were being held in trust for Daim or UMNO. This situation revealed that corporate ownership and control patterns involving politically well-connected companies were rather complex. Since the rise of most key businessmen was linked to the patronage of influential politicians, wealth accumulation depended on whether their patrons remained in power. Thus, most Malay and Chinese businessmen who emerged under former Finance Minister Anwar Ibrahim’s patronage have had to struggle to maintain their corporate base. Similarly, now that Daim appears out of favor with Mahathir, corporate assets owned by his business allies are being taken over by the government or by businessmen aligned with the Prime Minister.13 Although businessmen, particularly Chinese entrepreneurs, who had little or no links with politicians, appeared to have been able to retain control over their companies, mainly by conforming to government policies, it was not difficult for a hegemonic state to remove corporate assets at will. In spite of the rise of huge enterprises and the development of capital in Malaysia, capitalists remained very subservient to the state. This subordination brought into question the sustainability of corporate enterprises. Even those founded on economic rather than political origins could be dismantled or taken over following power struggles in UMNO. Did this affirmative action work? With the rapid fall of the stock market during the 1997 financial crisis, many well-connected companies fell off the list of the top 100 Malaysian firms far more rapidly than they got there. Chinese capitalists seemed to have fared better in the crisis, as did the listed companies owned by state-owned enterprises (SOEs). By the beginning of 2001, according to one study of the wealthiest business people in Malaysia, no Malay figured among the richest 10 businessmen (see Table 6.2). Apart from one ethnic Indian, the top 10 wealthiest corporate figures were all ethnic Chinese (see Malaysian Business 1/2/2001). Of the top 20, only three were

Edmund T. Gomez 127 Table 6.2

Malaysia’s 20 Richest Business People, 2001

Name

Estimated value of wealth

1. Robert Kuok 2. T. Ananda Krishnan 3. Lim Goh Tong 4. Quek Leng Chan 5. Yeoh Tiong Lay 6. Tiong Hiew King 7. Teh Hong Piow 8. Loh Cheng Yean 9. Lee Oi Hian 10. Lee Shin Cheng 11. Abdul Rashid Hussain 12. Tan Kim Hor 13. Khoo Kay Peng 14. Low Yow Chuan 15. Yaw Teck Seng 16. Azman Hashim 17. Lau Hui Kang 18. Tan Chin Nam 19. Shamsuddin Abdul Kadir 20. Tan Teong Hean

RM 15 billion RM 10.7 billion RM 9.6 billion RM 9.2 billion RM 5.5 billion RM 3 billion RM 2.8 billion RM 1.4 billion RM 1.2 billion RM 1.01 billion RM 891 million RM 890 million RM 700 million RM 691 million RM 596 million RM 542 million RM 500 million RM 485 million RM 365.6 million RM 337 million

Source: Malaysian Business (2001, February 1).

Bumiputeras, while 16 were ethnic Chinese. An analysis of the top 100 quoted firms in the year 2000 provided further evidence of the failure of the government to develop Malay entrepreneurs.

6.4

Ownership and control: top 100 firms

An analysis of stock distribution of the top 100 companies suggests that there is little concentration of corporate power in the hands of an elite business class. No group of companies under the control of one family or individual seems to dominate the top 20 listed corporations. One reason for this is that some of the dominant Bumiputera groups that had emerged by the mid-1990s, like the Renong/UEM, HICOM Holdings, TRI-MAS, Rashid Hussain and Arab-Malaysian groups, had been badly affected by the 1997 financial crisis and were taken over by the government. All these Bumiputera groups are controlled by wellconnected businessmen: the nexus of politics and business based on patronage and political loyalty has undermined the development of genuine Bumiputera entrepreneurship.

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This analysis of the owners of the top 100 quoted firms does not, however, indicate another aspect of the complexity of ownership and control patterns in Malaysia. In the presence of a strong state, it has been more important even for rather independent capitalists to link up with influential politicians. The Chinese firms in the top 20 KLSE list, for example, include companies from the YTL Corp, Genting, MPHB and Berjaya groups, which have been privy to state patronage. Probably the only two companies in the top 20 list with some semblance of independence from ruling politicians are Public Bank and KLK, but both firms have been led by men with proven entrepreneurial skill (see Gomez, 1999).

6.4.1 Interlocking stock ownership, interlocking directorship, corporate decline An analysis of interlocking stock ownership patterns reveals no links between the top 100 firms that suggest concentration of wealth or monopolization of economic sectors. A number of these quoted companies do, however, come under the umbrella of one holding company or are controlled by one businessman. This form of grouping, involving the use of a holding company – and, in some cases, pyramiding and cross-holdings – reflects the most important form of corporate control. This corporate grouping pattern also indicates the conglomerate style growth adopted by a number of Malaysian businessmen, a trend that began to gain prominence in the early 1980s. The limited evidence of interlocking stock ownership among the top 100 quoted firms indicates a number of important developments between 1970 and 2000. There is much evidence that political elites have attempted to concentrate wealth through their business allies (see, for example, Gomez and Jomo, 1999; Gomez, 1999, 2001, 2002). Between the early 1980s and late 1990s, businessmen linked to influential politicians like Daim and Anwar, and the children of the Prime Minister and some businessmen favored by him had began to accumulate and secure a prominent presence in the corporate sector. But, by the year 2000, mainly because of conflicts that had arisen between the political elites over control of lucrative corporate assets, these wellconnected businessmen had not managed to consolidate control over key economic sectors. It was widely believed that at the time of the NEP its implementation would compel ethnic Chinese to cooperate in business to protect their economic interests. Chinese capitalists had had a history of intra-ethnic business cooperation, evident notably during the colonial

Edmund T. Gomez 129

period among migrants.14 The shareholding pattern among Chineseowned firms in 2000, however, indicates that they tend to function rather independently. In fact, an in-depth study on the largest quoted Chinese enterprises in Malaysia revealed that the owners of most of these firms had established inter-ethnic ties, especially with politicallyinfluential Bumiputeras, in an attempt to help them expand their enterprises (see Gomez, 1999). There is similarly little evidence of ethnic cooperation between Bumiputera capitalists who own large quoted enterprises. Even Bumiputera firms owned by businessmen who share the same political patron seldom, if ever, work together. For example, when the government began its call for banks to consolidate after the financial crisis, there were no attempts by Bumiputeras in the financial sector to merge their enterprises. The bank consolidation exercise, as the case study will reveal, has been characterized by competition between these wellconnected Bumiputeras to secure the status as one of the few anchor banks approved by the government. Interlocking directorship is of as little importance as interlocking stock ownership. Two major types of interlocking directorate ties characterize the nature of such links: ownership ties, in which two or more organizations are jointly controlled by a single board of directors (BODs), and direct interlock ties, in which two companies share one or more persons as members of their respective boards (Burt, 1983, p. 3). The direct interlocking directorate tie is most common in Malaysia. Theoretically, such ties should help contribute to a reduction of competition and enhancement of monopolization of economic sectors. The large voting rights of these common directors allow for greater internal corporate control, leading to greater inter-company transactions which need not necessarily be beneficial to all the shareholders of a company, particularly to minority shareholders. A review of interlocking directorships among the top 100 companies listed on the KLSE suggests that there are no interlocking ties contributing to wealth concentration or reduction of competition. There is evidence of interlocking directorship involving the presence of one individual in a number of quoted companies. The men holding directorships in a number of unrelated companies are, however, primarily prominent former bureaucrats. These former senior bureaucrats probably serve as functional directors, that is, to facilitate dealings with the government, specifically to help these firms bypass bureaucratic red-tape. Although many of these influential ex-bureaucrats sit on the boards of Chinese, Bumiputera and government-owned firms, there is

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little evidence of business cooperation among these companies. This indicates the limited importance of these interlocking directorships in terms of facilitating inter-ethnic business deals or public-private cooperation, part of Mahathir’s much touted Malaysia Inc. policy. Similarly, even though some of these ex-bureaucrats are directors of firms owned by different Bumiputeras, there is limited evidence that they support intra-ethnic cooperation. The interlocking directorate tie of most importance is owner director. Owner directors hold directorships in a number of firms under the control of a holding company. This common tie can be used to facilitate intra-group transactions that tend to benefit owner directors over minority interests. The studies by Lim (1981), Tan (1982) and Sieh-Lee (1982) have revealed that the concepts of interlocking ownership and directorship were crucial in any analysis of ownership and control patterns of the corporate sector during the 1970s. By the year 2000, however, there was little evidence of much interlocking stock and directorship ties among a range of Malaysia’s leading publicly-listed companies. In effect, limited evidence of interlocking stock ownership and directorships indicates that firms had begun to evolve very independently with economic modernization and development of the corporate sector. The rise of large, diversified corporate groups has, however, come to characterize the pattern of growth adopted by some of Malaysia’s most prominent businessmen. A historical examination of Chinese enterprise since the colonial period has indicated that a diversified pattern of growth had been a popular business strategy. From the early 1980s, a similar pattern of growth was adopted by a number of Bumiputera businessmen. One significant difference in the conglomerate-style growth adopted by Chinese and Bumiputera businessmen was that a majority of the latter developed their diversified corporate base through acquisitions funded by bank loans. Other corporate groups, though diversified, tended to gain credibility through their primary focus on one or two industries. YTL Corp developed a reputation for itself first in construction and then in power production. Oriental and Tan Chong were focused primarily on the car assembly sector, while Public Bank was involved only in banking and financial services and Tan & Tan on construction and property development. Others, like plantation-based Kuala Lumpur–Kepong (KLK) group, were forced by circumstances to diversify – because of the decline of the plantation sector – but remained well-focused in their new ventures.15 Firms like these, that did not depend on bank loans to

Edmund T. Gomez 131

develop their corporate base, tended to cope better with the financial crisis that occurred in 1997. More importantly, most companies that appeared to rely on bank loans to finance their conglomerate style growth appeared to have strong political ties, and encountered problems revamping their corporate groups – even almost four years after the financial crisis. For example, in 2001, Tajudin Ramli sold back to the government the national airline, MAS, that had been privatized to him in 1993. The government also had to take over a light rail transit system project that was privatized to Halim Saad’s extremely diversified Renong group. The failure of the government’s policy to develop Bumiputera entrepreneurs was also due to the manner of implementation of this policy. The government selected these so-called “winners” in a nontransparent manner, and accorded them numerous concessions, particularly privatized projects, in an attempt to facilitate the rapid rise of major entrepreneurs. The non-transparent manner of award of most privatized concessions reflected the unaccountable form of public governance that emerged under Mahathir.16 Moreover, since there was no focus to the form of enterprise adopted by many well-connected Bumiputeras, and since political patronage also involved easy access to more government loans and privileges, there appeared to be little caution in the manner in which they developed their companies. This style of growth contributed to their rapid decline when the crisis occurred. Another key reason for the decline of most leading Bumiputera businessmen is that since most of them were closely linked to senior politicians, their corporate activities were often influenced by politicians and affected by political crises. In 1993, for example, Daim ensured that Renong, controlled by Halim Saad, divested ownership of the then highly profitable media companies, NSTP and TV3, to businessmen linked to Anwar. Anwar had at that time forged close ties with Daim to mount his bid for the post of Deputy President of UMNO. When Anwar and Daim fell from power, so too did businessmen that were linked to these politicians.17 Malay capitalists who have remained relatively independent appear to have fared better. Shamsuddin Kadir, for example, who owns Sapura Telecommunications and Uniphone Telecommunications, remained unaffected by the 1998 political crisis in UMNO. Another factor limiting the number of successful Bumiputera businessmen by 2000 is that many were involved in those sectors that have been most affected by the financial crisis. This point also highlights

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another crucial fact: none of the Bumiputera businessmen listed in the KLSE top 100 have shown a capacity to venture successfully into manufacturing; most of them have focused instead on finance, construction, property development and telecommunications. Shamsuddin Kadir’s telecommunications enterprises are probably the only Bumiputera firms actively involved in manufacturing, though none of his companies appear in the KLSE top 100. Although the debt crises faced by well-connected businessmen and the nationalization of privatized projects raised concerns about public and corporate governance in Malaysia, the government continues to play a dominant role in channeling important assets into the hands of a select minority in a non-transparent manner. This issue of executive hegemony over the state and its impact on public and corporate governance would become most evident during the government’s implementation of the consolidation of Malaysian banks.

6.5

Conclusion: paradoxes of governance

Although the manner of development of the corporate sector in Malaysia has been strongly influenced by Mahathir’s policies, and he alone has now achieved hegemony over the state, the study of the top 100 KLSE companies reveals some interesting paradoxes. The level of concentration of political power would suggest a concomitant concentration of corporate equity in the hands of an elite group. In mid-2001, however, there was evidence not of wealth concentration but rather of a rather wide dispersal of ownership of corporate equity of the top 100 quoted companies. The list compiled by Malaysian Business (2001, February 1) of the country’s 20 wealthiest business people also reflected this rather wide dispersal. In fact, the combined wealth of these 20 business people amounted to RM41.7 billion in 2001, then just 10% of the KLSE’s market capitalization (Malaysian Business, 2001, February 1). More importantly, it does not appear that any of these 20 wealthiest business people hold corporate equity in trust for influential politicians. This paradox, however, has emerged because of conflicts among Malaysia’s political elite. Between 1997, when the financial crisis occurred, and 2001, two influential politicians, Anwar and Daim, who had significant indirect control over important corporate enterprises were marginalized by Mahathir. The vast corporate assets owned by the business allies of these two leaders have been or are being re-allocated to government institutions or other private individuals. While it is still

Edmund T. Gomez 133

unclear whether Mahathir’s closest allies will come to secure ownership of these corporate assets, it is evident that the Prime Minister has the capacity to control how companies are developed. In spite of the executive’s dominance over the corporate sector, there is no evidence that Mahathir has corruptly benefited from the maneuvering of corporate assets,18 though his commitment to his – sometimes unviable – economic agenda and the need to respond to political crises have adversely affected the development of these enterprises. One serious outcome of Mahathir’s commitment to his economic visions has been the debt crisis in the private sector: the rights of shareholders appear seldom to be respected while company directors remain accountable only to the Prime Minister and not to the investors in the companies they lead. This is particularly true of companies controlled by politically well-connected businessmen. In other words, institutions and individuals who have ownership of key corporations seem to have little control over these enterprises. Control appears ultimately to be in the hands of political elites to whom these businessmen are closely linked. While the rise of politically-linked companies is indisputable, and there is conspicuous interference by politicians in the running of these firms, government leaders do not appear to interfere as much with the management of SOEs. A distinction, thus, needs to be made here between state-owned firms and companies owned by politically well-connected businessmen. Publicly-quoted SOEs, apart from banks, have not been as poorly managed as private, but politically well-connected firms. Most state-owned corporations do not carry the problems burdening politically-linked listed companies, in particular, a leveraged position that undermines future growth. Nor have they been as exposed to allegations of corruption and bailouts. Another paradox is that businessmen who have been privy to government concessions have also had to face competition; this is most evident in the power, telecommunications, financial and construction and property development sectors. This suggests that there has been some attempt by the government to get businessmen privy to state privileges to perform, but this does not appear to have encouraged independence or entrepreneurship. It is unclear, however, whether the promotion of large firms was intended to be an important avenue to create employment, promote research and development, enhance productivity, and encourage innovation, as none of these objectives appear to have been achieved. There is also little evidence of industrial concentration, though it is also obvious that very few businessmen

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who have benefited from state patronage have ventured into manufacturing, technology and heavy industrialization. In spite of the political-business nexus, institutions established to ensure proper governance of the corporate sector have the capacity to perform effectively and have, in fact, a good reputation in terms of regulating the equity and financial markets. However, in view of the hegemony of the executive over the state, the relevance and effectiveness of these institutions depends primarily on the government leaders. Simply put, regulatory institutions can – and usually do – act independently, but they are also used as a tool by powerful politicians for vested interests. These politicians can ensure that these regulatory institutions do not act against favored businessmen, in spite of evidence of corrupt practices, raising serious questions about transparency and accountability in government. This selective use of corporate regulatory powers is most obvious in the controversial bailouts of politically well-connected companies. An argument could be made that with the departure of Daim, the business sector no longer holds the view that this is a predatory state acting in its own interests. Moreover, with Mahathir’s stated desire to put an end to the promotion of politically-linked companies, the domestic press has argued that corporate governance in Malaysia will improve appreciably. But structural reforms to promote transparency and accountability in government are not being implemented. The concentration of power in the executive and the lack of regulatory institution autonomy to act in the interests of shareholders do not serve to inspire confidence that genuine reforms are imminent in Malaysia.

Notes 1. In the Bank Rakyat scandal, Harun Idris, then chairman of this government-controlled bank, who was then also chief minister of the state of Selangor, abused his position to involve the bank in some fraudulent deals. Harun served a jail sentence for the offence. 2. The Bank Bumiputra/BMF scandal involved the channeling of loans approved by this state-owned bank to its Hong Kong-based subsidiary, BMF, to government leaders for vested interests. For a detailed analysis of this scandal, see Hassan (1989). 3. The Pan-El/Multi-Purpose Holdings scandal involved abuse of authority by Tan Koon Swan, the then president of a leading party in the ruling coalition. Tan, who had control of Multi-Purpose Holdings, abused his position in the firm to channel funds to the ailing Singapore-based firm Pan-El. Tan served jail sentences in Malaysia and Singapore for his involvement in this scandal. See Gomez (1994, pp. 175–239) for details on this scandal.

Edmund T. Gomez 135 4. In March 1998, the Ministry of Finance (MOF) established the Finance Committee of Corporate Governance, which eventually proposed the Malaysian Code of Corporate Governance in February 1999. The new Code has two primary objectives. The first, to encourage disclosure to ensure that investors are aware of the way their company is being managed. The second objective of the Code is to inform company directors of their responsibilities. The four principles of corporate governance set out in the Malaysian Code refer to effective leadership by directors of companies, the transparent manner of determining the remuneration of directors, the accountability of directors by ensuring adequate internal controls and an independent external audit and the promotion of dialogue between the company’s management and its investors (Low, 2000, pp. 436–51). 5. Literally translated, ‘Bumiputera’ means ‘sons of the soil’, an epithet used to refer to the Malays, although it includes the indigenous people of Sabah and Sarawak. 6. Between 1995 and 1997, before the financial crisis occurred, an appreciable increase in the number of companies listed on the KLSE was recorded, from 529 to 708. By the year 2000, the number of companies quoted on the KLSE amounted to 757 (Low, 2000, pp. 44–45). 7. For an extensive critique of the implementation of privatization, see Jomo (1995). 8. Some information is provided in Table 6.2, of Chinese businessmen in control of unlisted companies that have emerged as major firms in Malaysia. For a more in-depth discussion on this matter, see Malaysian Business (2001, February 1). 9. For an in-depth study of the rise of these politically well-connected Bumiputera and non-Bumiputera businessmen, see Gomez and Jomo (1999) and Gomez (2002). 10. Most key business deals involving privatization did not evolve through any public-private collaboration involving transparent discussion. Almost all major privatized projects were awarded based on private discussions between the Prime Minister and his closest allies and a select number of businessmen, many of whom are now in trouble. The beneficiaries of privatized projects also included Chinese businessmen. The most prominent privatizations, including the Bakun Dam, monorail and sewerage projects and the sale of MAS and the Heavy Industries Corporation of Malaysia (HICOM), have been dismal failures. In all these cases, there was no transparency in the manner of their privatization. 11. Following a political struggle in 1987, when he narrowly managed to retain power, Mahathir moved to concentrate power in the office of the Prime Minister and UMNO president. This concentration of political power reduced significantly the bureaucracy’s influence in policy planning and implementation. 12. Between the early 1970s and late 1980, UMNO had managed to acquire a huge interest in the corporate sector. The prominent role of UMNO firms in the corporate sector led to allegations of conflict-of-interest and corruption when the party’s companies secured major government contracts. During the late 1980s, a faction within UMNO split to form a new party and began to make claims on UMNO’s corporate investments. In 1990, because of

136 The Governance of East Asian Corporations

13. 14.

15.

16.

17. 18.

such problems, Mahathir permitted the transfer of UMNO-owned companies to private individuals, all of whom were closely aligned to Daim. More details on the takeover of assets controlled by Anwar’s allies and Daim’s protégés are provided later in this chapter. Members of the Chinese sub-ethnic Hokkien community in Malaysia and Singapore, for example, were responsible for merging their enterprises or resources to establish some major banks, including the Oversea-Chinese Banking Corporation (OCBC) in Singapore and Malayan Banking in Malaysia. See Gomez (1999) for case studies on the YTL Corp, KLK and Oriental groups, which profile the growth of these enterprises from the time of their incorporation. These case studies indicate that these companies standing as leading Malaysian firms are due to their predominantly vertical or horizontal pattern of growth in the main area of their business. See Gomez and Jomo (1999, pp. 75–116) for an in-depth review of the impact of political patronage on the implementation of privatization and its implications for the economy. Evidence for this argument is provided in the case study below on the banking sector. There is, however, some evidence of nepotism. Mahathir’s son, Mokhzani, was awarded a 15-year privatized concession to provide cleaning, laundry and engineering maintenance services to government hospitals in southern districts of Peninsular Malaysia (New Straits Times, 2000, February 14).

References Asian Wall Street Journal (2001). July 26. Blair, M. M. 1995. Ownership and Control: Rethinking Corporate Governance for the Twenty-First Century, Washington, D. C.: The Brookings Institution. Burt, R. S. (1983). Corporate Profits and Cooptation: Networks of Market Restraints and Directorate Ties in the American Economy, New York: Academic Press, Inc. Gomez, E. T. (1994). Political Business: Corporate Involvement of Malaysian Political Parties, Cairns: James Cook University Press. Gomez, E. T. (1999). Chinese Business in Malaysia: Accumulation, Accommodation and Ascendance, Honolulu: University of Hawaii Press. Gomez, E. T. (2001). Why Mahathir axed Daim. Far Eastern Economic Review (5 July). Gomez, E. T. (2002). Political business in Malaysia: Party factionalism, corporate development and economic crisis, in Edmund Terence Gomez (ed.) Political Business in East Asia, London: Routledge. Gomez, E. T. and K. S. Jomo (1999). Malaysia’s Political Economy: Politics, Patronage and Profits, Cambridge: Cambridge University Press (revised edition). Hassan, A. K. (1989). ‘BMF – The people’s black paper, in Jomo K. S. (ed.) Mahathir’s Economic Policies, Kuala Lumpur: INSAN. Jomo, K. S. (ed.) (1995). Privatizing Malaysia: Rents, Rhetoric, Realities, Boulder: Westview Press. Lim, M. H. (1981). Ownership and Control of the One Hundred Largest Corporations in Malaysia, Kuala Lumpur: Oxford University Press. Low, C. K. (ed.) (2000). Financial Markets in Malaysia, Kuala Lumpur: Malaysian Law Journal Sdn Bhd.

Edmund T. Gomez 137 Malaysia (1996). Seventh Malaysia Plan, 1996–2000, Kuala Lumpur: Government Printers. Malaysian Business (2001). February 1. New Straits Times (2000). February 14. Puthucheary, J. J. (1960). Ownership and Control in the Malayan Economy, Singapore: Eastern Universities Press. Sieh-Lee, M. L. (1982). Ownership and Control of Malaysian Manufacturing Corporations, Kuala Lumpur: UMCB Publications. Tan, T. W. (1982). Income Distribution and Determination in West Malaysia, Kuala Lumpur: Oxford University Press. The Star (1992). May 19.

7 Corporate Governance in the Philippines: Legal and Institutional Aspects and Impact on the 1997 Financial Crisis and its Aftermath Stephen G. Lynn

7.1

Introduction

The Philippines is a group of islands roughly 300,000 square km in area. It was a Spanish colony until 1898 at which time it was ceded to the United States of America following the Spanish-American War. Independence from the U.S. was achieved in 1946. Ferdinand Marcos ruled the Philippines as a dictator for almost the two decades from 1972 to 1986. In 1986, the current democratic system of government was installed by a popular rebellion following an economic crisis. Under Marcos, “crony capitalism” dominated the Philippine economy, leading to serious undermining of the effectiveness of the courts and other governance structures (Root 1997, chapter 8). This may have exacerbated the impact on the Philippines of the Asian Financial Crisis (AFC) in 1997. The AFC in late 1997 hit the Philippines hard – foreign capital fled the country in large amounts, and interest rates shot up, leading to dramatic declines in company profitability in subsequent years. As in other countries in the region, the crisis exposed structural weaknesses in the Philippine corporate sector. Specifically, these are overconcentrated ownership of companies, and over-reliance on debt capital. Another problem that should be mentioned is weak accounting and auditing systems. These broad features of the Philippine corporate scene have not changed, but a number of measures have been put in place to improve corporate governance and disclosure. As Montes (1988) points out, the 1997 crisis in the Philippines and other Asian countries followed a pattern that had been observed in other regions before. Economic liberalization led to an inflow of foreign capital 138

Stephen G. Lynn 139

into the banking system. This in turn triggered a domestic lending boom with lenders taking advantage of the spread between foreign and domestic interest rates. The lending boom in turn led to an increased volume of unprofitable speculative investments and a mounting proportion of nonperforming loans, and the collapse occurred when a crisis of confidence caused foreign capital, most of it short-term, to take flight. Measures to reform the Philippine banking sector began in the early eighties and have shown steady progress. Regulations were introduced to prevent loans to “Directors, Officers, Shareholders and Related Interests” of the borrowing party or DOSRI. Starting in 1983, the banking sector was liberalized. Foreign banks were allowed into the country (though relatively few took advantage of this), and the Philippine National Bank was privatized. Reserve requirements were reduced. The liberalization had limited effects. Competition between banks did not increase and interest rates remained high. This was because major private banks had a close cartel-like relationship (Montes, 1988). At the same time, restrictions on interest rates were also removed in 1983 and the regulation of capital flows both domestic and foreign was liberalized. Exchange controls and restrictions on foreign investment were removed. At the same time as the 1997 economic crisis, the Philippines were undergoing a parallel political crisis. Supporters of President Fidel Ramos were pressing for a constitutional amendment to permit him a second term in office. One effect of the crisis was to bring an end to this proposal, with the President announcing that he would not seek a second term. The political uncertainty may have been another factor behind foreign capital taking flight, with memories of the Marcos era still fresh. This chapter provides an overview of corporate governance in the Philippines. The next section discusses firm-level mechanisms, specifically ownership and the role of directors. The section after that discusses the legal and regulatory environment. Section 7.4 uses the World Bank’s review of corporate governance in the country (World Bank, 2001a, 2001b) to identify key problems faced by the Philippines in its drive to improve corporate governance. The final section provides an overall assessment and summary.

7.2 Governance mechanisms available 7.2.1

Ownership pattern

Companies in the Philippines tend to have concentrated ownership, with most shares being held by controlling shareholders and only a

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small percentage being traded. In 1997,1 the top shareholder held on average 40.8% of the shares for non-financial firms, and 27.2% for financial firms. The top five shareholders held on average 59.2% for financial firms and 65.3% for non-financial firms. The top 20 shareholders held on average 76.2% for financial firms and 75.9% for non-financial firms. In terms of control over corporations, the top shareholder held more than 50% of shares in 30% of all listed corporations, and more than 66% (a two-third majority) of shares in 14% of all listed corporations. The corresponding figures for the top five shareholders were 74% and 51% respectively, and for the top 20 shareholders 78% and 72%. One effect of the concentrated ownership is that trading on the stock exchange is not liquid. As a consequence, the capital market is underdeveloped in terms of information flows, and even major firms do not have a significant analyst following. In fact, many of the largest Philippine corporations are not listed at all. A principal feature of the ownership pattern in the Philippines is family ownership. This makes it similar to almost all the other countries surveyed in this book, with the exceptions of Japan, Singapore and China (although the state accounts for the role in the latter two). Some of the most important business families are the Cojuangco’s, Lopez’s and Ayala’s. Many family-owned businesses operate through holding companies which may be unlisted, with a listed subsidiary. This pattern creates a risk of a pyramidal ownership structure, with a controlling family’s control rights of a group being greater than their cash flow rights, e.g., Saldaña (2001, fn. 11 and 12) uses the example of the Ayala group’s relationship with the Bank of Philippine Islands (BPI) savings bank (ratio of control rights to cash flow rights is 1.7 times) and the Lopez group’s relationship with Manila Electric Rail (Road) and Light Company (now Manila Electric Company, Pasig City, Metro Manila, Philippines) (MERALCO) (ratio of control rights to cash flow rights is 5.7 times). As noted above, financial firms are not major shareholders of nonfinancial corporations in the Philippines. However, banks tend to be affiliated with corporate groups. Saldaña (2001, pp. 179ff.) points out that a substantial portion of group profits comes from financial affiliates for four selected examples of family conglomerates – Ayala, Gokongwei, Lopez and Henry Sy. Except in the case of Henry Sy, the groups did not own a majority of shares in the banks concerned. They were able to exercise control owing to the dispersed nature of the remaining shareholding.

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Financial firms are also apparently not very effective as agents of debt monitoring. Results of an Asian Development Bank (ADB) survey reported in Saldaña (2001, p. 198) show that 85% of borrowers opined that creditors had no or very little influence on management. However, the banking sector dominates the supply of capital. Over 75% of the Philippines’ capital is supplied by banks, and debt financing strongly dominates equity financing throughout the economy.

7.2.2

Board of directors and principal officers

The ADB conducted a survey of 44 Philippines-based companies in early 1999 to elicit information on their corporate governance practices. The results, reported in Saldaña (2001) are briefly discussed here. When asked about the main criterion for appointing a director, 31.9% of respondents stated that it was relationship with major shareholders, 28.7% mentioned the size of the appointee’s shareholdings, and another 28.7% mentioned professional expertise. Thus, major shareholders appear to dominate the board selection procedure. Surprisingly however, the survey showed that the average ownership by a chairperson was less than 5%, with the maximum being 36%. This can be explained as the ownership figures representing only the direct ownership, while in practice major shareholders exercise their control through holding companies owned by family members. When asked to rank the most important functions of the board, the respondents indicated that strategic decision-making was the most important function, outranking protecting shareholders’ interests. Thus, many respondents may view the Board more as an über-management team to advise on broad company policy rather than as a way to protect shareholders from agency costs. Although chairpersons and board members typically faced reelection every year (consistent with the provisions of the Corporation Code), the average term of office in the ADB survey was 6.6 years for board chairpersons and 7.5 years for directors. For the average firm therefore, board entrenchment may not be a serious problem, although one respondent reported tenure of 27 years for the Chairperson. When questioned about director compensation, 52% of respondents reported that directors were paid only a fixed fee, 30% reported a fixed fee plus performance-based bonuses, 18% reported a fixed fee plus a per diem for meetings. This contrasts with the Corporation Code provisions that suggest only per-diem compensation as a benchmark. The

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chairperson’s compensation was decided by the Board in 54% of cases, by-laws in 21%, and by management in 15%. The ADB survey showed a bleak situation in terms of board committees. Only 35% of respondents had any board committees, and most of these had been set up very recently. As Saldaña (2001, p. 188) remarks, “…large shareholder-dominated companies often view such committees as unnecessary formalities.” The ADB survey showed that the most common active committees were audit and nomination committees. Chief executive officers (CEOs) were identical with the Board chairperson (CEO dominance) for 41% of respondents. For companies without CEO dominance, in every case but one, the CEO had no family relationship to the Chairperson. Respondents cited the following criteria for selecting a CEO who is not also Board Chairperson – expertise (42%), relationship with controlling shareholders (35%) or amount of shares held (15%). A majority of respondents reported CEO compensation to be based on a fixed salary plus a performance-related bonus. Share options are not important, with controlling shareholders exercising leverage over top management more through tenure and compensation (Saldaña, 2001). The average CEO tenure was 5.2 years. The survey results indicate that large separation packages are uncommon. Other interesting statistics from the ADB survey (Saldaña, 2001, p. 191) are: 36.8% of respondents do not allow loans to directors, 43.2% require mandatory independent board committees, and 69.4% impose penalties for insider deals. The Institute of Corporate Directors was set up with broad corporate support to help Philippine corporations meet The Organization for Economic Cooperation and Development (OECD) principles of good corporate governance relating to Boards of directors (BODs). The Institute seeks to provide training programs for directors to strengthen their role in corporate governance.

7.3 Legal and regulatory influence Important statements of corporate law are the Corporation Code, the Presidential Decree (PD 902-A) reorganizing the Securities Exchange Commission (henceforth SEC), the Securities Regulation Code (SRC), the insolvency law, and the general banking law. In addition to these, mention should be made of the Philippine Stock Exchange (PSE) listing rules. Many aspects of corporate law in the Philippines, e.g., the Revised Securities Act, reflect the influence of laws in the U.S.

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7.3.1

The Corporation Code

The Corporation Code (1980) provides a framework for the constitution of a Philippine corporation, governing its formation and dissolution, and broad aspects of its functioning. The Code requires companies to issue articles of incorporation, which must contain information on the number of directors on the initial BODs, with details of authorized capital stock; and details of original subscribers, similarly with amount subscribed and nationality. The Corporation Code also prescribes limits on the number of directors, which should be at least five and at most 15. The articles of incorporation can only be subsequently amended with the approval of an absolute majority of the directors followed by a two-third majority of the outstanding shares. In addition to the articles of incorporation, companies are required to adopt a set of by-laws within one month of incorporation. The SEC must certify that by-laws are consistent with the Corporation Code. The by-laws may include for example: the time, place and rules of procedure for meetings of the directors, the rules of procedure for shareholder meetings, procedures for proxy voting, qualifications of directors and officers, rules governing the election of directors, rules governing the appointment of officers, penalties for by-law violations and rules for issuing share certificates, among other matters. By-laws may be amended by an absolute majority of the BODs with the concurrence of an absolute majority of the outstanding shares. However, the outstanding shares may by a 2/3-majority vote, delegate the power to amend by-laws to the directors, while retaining the right to revoke this power at any time by an absolute majority of shares. The Code provides that all directors must be shareholders of the company. This provision to some extent restricts competent independent outsiders from being awarded directorships, and makes the board particularly vulnerable to control by holders of a majority bloc of shares. The directors are elected by a majority of shares and hold office for a period of one year. However, they can be removed from office by a 2/3majority of outstanding shares. With this provision and those mentioned earlier, there are two levels of control – absolute majority of shares and 2/3-majority. Thus, if a party controls more than 50%, but less than 2/3 of the voting shares, that party does not exercise full control of a company. The Code therefore arguably provides some protection to minority shareholders.

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Restrictions are placed on the compensation of directors. The total compensation to the directors in a year should not exceed 10% of the previous year’s reported net profits (though this restriction does not include compensation received by the President or other ex-officio directors except insofar as it directly relates to their board-related work). The Code suggests only per-diem compensation for directors as a benchmark practice. This provision may improve the independence of directors, but may also lead to a lack of interest in the job on their part due to insufficient compensation. The Code stipulates that a corporation should have a president who should be a member of the BODs, and also requires that corporations should have a company secretary and treasurer, who need not be directors. The company secretary must possess both Philippine citizenship and residency. Directors can be held personally liable for unlawful acts of the company or acts of negligence or misappropriation on their part. The directors can be held jointly and severally liable for all damages. Their responsibility under the Code extends not just to the corporation itself, but also to its individual shareholders and even other affected persons. In fact, the Code stipulates that a director should refrain from personally pursuing a business opportunity that the corporation itself could have pursued, and holds him liable to refund all the resulting profits, unless his action is ratified by a 2/3-majority of shares. Therefore, the directors’ duty of care has a broad scope. This perhaps reflects the influence of comparable U.S. regulation. The Code has restrictions on transactions between the company and insiders. It stipulates that contracts between a director or an officer and the corporation can be legally declared void unless a number of conditions are met – the board meeting that approved the contract had a quorum even excluding the concerned director, the director concerned did not cast a deciding vote for approval of the contract, the contract is “fair and reasonable”, and in the case of an officer, the contract must be first authorized by the board. However, if one or more of the first two conditions is absent, the shareholders may still ratify the contract by a 2/3-majority of outstanding shares, provided that full disclosure of the contract terms is made to them. These provisions also apply to contracts between the corporation and another corporation in which one of the directors has a substantial interest, where substantial is defined as at least 20% of outstanding shares, provided that the director’s interest in the former corporation is nominal. While the Code does recognize the phenomenon of inter-

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locking directorships, it does not consider it sufficient grounds to void a contract. The Code provides that a board may create an executive committee that includes at least three of its members, and delegate many of its routine executive functions to the committee. However, some actions, such as changes in the by-laws and payment of cash dividends, always require the approval of the full board. The preceding discussion shows that under the Philippine Code, many major corporate decisions require ratification by holders of at least 2/3 of the outstanding share capital. Thus ownership of a simple majority of shares is not sufficient to provide complete control of a corporation. To some extent, this feature of the Code empowers the minority shareholders. Additional protection to the minority shareholders comes from the stern provisions regarding directors’ responsibilities and liability in Sections 31, 32 and 34. To some extent this counteracts the fact that corporations may not have truly independent directors, owing to the stipulation that all directors must also be shareholders.2

7.3.2 SEC Reorganization Act (PD 902-A) and the Securities Regulation Code (SRC) The SEC is a government agency directly under the office of the President.3 It can be considered to be the main executive agency responsible for enforcing the Corporation Code. The Securities Act or Commonwealth Act No. 83 established the SEC in 1936, the primary motivation being to regulate speculative activity in the stock market at that time. It was later temporarily abolished during the Japanese occupation of the Philippines, but re-established after World War II in 1947. In 1976, the dictator Marcos issued Presidential Decree 902-A, establishing the SEC as a college of three commissioners with sweeping quasi-judicial powers over corporations. In 1981, the SEC was expanded to include two additional commissioners and two departments, one for prosecution and enforcement and one for supervision and monitoring. In 2000, the Securities Regulation Code (Republic Act 8799, henceforth abbreviated to the SRC) was issued reorganizing the SEC. Under the SRC, the SEC has the following powers and functions among others: • jurisdiction and supervision over all corporations licensed by the government;

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• advises the Philippines Congress on issues concerning any aspect of the securities markets and proposes draft legislations relating to this area; • supervision of the stock exchanges; • punishing violators of securities laws; • preparation of securities rules and guidance on their application; • power to force managers of any corporation under its jurisdictions to call shareholder meetings; • suspension or revocation of the registration of corporations, provided that sufficient legal grounds exist for such action (PD 902-A s.6(i) lists as some valid grounds: fraud, misrepresentation and five years of no operations). It can be seen that under the law, the SEC is a powerful branch of the government armed with considerable legislative, executive and judicial authority. In addition to these functions, PD 902-A had earlier conferred sweeping powers on the SEC to adjudge cases involving fraud and misrepresentation by directors, officers or business associates of corporations, controversies between shareholders, or between them and the corporation, or between the corporation and the government, and controversies in the election of directors or the appointment of officers. However, in 2000, the SRC transferred this authority to the general courts. Specific provisions of the SRC are interesting in our context. These include provisions relating to required corporate disclosures and those relating to shareholder protection, particularly the regulation of insider trading. A brief discussion of these provisions ensues. Listed companies are required under the SRC to furnish an annual report to the SEC within 135 days of the fiscal year-end, which must contain at least a balance sheet, profit and loss account, statement of cash-flows and management discussion and analysis. In addition, the SEC is authorized to prescribe any additional reporting requirements that it may see fit. The Rules for Implementation of the SRC currently include the following requirements: an annual report (Form 17-A) to be furnished within 105 days of the fiscal year-end; a quarterly report (Form 17-Q) to be furnished within 45 days of each quarter for the first three quarters; a special report (Form 17-C) to disclose price-sensitive information. In addition, companies are required to provide an information sheet to the SEC and all shareholders 15 days prior to a shareholder meeting. The statute requires acquirers of 5% or more of

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the ownership of the company to disclose their acquisitions to the SEC within five days. Of interest is the General Information Sheet that all companies are required to file at most 30 days after the annual shareholders’ meeting. A blank sample of this statement is currently available from the SEC website at http://www.sec.gov.ph. The statement requires companies to disclose, among other things, details of the top 20 shareholders. SRC Section 20 provides for proxy statements (Form 20). Rule 20 provides details of the information required in proxy statements. This includes: financial statements, disagreements with auditors if any, management discussion and analysis and details of directors and principal officers, including principal occupation and the principal employer of each individual. The level of disclosure in a proxy statement is therefore similar to that in the U.S. The SRC requires directors, officers and principal shareholders (beneficial owners of at least 10% of stock) of a listed corporation to make monthly disclosures of their positions (beneficial ownership) in that company to the SEC and the Exchange using a Form 23-B. Beneficial ownership by an individual is defined as including shares or voting rights held by any family member living in the same house, shares held indirectly through a partnership or a corporation over which she has significant control, or shares held by a third party where a contract exists giving her voting or selling rights. Beneficial ownership is not disclosed to the general public or to the other shareholders. The latter however are entitled to a report of nominal ownership (as opposed to beneficial) as discussed below. The rules require company transfer agents to file an annual report on SEC Form 36-AR within 105 days after the end of the company’s fiscal year. The report contains a complete list of shareholders. In addition the rule requires periodic reports of ownership to be provided to the SEC and the exchange (according to the Report on the Observance of Standards and Codes (ROSC) [World Bank, 2001a, p. 8], quarterly to the PSE and monthly to the SEC). The ROSC (World Bank, 2001a, p. 8) reports that all shareholders can request information about company ownership, but this is not beneficial ownership as defined in the rules, only nominal ownership. The code regulates transactions of directors, officers and principal stockholders (beneficial owners of more than 10% of equity). These parties must file statements of their beneficial ownership every month as discussed earlier. Further the company may sue to recover any profits that an insider (director, officer or principal stockholder) may

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make due to trades that can be proved in court to be based on unfair use of insider information. Moreover any individual shareholder may file a derivative suit on behalf of the company if the company itself fails to sue within 60 days of a request, or does not diligently pursue the lawsuit. The timeframe during which such lawsuits may be brought is at least six months but not more than two years after the alleged insider trading occurred. Regulations on insider trading extend to relatives and friends of insiders. The code explicitly prohibits trades by any holders of material inside information or their relatives, unless the private information is disclosed to the other party in the transaction, with the code providing for civil and criminal penalties for violators. However, these strict regulations may not be implemented effectively. The ROSC (World Bank 2001a, p. 9) reports zero prosecutions for insider trading in the preceding five years. The SRC prohibits a number of unfair trading practices that can result in the manipulation of security prices, e.g., trades that do not result in a change in beneficial ownership, price fixing, and circulating misleading price-sensitive rumors. Thus the SRC supports the Corporation Code in providing extensive provisions for shareholder protection. Its provisions are comparable to U.S. regulation in this area. However, implementation may be weak.

7.3.3

Insolvency Law4

The two principal laws available to a company seeking debt relief include the Insolvency Law (Act No. 1956) and PD 902-A as amended by PD 1758 in 1981. The Insolvency Law provides for bankruptcy proceedings in the regular courts. Owing to a spate of bankruptcies around 1979, the SEC was also given jurisdiction over some bankruptcy proceedings, and was given powers to set up a rehabilitation procedure for corporations, specifically to evaluate the feasibility of a restructuring, and if feasible, to appoint a rehabilitation receiver or a management committee to oversee the reorganization. The proceedings where the SEC has authority are those where the company seeks some rehabilitation or interim relief, while standard petitions for liquidation are still handled by the regular courts and covered by Act No. 1956. In practice, Regala and Regala (2001) report that in recent years almost all filings for debt relief by corporations are with the SEC and not with the regular courts. They opine that this may be because: the suspension of creditor claims that occurs with an SEC filing, the less strict rules of procedure that the SEC follows, and that the SEC is perceived as being

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more debtor friendly, since it primarily represents shareholders rather than creditors. Companies file their debt relief petitions with the SEC either if their assets are insufficient to meet their liabilities or if they have sufficient assets, but these assets are not sufficiently liquid or they foresee a looming cash crunch. The petitions are filed together with a request for appointment of a management committee or rehabilitation receiver. Upon appointment of a receiver or management committee, all claims filed by creditors are suspended. If the SEC finds that the corporation cannot be rehabilitated, it can order its liquidation and the distribution of its assets among the creditors. The SEC is reported to have faced numerous criticisms for its handling of debt relief cases, including charges of corruption and inefficiency (Regala and Regala, 2001).

7.3.4

General banking law

The general banking law does not prohibit or restrict shareholdings by banks in other enterprises. Unlike, say, Thailand and Japan, bank ownership is not a major feature of the Philippines business environment. In 1997, the average financial institution holding in non-financial enterprises was only 7.2%, and the figure is inflated because it includes shares held by institutions for their depositors (Saldaña, 2001, p. 177). However, the law does set restrictions on ownership by non-financial corporations (who are potential debtors) in banks. A group is restricted to a 30% holding in a bank, and if the group is family-controlled, this ceiling is lowered to 20%. In spite of this, Saldaña (2001) reports that banks in practice have close relationships with non-financial firms. The general banking law also sets a limit on the maximum amount that a bank can lend to a particular group. The Central Bank (Bangko Sentral ng Pilipinas or BSP) places some restrictions on loans by banks to their DOSRI. Directors or officers can borrow or guarantee others’ borrowings only with the permission of other directors (but this excludes loans given to officers as standard perquisites of their employment). There is also a limit on the amount that a shareholder can borrow.

7.3.5

Response to the Asian Financial Crisis (AFC)

The AFC in late 1997 had the following effects on the Philippines (Saldaña, 2001, pp. 212 ff.): Net foreign investment declined by 78% in 1997; foreign capital amounting to US$406 million left the Philippines; average company performance deteriorated in 1997 – profit margins

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fell to 4.9%, a 10-year low; Return on Equity (ROE) was barely higher than inflation, and leverage increased from 109% to 149%; interest rates on corporate loans dramatically increased, curbing companies’ investment in the following year. The banking sector itself did not suffer extensively, owing to a healthy capital position. Some small banks closed, representing less than 1% of the resources in the financial system. The government responded to the crisis mainly through the Central Bank. The principal effect of the crisis was the rise in interest rates. Through Central Bank intervention, this was brought under control by 1998. The economy staged a modest recovery in 1999. A number of corporations responded by restructuring (Saldaña, 2001). Philippines Airlines Inc. was privatized, with the Lucio Tan group gaining control. The telecommunications company Philippine Long Distance Telephone Company (PLDT) was taken over by a foreign investor, First Pacific. Another company, San Miguel Corporation restructured by divesting subsidiaries and re-focusing on its core brewery business.

7.4 Country-specific obstacles and difficulties This Section is based on the assessment matrix in the Report on Standards Compliance (ROSC: World Bank, 2001a, pp. 24ff.), which discusses areas where Philippines corporate governance falls short of the OECD Principles of corporate governance. Currently, shareholders do not have access to information on a level that is consistent with the OECD guidelines. A main problem is that the identity of major shareholders and the size of their holdings is not clearly disclosed, because what is disclosed is only nominal and not ultimate ownership. Another problem is that minority shareholders do not have the right to convene an irregular general meeting, or to table items on the agenda of a scheduled meeting. There is also no protection for minority shareholders against anti-takeover provisions in by-laws. Such provisions in fact may not be necessary, since most companies are closely held, but the ROSC suggests (p. 27) under this point that laws could be implemented to prevent majority shareholders from voting on issues where they have a conflict of interest, on the pattern of recent reforms in Malaysia. A major problem is poor disclosure of material information. The ROSC complains (p. 28) for example that related party transactions

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are often not properly disclosed, owing to the existence of pyramid structures leading to complex relationships between entities. Another lacuna that the ROSC comments on is that boards or management are not required to provide a discussion and analysis of risk or other material issues on the pattern of the director’s report in Hong Kong or Management Discussion and Analysis (MD&A) in the U.S. A further major problem may be weak accounting standards and auditing. This is addressed in more detail in World Bank (2001b), the parallel ROSC on accounting and auditing. Apart from a weak quality of auditing, and gaps in standards when benchmarked against applicable International Accounting Standards (IAS), this review found that compliance with standards was poor, and disclosure levels were low. This problem is discussed in more detail below. In terms of BOD functioning, the review noted the following lacunae. Firstly, there is no requirement in the Philippines that audit or remuneration committees should be composed of independent directors (as directors must hold shares). Secondly, there is no disclosure requirement regarding directors’ participation in board meetings. The ROSC comments on the regulation of institutional investors with voting privileges. Best practice requires that representatives of institutional investors should treat their voting rights as a privilege to be exercised on behalf of their clients. However, there is currently no provision in the Philippines to enforce this. In addition to these points, Saldaña (2001) mentions: firstly, the Philippine capital markets are illiquid. As a consequence, retail investor interest is low, and financial analyst’s following of Philippine firms is not very extensive. Secondly, and as mentioned by both ROSCs, financial statement quality is poor, with even large widely held firms often providing statements of poor earnings quality and inadequately audited. Thirdly, the biggest obstacles in corporate governance, from a minority shareholder perspective, are the closely held nature of most firms, the family ownership pattern, and the dominance of BODs by the controlling shareholders.

7.4.1

Accounting and auditing in the Philippines

The Board of Accountancy (BOA), the overseer of accounting regulation in the Philippines, comprises a chairman and six members appointed by the President of the Philippines. The President acts on recommendations from the Professional Regulatory Commission (PRC), the body that supervises the BOA. These recommendations in

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turn are based on nominations from the professional accounting association, the Philippines Institute of Certified Public Accountants (PICPA). The BOA members are required to be Certified Public Accountants (CPAs), and perform their Board functions as a parttime job. The ROSC points out that this manpower constraint, among other factors, leads to weak governance in the accounting profession. In the words of the ROSC, “There have been no known cases of penalties imposed on auditors for failure to comply fully with the established requirements on accounting and auditing.” The SEC has the statutory authority to prescribe accounting standards. In practice though, the Accounting Standards Council (ASC) and Auditing Standards and Practices Council (ASPC) respectively set accounting and auditing standards. According to the ROSC, “In order to meet recommendations of the International Organization of Securities Commissions (IOSCO), the SEC, following discussion with BOA, has decided in principle to mandate the use of IASs by listed companies.” Since there are currently several areas of divergence between Philippine and international standards, there is an official attempt to move to IAS as the basis of Generally Accepted Accounting Principles (GAAP), though this is still in its early stages. All corporations, listed or not, with paid-up capital of at least P50,000 are required to have their annual financial statements audited by a CPA, and to file these statements with the SEC. The ROSC points out that compliance with this requirement may be poor, since “the SEC is unable to review more than a small proportion of the submitted financial statements.” Other reporting requirements: audited financial statements are required along with the tax return for enterprises with quarterly earnings of more than P150,000, and banks are required by the Central Bank to publish their financial statements without footnotes in newspapers. Auditing of large corporations in the Philippines is dominated by the Big-5. The ROSC quotes a local study in Business World stating that in 1999, the dominant Big-5 firms audited 48% of the top 1000 corporations in the Philippines, the remaining big-5 firms audited 23% while local firms picked up 26%. The ROSC points to this nearmonopoly in the audit industry as a potential source of poor audit quality. Problems with the educational requirements for a CPA qualification are also pointed out by the ROSC: there is no practical training requirement to get a CPA.

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7.5 Overall assessment The corporate governance picture in the Philippines is characterized by closely held family-owned businesses. Often these operate through a private or public holding company. This scenario has both advantages and disadvantages. The moral hazard problem that is a principal focus of agency theorists is substantially mitigated by the identity of interest between top management and controlling shareholders. However, other problems are exacerbated – e.g., the potential for insider trading or risky investments at the disproportionate expense of minority shareholders. Debt monitoring is not very effective as a governance mechanism in the Philippines because banks tend to have ties with important non-financial business groups. Another major problem is the weak accounting system – standards, compliance and audit quality are all in need of substantial improvement (World Bank, 2001b). This contributes to poor disclosure. However, it may be noted that the Philippines was in many ways more successful than other economies in the region in responding to the 1997 AFC (Saldaña, 2001). Subsequently, a number of key initiatives have been put in place to improve corporate governance, including the SEC’s Code of Corporate Governance, and the establishment of the Directors’ Training Institute to improve the quality and the functioning of directors.

Notes 1. Statistics in this Section based on tables in Saldaña, 2001. 2. However, it should be noted that the SRC (2000) requires (Section 38) that listed companies above a certain size must have a certain number of independent directors, where independence is defined as not being an executive of the company or possessing any other material business relationship with it. Independence under this statute is therefore defined as independence from management, not necessarily independence from controlling interests. 3. In 1981, responsibility for supervising the SEC was transferred to the Ministry of Finance (MOF), but in 1998, it was returned to the President’s Office. 4. The discussion in this Section draws extensively on Regala and Regala (2001) Section I.

References Montes, M. F. (1988). The Business sector and development policy, in Aiichiro Ishii et al. National Development Policies and the Business Sector in the Philippines. Tokyo: Institute of Developing Economics.

154 The Governance of East Asian Corporations Regala, T. and A. Regala (2001). Asian Development Bank Regional Technical Assistant Project No. 5795-REG – Insolvency Law Reforms: Report on Philippines, Manila: Asian Development Bank. Root, H. (1997). Small Countries, Big Lessons: Governance and the Rise of East Asia. Oxford: Oxford University Press. Saldaña, C. G. (2001). The Philippines, Chapter 3 in Capulong, M., Edwards, D. and Zhuang, J. (eds) Corporate Governance and Finance in East Asia: A Study of Indonesia, Republic of Korea, Malaysia, Philippines, and Thailand. Volume Two (Country Studies), Manila: Asian Development Bank. World Bank (2001a). Report on the Observance of Standards and Codes: Corporate Governance Country Assessment Republic of the Philippines, Washington, D. C.: World Bank. World Bank (2001b). Report on the Observance of Standards and Codes (ROSC) The Philippines Accounting and Auditing, Washington, D. C.: World Bank.

8 Corporate Governance in Singapore: Past, Present and Future Yuen Teen Mak

8.1

Introduction

Singapore is a small country (582 square kilometers) with no natural resources. It achieved independence in 1965, at which time it had a population of 1.9 million and was growing at a rate of 2.5% per annum, with an unemployment rate estimated at 10%. The economy was highly dependent on entrepot trade and the provision of services to British military bases in Singapore. There was a small manufacturing base, limited industrial know-how and local entrepreneurial capital. In order to develop Singapore, the government adopted the following strategies: 1. Industrialization to solve the unemployment problem and diversification away from regional entrepot trade. 2. Internationalization by attracting foreign investors to develop the manufacturing and financial sectors. 3. Improvement of the investment environment by introducing employment and industrial relations legislation and investing in key infrastructure, such as the development of the Jurong Industrial Estate and Port of Singapore. 4. Establishment of new companies such as Singapore Airlines, Neptune Orient Lines, Development Bank of Singapore and Sembawang Shipyard in areas where the private sector lacked capital or expertise. By the 1980s, the labor market had become tight, and so the government adopted strategies to restructure the economy towards higher value-added activities. These strategies included ensuring the wage 155

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increases expected in the tight labor market materialized, increasing emphasis on education and training, encouraging the increased use of technology, adopting a more selective investment promotion policy, increasing emphasis on research and development, and developing higher value-added services. By 1990, Singapore was classified a Newly Industrialized Economy (NIE) by the United Nations. The economy had matured, and was enjoying rapid growth, as were many others in the region. The Strategic Economic Plan was then formulated to transform Singapore into a developed country. In the 1990s, the aims of Singapore were to become a globally-oriented city, a center for high-tech manufacturing industries and an international business hub. She hoped to achieve this by being the hub of an Asia Pacific economic community through active participation in regional economic initiatives, and investing in other rapidly growing economies in the Asia Pacific. Singapore’s small size and lack of natural resources have necessitated an open trade policy. In addition, Singapore has virtually no exchange controls on inflows and outflows of foreign currency funds by residents and foreigners, whether in amount or destination. Singapore also has a very liberal policy towards foreign direct investment (FDI). Disclosure and corporate governance in Singapore have been widely recognized as being among the best in Asia, and many commentators have attributed the robustness of the Singapore economy during the financial crisis to her relatively good disclosure and corporate governance. In the PriceWaterhouseCoopers survey of companies (PWC, 1997), respondents rated corporate governance in Singapore as being better than Taiwan, Malaysia, Hong Kong, and Japan, although lagging behind Australia, U.K. and U.S. Similarly, a more recent PWC (2000) survey of institutional investors ranked Singapore as second only to Australia among principal markets in the region, in the areas of auditing and compliance, accountability to shareholders, disclosure and transparency and board processes.

8.2 8.2.1

Corporate governance in Singapore: pre-crisis Regulatory environment

The Singapore corporate governance system is loosely based on the Anglo-American model (Li, 1994; Prowse, 1998). However, because the capital market in Singapore is thin,1 and equity is tightly held among the investors (including government, corporations, individuals and

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institutions), takeovers tend to be friendly rather than hostile. Furthermore, the lack of strict accounting standards and the lack of legal backing and enforcement of these standards mean that the quality of publicly available corporate information is generally lower than in the U.S. More importantly, the high concentration of ownership among company management and large shareholders potentially violates the principle of the decision management and decision ratification (Fama and Jensen, 1983), and may result in the expropriation of wealth from minority shareholders to large shareholders (La Porta et al., 1996).

Regulation of takeovers The major source of guidance on the conduct and procedures to be followed in takeover and merger transactions is the Singapore Code on Take overs and Mergers (hereafter, “The Code”). The Code is nonstatutory and supplements and expands on the statutory provisions on takeovers found in sections 213 and 214, and the Tenth Schedule, of the Companies Act. Companies listed on the Singapore Exchange (SGX) that are parties to a takeover or merger also have to comply with the provisions in the Listing Manual of the SGX. The Securities Industry Council (SIC) administers the Code, which is divided into General Principles, Rules and Practice Notes. It was developed to aid directors and officers in the discharge of their duties in the event of a merger or takeover of a listed company. In general, the Code was set up as a way to protect the minority shareholder from possible adverse impact. As the concentration of stockholdings is very high in Singapore, the likelihood of minority oppression is very real because many takeover resolutions require only majority, rather than super-majority assent by the shareholders.

Regulation of accounting and auditing Prior to the crisis, the philosophy of regulation in Singapore was predominantly merit-based. Under the merit-based philosophy of regulation, the securities regulator decides on whether transactions should be allowed to proceed based on their perceived merits. Under this philosophy, regulators rather than shareholders primarily determine whether certain transactions are allowed, and strict rules are set to restrict the transactions that companies may undertake. The regulation of accounting in Singapore involves a combination of private and public sector participation. Regulation in the public sector is effected primarily by the Registry of Companies and Businesses (RCB), which administers the Companies Act of 1990. The Companies

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Act requires financial statements to comply with the detailed disclosure requirements in the Ninth Schedule and to present a true and fair view. The two major institutions involved in private sector regulation are the professional accounting body, The Institute of Certified Public Accountants of Singapore (ICPAS), and the SGX. The ICPAS has the sole responsibility for developing and maintaining the Statements of Accounting Standards (SAS) which, together with the rules contained in the Stock Exchange Listing Manual and the Companies Act, determine how accounting is practised in Singapore. The SAS is based on the International Accounting Standards (IAS) issued by the International Accounting Standards Committee (IASC). In most cases, SAS are identical to IAS, although there are occasional deviations and omissions. The ICPAS also issues Statements of Recommended Accounting Practice (RAP) which specify how to account for certain business transactions. Standard-setting is done through the Accounting Standards Committee appointed by the Council of the ICPAS. Each new Standard becomes part of Generally Accepted Accounting Principles (GAAP), the “accounting law of the land.”2 Since the SAS issued by the ICPAS do not have legal backing and the ICPAS only has the authority to require members to follow its standards and guidelines; compliance with these standards depends largely on general acceptance by the business community. In Singapore, the Public Accountants Board (PAB) was set up under the Accountants Act of 1987 (revised 1998) to register and regulate public accountants which include external auditors. The PAB is empowered to regulate the professional conduct and ethics of public accountants and to hold disciplinary inquiries and mete out punishments if necessary. Under the Code, a public accountant or his firm cannot be appointed as an external auditor of a company if: 1. he or his immediate family holds a significant beneficial interest, directly or indirectly, in shares of the company (significant = 5% or more for public companies and 20% or more for private companies); or 2. for the year immediately preceding prospective appointment, he was an officer or employee of the subject company, or was a partner of such person(s); or 3. he has a direct or indirect material financial interest in the company. The above requirements of the Code are specific and fairly stringent in setting minimum benchmarks for the (“appear to be”) independence

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of external auditors. In contrast, Section 8 of the Code of Ethics for Professional Accountants put out by the International Federation of Accountants (IFAC) is similar in spirit to the Singapore Code but lacks specification of thresholds. However, the IFAC Code does provide a more comprehensive listing of situations that are increasingly common in practice and which may impair (“actual”) auditor independence. The SAS and Standard Accounting Practices (SAPs) in Singapore are mostly equivalent to their international counterparts. Given the increasing globalization of business and investments, this equivalence is a welcome feature, and enhances the international credibility of the external audit as a corporate governance tool in Singapore. In the same vein, foreign investors are likely to be more confident of audit reports on listed Singapore companies because the market for external auditing services is dominated by the Big 4 in Singapore.

Financial sector regulation The Singapore government, as part of its industrial policy, targeted the financial services sector 15 years ago for development into one of the three lynchpins of the local economy (information technology and distribution being the other two). The regulation of disclosure standards in financial institutions is spread over a number of institutions, namely the SGX, Monetary Authority of Singapore (MAS), SIC, RCB, and Commercial Affairs Department of the Ministry of Finance (MOF). Banks have traditionally been subject to lower disclosure standards than other corporations through modifications by the MAS. Lower disclosure was mandated because of the high regulatory and supervisory standards practised by the MAS, and concern that fuller disclosure may have an adverse impact on the stability of the banking system.

8.2.2 Structural environment Takeovers The takeover market, as might be surmised, is not active in Singapore. This is due, in large part, to the concentration of stockholdings, the pervasive presence of the government, and the tight controls by the SGX (for example, secrecy rules are in place and strictly enforced in order to reduce speculative buying on rumors). Hostile takeovers are almost unheard of. Thus, the discipline of a takeover market on director behaviors, envisioned by (Jensen and Ruback, 1983), does not exist or is very weak in the Singapore context.

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Government-linked corporations A major feature of the Singapore economic landscape is the dominance of government-linked corporations (GLC). Up to about 80% of some GLCs are directly and indirectly controlled by the government. At the end of the 1980s, GLCs comprised 69% of total assets and 75% of profits of all domestically controlled companies in Singapore. In the 1990s, through a program of privatization which dispersed the equity of these companies, those numbers have been reduced. However, the government continues to hold controlling stakes in some of the largest companies, mainly through the government holding company, Temasek Holdings. A study of corporate governance in Singapore would not be complete without understanding the role and governance structures of the GLCs. In many ways, these companies form the bulwark of the domestic economy and are often seen as opinion leaders in the practice of management. Singh and Ang (1998) suggest that inter-firm competition in Singapore is tempered by co-operation and co-ordinated action in ventures that represent unrelated diversification strategies. This is particularly true for the GLCs, which have a social as well as economic objective, i.e., that of promoting the development of Singapore. However, while the government appears to facilitate governance through GLCs, there are some problems with this approach. The appointment of government officers to senior management and board positions within GLCs raises the question as to whether the best managers are running corporations that form an important part of the economy. In addition, according to Vernon and Aharoni (1981), GLCs must respond to a “set of signals from the government to which private managers are less alert. These signals are not related to profits but to goals associated with the well-being of the nation. These goals may be in conflict with the commercial objectives of the enterprise”. GLCs may also face less pressure to pay dividends. In addition, unlike other blockholders, who may play an important third-party role in facilitating takeovers of poorly-performing firms, the government is expected to play the role of the long-term investor in these GLCs. Therefore, GLCs are even more protected from an already weak market for corporate control. GLCs are also likely to have easier access to different sources of finance than non-GLCs. Often, the government is perceived by the lenders to have a moral and legal responsibility for their liabilities and this tacit backing of the state implies that the enterprise is guaranteed solvency (La Porta et al., 1998). This results in greater willingness by banks and non-banking financial institutions

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such as insurance companies to lend them money. Accordingly, “the fact that [GLCs] are part-owned (or managed) by the Singapore government enables them to raise funds much more cheaply – by up to four percentage points lower – than others” (Business Times, 1997, March 4). The MOF noted that GLCs, being largely cash-rich, usually do not need to resort to raising bonds or bank borrowings (Business Times, 1997, August 23). This of course reduces the potential discipline to which a GLC will be exposed in a competitive capital market. In a competitive market, one would expect any wealth-decreasing diversification to be penalized by investors. However, the reduced exposure to market disciplines (such as less exposure to takeovers and lower cost of capital because of implicit government guarantee) faced by GLCs may cause them to be less efficient than other companies. There is little doubt that GLCs were instrumental in the rapid transformation of the Singapore economy from an entrepot-based to an industrialized one. Most commentators would also agree that, relative to state-owned enterprises (SOEs) in most other countries, GLCs in Singapore are well run. However, the relative success of the GLCs may have come at the cost of development of private enterprise. Entrepreneurs wanting to start their own businesses in Singapore often have to contend with well-resourced and powerful GLCs. One could conjecture that perhaps the greater entrepreneurship that appears to characterize say the Taiwanese and Hong Kong economies may be attributable to the relatively minor role of the governments in those economies. One can also question whether GLCs can compete in the globalized economy, given that it is difficult, if not impossible, to find a worldclass global company that is government-controlled. Recent events also suggest that international investors, management and policy-makers often hold a dim view of significant government ownership. There is also considerable theoretical and empirical evidence that private ownership is superior to government ownership.

Ownership structure La Porta et al. (1998) reported that the three largest shareholders own an average of 49% of the ten largest non-financial domestic firms in Singapore. This is comparable to other East Asian countries but is much higher than the developed Western economies such as the U.S. (20%) and the U.K. (22%). Mak and Li (2001) reported that the mean and median proportion of shares owned by substantial shareholders is more than 60%, which is very high relative to many developed Western economies. The substantial shareholders in Singapore

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companies consist mostly of families, the government (through government controlled investment vehicles), corporations, and especially nominees. As Shleifer and Vishny (1997) note, while large shareholders potentially improve the monitoring of managers because of the alignment of cash flow and control rights, large shareholders represent their own interests. Where corporate governance is weak, large shareholders may expropriate wealth from minority investors and other stakeholders. Large shareholdings also result in a loss of diversification and inefficient risk-sharing. The high concentration of shareholdings in Singapore may be a result of the relatively weak corporate governance environment by Western standards (i.e., weak takeover market, lack of disclosure, and weak protection of minority shareholders’ rights).

Foreign share ownership limits Prior to the crisis, about 30 companies on the SGX had imposed restrictions on foreign ownership. Foreign ownership limits ranged from 20% to 49%. Foreign ownership limits were imposed by statute in the banking and news media industries. In other cases, these restrictions are adopted voluntarily by the firms themselves through amendments to their Memorandum and Articles of Association. The adoption of foreign ownership limits, whether statutory or selfimposed, can facilitate managerial entrenchment. The imposition of a foreign ownership limit prevents control of the firm from being passed to the hands of foreign investors. It also reduces the ability of foreign investors to acquire large stakes in these firms, thereby reducing the potential monitoring that can be provided by large foreign investors.

Disclosure and accounting practices Many commentators, regulators and government officials have lamented the fact that Singapore companies generally disclose the minimum information that is required by law, regulations and accounting standards. Companies often comply with the letter rather than the spirit of these requirements, and are rather liberal in taking advantage of the discretion that is often permitted under accounting standards. One of the recurring criticisms of East Asian economies during the crisis has been the low quality of accounting standards and their enforcement. Although Singapore’s SAS are identical to IAS in most cases, and despite being ranked among the best in terms of corporate disclosure in this region, disclosure and enforcement of accounting standards in Singapore still lag significantly behind more developed

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economies. A study by Goodwin and Seow (1998), in which they examined the annual reports of 94 Singaporean companies from 1994 to 1996, concluded that, compared to U.S. firms, disclosure practices of Singapore corporations were poor, although they were better when compared to their South Asian counterparts. In the PWC (1997) survey, 27% of companies admitted that disclosures in their annual reports only met minimum requirements, and a further 51% stated that their disclosures exceeded the minimum by a little. Only 11% of the respondents stated that they strive for full disclosure and transparency. The PWC (2000) survey reported that greater disclosure and transparency in the annual report and financial statements were ranked as the most important area where improvements should be made. Greater disclosure of directors’ dealings with related parties and greater frequency of company reporting were ranked as the second and fourth most important areas. In general, corporate governance disclosures in Singapore annual reports lag behind those in more developed markets. Although the SGX introduced a (non-mandatory) Best Practices Guide (BPG), it deals only with two aspects of corporate governance – audit committees and dealing in securities by directors. Disclosure of compliance with the BPG is only required for audit committees. Further, although the BPG specifies that companies should provide sufficient disclosure of their corporate governance processes and activities, specific guidelines on what should be disclosed are lacking. In a survey of corporate governance disclosures in 150 SGX-listed companies, only six companies did not make corporate governance disclosures. Thirty-three companies (22%) incorporated their corporate governance disclosures within the directors’ report, while the remaining companies (74%) included a separate statement of corporate governance. However, most companies did not go beyond the minimum requirements in the BPG in their corporate governance disclosures. The PWC (2000) survey identified more guidance on corporate governance and activities in the BPG as an area requiring improvement. In the same survey, 38% of institutional investors felt that considerable improvement in the corporate governance regime in Singapore was required, while another 54% felt that some improvement was needed. Interestingly, in the PWC (1997) survey of companies, 17% felt considerable improvement was needed while 63% felt some improvement was needed. Therefore, institutional investors seem to be somewhat less satisfied than companies with the state of corporate governance in Singapore.

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8.3

Recent corporate governance developments in Singapore

Although Singapore was less affected by the 1997 financial crisis than most other Asian economies, the effect was still severe relative to its previous growth patterns. The strategy of increasing regionalization adopted in the early 1990s meant that the health of the Singapore economy was closely linked to that of other regional economies. Contagion was also widely seen as contributing significantly to the effects of the crisis on Singapore. The effects of the crisis included significant declines in stock and property prices, a large fall in demand in the local property market, a significant decline in the value of the Singapore dollar relative the U.S. dollar, increasing unemployment and bankruptcies, and a significant decline in Gross Domestic Product (GDP) growth. In 1998, real GDP growth fell to 1.5%. All sectors of the economy experienced deterioration in growth, with the manufacturing, distribution, and financial services sectors particularly badly hit. Total employment fell in the second and third quarters of 1998. The seasonally adjusted unemployment rate rose from 2.3% in the second quarter of 1998, to 4.5% in the third quarter. The Straits Times Index (STI) fell from around 2200 points at the end of 1996 to around 1400 points at the end of 1998. In summary, the impact of the crisis on the Singapore economy, while not crippling, has been severe. In late 1997, the MAS embarked on a fundamental review of its policies in regulating and developing Singapore’s financial sector. In February 1998, the MAS unveiled a series of sector reforms aimed at making Singapore the dominant financial center in South East Asia. The new strategy involved the creation of an investor friendly regulatory environment that had, as its primary objectives, transparent supervision, product innovation, and aggressive advocacy for the industry. The Singapore government has identified meeting international standards of disclosure and corporate governance as being extremely important, given the globalization of business and Singapore’s aim of becoming an international financial center. In December 1999 the Corporate Regulation and Governance Policy Committee (hereafter “Policy Committee”) was established to oversee private sector-led Review Committees in three areas: (a) Company Legislation and Regulatory Framework, (b) Disclosure and Accounting Standards, and (c) Corporate Governance. One key recommendation which has been adopted by the government is that Singapore should move from a predominantly merit-based

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philosophy of regulation towards a predominantly disclosure-based philosophy of regulation. The merit-based philosophy was discussed earlier. Under the disclosure-based philosophy of regulation, the merit of transactions will be largely determined by shareholders. This requires a high level of disclosure and monitoring, by shareholders rather than regulators. Moving from a merit-based to a disclosure-based one not only changes the role of regulators, but also requires fundamental changes in the areas such as the legal and regulatory framework, accounting and auditing standards, codes of best practices, and the role of third-party watchdogs such as the news media and investors’ associations.

8.3.1

Changes to takeover rules

The SIC has recently announced a proposed revised Takeover Code, with a view to making takeover rules clearer, more certain, and less expensive. The current U.K. model for regulating Mergers and Acquisitions (M&A) activities, whereby shareholders rather than directors have the right to decide on the offer, is to be retained, as is the non-statutory form of the takeover rules. However, in my view, the proposed changes to the Takeover Code will not have a marked impact on the incidence of M&A activities in Singapore, especially those that are disciplinary in nature. Therefore, the role of the market for corporate control as a disciplinary mechanism is likely to remain weak in Singapore for the foreseeable future.

8.3.2

Changes to companies and securities legislation

Another recommendation is the consolidation of securities legislation into a unified code, and moving to a single securities regulator responsible for enforcing all aspects of securities law and regulation (including disclosure obligations) and prescribing accounting rules. Currently, enforcement of companies and securities laws and regulations resides with a number of regulatory bodies, such as MAS, MOF, and RCB. This issue is currently being considered by the Committee on Companies Legislation and Regulatory Framework, which is due to report back near the end of 2001. A recommendation that has already been implemented is to make it easier for shareholders to institute civil right of action for insider trading and to obtain compensation for losses from insider trading. Following changes to the Securities Industry Act, aggrieved shareholders can now file civil actions for damages and penalties for insider trading without first securing a criminal conviction, which was the case in the past.3

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8.3.3

Divestment of non-financial activities by banks

In June 2000, the government announced proposed measures to separate the financial and non-financial activities of banking groups, and to unwind the cross-shareholdings between the two.4 Under the measures, all the financial activities of the banking groups are to be consolidated, either under the bank or under a non-operating financial holding company. The non-financial activities must be segregated and divested. These non-financial activities can be sold to third parties or to the principal shareholders of the bank, in which case the principal shareholders will own them directly, rather than through the financial entities in the group. The bank or financial holding company must be listed, and cannot be a wholly-owned subsidiary of a listed holding company which owns both the bank and other non-financial entities.

8.3.4

Development of fund management industry

As discussed earlier, substantial shareholders in Singapore companies consist mostly of families, the government (through government controlled investment vehicles), corporations, and especially nominees. Unaffiliated institutional investors, such as pension and mutual funds, are not major investors in most Singapore companies. The government has now committed to placing S$25 billion of government Investment Corporation (GIC) funds and S$10 billion of MAS funds to external (international) fund managers to manage. Further investments through fund managers are likely. The use of external fund managers and the development of the local fund management industry may alter the ownership structure of Singapore companies, with a shift towards greater ownership by these institutional investors. Therefore, the importance of these institutional investors to corporate governance in Singapore is likely to increase in the future. It is hoped that, as in the U.S., these institutional investors will more actively monitor the companies they invest in, and encourage the adoption of best practices in corporate governance that are comparable to international standards.5

8.3.5

Divestment of government ownership

Recent problems in attempted overseas acquisitions by major GLCs such as SingTel have highlighted some of the costs of significant government ownership. Some commentators have attributed these failures partly to the significant government ownership, and senior government officials have acknowledged that this may have been a factor. Over the years, GLCs have been accused of having unfair advantages

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over other private sector companies, of stifling private enterprise, and of over-diversification into non-core businesses.6 The government recognizes these problems and has recently indicated that it is willing to divest more of its ownership. Therefore, government ownership in Singapore companies may be further reduced in the near future. The author believes that further divestment of government ownership will have the multiple benefits of stimulating private enterprise, energizing the local equity markets (by improving liquidity and increasing the investment by international institutional investors), improving efficiency in the management of GLCs, and contributing significantly to the development of the fund management industry in Singapore (if funds released from privatization are re-invested through fund managers).

8.3.6

Changes to share ownership limits

The government has removed the statutory 40% foreign shareholding limit for banks. As a result of this change, all five local listed banks have merged their foreign and local shares, and the market has reacted positively to this development. Nevertheless, the 5% limit on shareholding by a single party in banks remains, and this 5% limit applies to nominee interests. 7 This precludes institutional investors holding nominee interests from acquiring shares above these limits for banks. These limits should be reviewed as they discourage large institutional investors from investing in these companies, and restrict their ability or incentives to participate in the corporate governance of these companies. There is now considerable empirical evidence internationally on the positive role of unaffiliated institutional shareholders (such as pension and mutual funds) in corporate governance. The government has recently reiterated that it will not allow local banks to be taken over by foreign banks.

8.3.7

Code of Corporate Governance (the Code)

After a period of consultation following the release of its consultation document on the proposed Code in November 2000 by the Corporate Governance Committee (CGC), the government announced in April 2001 that it has accepted all the recommendations of the Committee.8 Shortly after, the SGX modified its listing requirements to require Singapore companies to comply with the Code or, where they do not, to explain deviations from the Code. As recommended by the CGC, listed companies are required to give a complete description of their

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corporate governance practices with specific references to each of the guidelines set out in the Code, and where they deviate from these best practices, they should disclose non-compliance with appropriate explanations. Listed companies are required to do so in their annual reports for Annual General Meetings held from 1 January 2003 onwards. However, they are encouraged to comply with the Code before that, if they are able to do so. The Code is modelled after the U.K. Combined Code, but also incorporates best practices from other jurisdictions and is suitably modified to take into account local conditions. It has generally been wellreceived by the business community and can be expected to lead to a significant improvement in corporate governance and disclosure for Singapore listed companies.

8.3.8

Disclosure and accounting standards

The ICPAS has recently embarked on a program of fully aligning Singapore standards to IAS. In May 2001, the Disclosure and Accounting Standards Committee (DASC) released its second consultation document. This document contains many recommendations, including alignment of Singapore accounting standards to IAS. These developments are expected to significantly improve the quality of accounting and auditing in Singapore.

8.4 Corporate governance practices in Singapore 8.4.1

Board composition and leadership

Two characteristics of the board that are generally believed to be related to board independence are the separation of the Chief Executive Officer (CEO) and Chairman roles, and the inclusion of nonexecutive, especially independent, directors. In both the PWC (1997) and PWC (2000) surveys, both these areas were identified as requiring improvement. Appendix 1a of the SGX Listing Rules requires companies applying for listing to have at least two non-executive directors who are independent and free of any material business or financial connection with the issuer. Listed companies are also required to have at least two independent directors on the board under the Act.9 The BPG states that a majority of audit committee members, including the Chairman, should be independent of management. An examination of the top 100 listed companies shows that the typical board consists of approximately two-thirds non-executive direc-

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tors, and one-third executive directors. In terms of board leadership, only 15% have a CEO who is also the Chairman. However, as Mak and Chng (2000) reported, around two thirds of all Singapore companies either have the CEO or another executive director as the Chairman of the Board, and very few have an independent Chairman.

8.4.2

Board committees

Under the Companies Act, all listed companies in Singapore are required to have an audit committee with at least three members, with the majority of the members being independent directors, and the Chairman being a non-executive director. Mak and Chng (2000) report that, for a sample of 150 SGX-listed companies, two-thirds have an executive director serving as a member of the audit committee. Apart from the audit committee, neither statute nor listing rules contain requirements for other board committees. It is therefore not surprising that for the top 100 companies, only 11% reported the existence of a nomination committee and 19% the existence of a remuneration committee. In the PWC (1997) and PWC (2000) surveys, the introduction of remuneration (compensation) and nomination committees were both identified as areas requiring improvement in Singapore.

8.4.3

Directors’ remuneration

In Singapore, disclosure relating to directors’ remuneration (including the process by which the level and mix of compensation is determined) is currently very poor by international standards. Under the SGX Listing Rules, companies are only required to disclose, for the current year and the previous year, the number of directors whose remuneration falls within the following bands: below $250,000, $250,000–$499,000, and $500,000 and above.10

8.4.4

Stock options

In recent years, many Singapore companies have adopted employee share option schemes (ESOS) as a means of compensating directors, managers and employees. Most companies only issue options to senior management and directors, although there have been several recent instances of the adoption of broad-based ESOS that include stock options for lower-level employees. Stock options can be an effective tool to align the interests of managers/employees and shareholders and provide a stronger link between pay and performance, and therefore perform an important corporate governance function. However, as many writers have noted, providing proper incentives through stock

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options requires a well-designed ESOS. Further, as the recent U.S. experience indicates, stock options can be controversial as they are often seen to lead to an inflation of executive compensation. Further, questionable practices such as repricing options can mitigate the incentive effects associated with options. In the annual report, the name of each participant who is a director, controlling shareholder or who receives 5% or more of the total number of options available must be disclosed, together with the number and terms of options, aggregate number of options issued since commencement of the ESOS, aggregate number of options exercised since commencement, and aggregate outstanding options.

8.4.5

External auditing

Around 96% of the top 100 companies have a Big 5 auditor. Based on the argument that Big 5 firms offer higher-quality auditing, we can infer that the quality of auditing for these companies is high. Further, as discussed in Section 8.2, external auditors in Singapore are subjected to strict registration requirements and professional standards, and auditing standards are based on international auditing standards. Under the statutory Code issued by the Public Accountants Board, a person with significant financial interest in, or having a past employment relationship with the audit client (as described in Section 8.2) cannot be appointed as an external auditor. Nevertheless, there are concerns with auditor independence in Singapore, and both the CGC and DASC have proposed additional safeguards for auditor independence, including increasing the monitoring of the external auditor by the audit committee, imposing more stringent restrictions on financial interest in the audit client, and restricting and increasing the disclosure of non-audit services provided to the audit client.

8.5 Summary and conclusions Many significant proposals have been made to improve corporate governance in Singapore, and many of these proposals have been implemented. It can be expected that, with the implementation of the Code of Corporate Governance from January 2003, many of the current corporate governance practices and disclosures will change. For example, we can expect changes in the composition of the board and the composition of the audit committee, more widespread establishment of nomination and remuneration committees, more detailed disclosure

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about the directors and about how the board conducts its affairs, better remuneration disclosures (including cost of stock options issued), and better designed remuneration schemes for executive directors and senior executives. In addition, once the recommendations of the DASC have been adopted, disclosure, accounting standards and the independence of the external audit will be enhanced. Other financial sector developments such as the development of the funds management industry are likely to further enhance corporate governance in the future. The development of the local fund management industry could increase the role of fund managers in corporate governance in Singapore, and overseas evidence generally suggests that such institutional investors play an important role in enhancing shareholder value. Another important development is the establishment of self-regulating organizations, especially the Singapore Institute of Directors (SID) and the Securities Investors Association of Singapore (SIAS). In recognition of the importance of corporate governance, the SGX, with support from the MAS, instigated the formation of the SID in May 1998. The Institute, governed by a Council made up of practising directors and representatives from the SGX, academia and other bodies, is a voluntary association registered under the Companies Act. The SID aims are to promote the highest professional and ethical standards of directors through networking, education and information, thereby helping to bolster standards of corporate governance and disclosure among Singapore companies. With the help of experts from industry and academia, the Institute has developed a director training program, the Company Directors Course (CDC), covering basic directors’ duties, responsibilities and skills, strategic management, and finance and accounting. Directors of newly listed companies and those wishing to obtain full membership in the Institute may participate in this program in order to enhance their directing skills and knowledge. The SID has also been active in organizing seminars and talks on topics of interest to directors, and in providing feedback on proposed reforms in corporate regulation, corporate governance, and accounting and disclosure in Singapore. The institutionalization of directorship in Singapore will raise the level of awareness of directors’ legal and moral responsibilities and professional conduct in the boardroom. The SIAS was established as an association for small investors. Its primary objectives are to provide a forum for members to meet and discuss matters affecting their investments; to present the views of members at company meetings, to Stock Exchanges and other

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appropriate bodies; to educate members on matters of investment, and to act on behalf of members, such as co-ordinating class and common legal actions. Since its establishment, the SIAS has been vocal in the financial press on corporate actions impacting investors, and has had some success in ensuring that the voice of the small investor is heard by companies. There is some evidence that the financial press and investors have become more critical of questionable corporate practices. The publication of the Corporate Transparency Index (CTI) by the Business Times and the proposed development of the Corporate Governance Scorecard by Standard & Poor’s are likely to lead to further improvements in corporate governance in Singapore. However, further changes are necessary in order for corporate governance in Singapore to meet the standards in more developed economies. These include: 1. Strengthening the regulatory and institutional framework, including improved enforcement of laws and regulations. 2. Encouraging the development and more active participation of private sector institutions and third-party watchdogs, such as institutional investors, investment managers’ and shareholders’ associations, news, media, and institute of directors. 3. Attempting to control the shareholding structure of companies, for example, by restricting ownership by particular types of private shareholders may not be good corporate governance. 4. Given the weight of evidence on the superiority of private ownership over state ownership in terms of corporate governance, and other costs of state ownership that have recently being highlighted (such as stifling of private enterprise, perception of government interference), the government should aggressively divest its ownership. In addition, improving the efficiency of the market for corporate control, a continuing push toward liberalization of markets, and the strengthening of laws covering areas such as fair competition and trading will further enhance the functioning of external corporate governance mechanisms.

8.5.1

Barriers to improvements in corporate governance

There are a number of barriers to improvements in corporate governance in Singapore. First, although effective enforcement of corporate

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and securities laws and accounting standards is fundamental to a disclosure-based environment, a small country like Singapore will always find it difficult to duplicate the strong regulatory environment that exists in larger economies such as the U.S. Consequently, ownership in Singapore is likely to remain heavily concentrated with significant ownership by executives (and their families), which violates the separation of decision management and decision control and leads to the inefficient sharing of risks. With significant concentration of ownership among individuals who are either managers or relatives of managers (especially for smaller listed companies), matters such as related party transactions and insider trading will remain a concern. Second, it is likely that the impact of global convergence will be most keenly felt by larger companies that operate internationally and access international financial markets. Many smaller listed companies have little need to access capital markets, either domestically or internationally. Although poor corporate governance may translate to poor share price performance, these companies may continue to adopt minimal, rather than internationally acceptable, corporate governance practices. This is especially so as the threat of hostile takeovers (usually triggered by a poorly-performing stock price), which is often seen as an effective “last resort” disciplinary mechanism, is not likely to be significant in Singapore. Third, although the government has expressed its willingness and intent to divest its ownership in government-linked corporations, the fact that the GLC-model has served Singapore well in the past may make the government reluctant to do so. Further, there have been concerns expressed as to whether the market can absorb a large divestment of government ownership, especially given its current state. This may slow down the divestment process. Finally, a major problem is that under the merit-based philosophy of regulation that was practised in Singapore, the emphasis was on compliance with rules and regulations set by regulatory and quasi-regulatory agencies. Under this environment, companies were conditioned to disclose the bare minimum as required by rules and regulations, and no more. Since the merit of transactions was frequently determined by regulators rather than by shareholders, there was little benefit from companies disclosing more to shareholders. Moving to a disclosurebased philosophy of regulation requires a significant change in mindset by both companies and shareholders. Companies must be prepared to disclose more, and shareholders must be prepared to exercise their rights and participate more actively in corporate governance. There is a

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danger that inertia will cause companies to comply with the rules (as they did in the merit-based environment) rather than responding to the market demand for disclosure and good corporate governance (as is required in a disclosure-based environment). Furthermore, as strict rules are relaxed in a disclosure-based environment, one can question whether shareholders in Singapore are willing or able to play a more active role in corporate governance at the present time. It can be argued that the merit-based approach to regulation that was practised in Singapore for so long reflects the cultural, social and economic environment in Singapore (including the significant concentration of ownership among the government and families). Although a disclosure-based philosophy of regulation is the right path to take in the long-term, and is inevitable given the globalization of markets, the move to a disclosure-based philosophy may be a slow and sometimes painful process for shareholders.

Notes 1. There were about 325 companies listed on the two boards of the Singapore Exchange (SGX) as at the end of 1996. 2. The ICPAS has regular interactions with numerous government agents, especially, Monetary Authority of Singapore (MAS), the Economic Development Board (EDB), and Inland Revenue Authority (IRA). The Institute discusses with these agents frequently on accounting and auditing issues related to banking and finance (with MAS), industry and commerce (with EDB) and taxation (with IRA). The ICPAS also sends a draft copy of the standards, guidelines and key reports to these agents for their comments and review before formal publication. 3. In fact, since the enactment of the Securities Industry Act 1973, there has been no reported case of compensation being awarded on a civil action for insider trading violation (Woon, 1997). 4. “Measures to separate financial and non-financial activities of banking groups” – Speech by Deputy Prime Minister Lee Hsien Loong, 21 June 2000 (http://www.mas.gov.sg). 5. In the U.S., for example, giant pension funds such as the California Public Employees Retirement System (CalPERS) are widely known to be active monitors of investee companies. They develop yearly “hit” lists of underperforming companies, hold closed door meetings with boards to encourage a shareholder friendly business agenda, organize shareholder revolts through the proxy system, and employ the heavy leverage of public opinion and the popular media to pressure companies to conform to best practices standards for corporate governance. 6. In an interview, Ho Kwon Ping, Chairman of Singapore Power (the Singapore utility) criticized GLCs for excessive diversification (Straits Times, May 15, 1998, p. 52). In a competitive market, one would expect any wealth-decreasing diversification to be penalized by investors. However, the reduced exposure to market disciplines caused by a reduced exposure to

Yuen Teen Mak 175

7.

8. 9. 10.

takeovers and access to cheap capital because of implicit government guarantee may allow GLCs to be less efficient than other private companies. This criticism is supported by a recent empirical study by Lim and Mak (1999), which found that listed companies in which the government is a significant shareholder were more likely to be highly diversified. This limit is 3% for media companies. In the media release by the MAS dated 17 May 1999, it was stated that “The concern that local banks should give priority to the national interest remains valid … . The requirement to create Nominating Committees, and to have a majority of citizens and permanent residents on the board, will effectively ensure that control of the banks rests with individuals or groups who will act in a manner consistent with the national interest. In addition, MAS will tighten existing safeguards on the accumulation of significant ownership in a local bank”. Therefore, the need to prevent local banks from falling into foreign control remains a concern for the Singapore government. Corporate Governance Committee, Report of the Committee and Code of Corporate Governance, April 2001. The requirements relating to board committees are discussed in greater detail in the next Section. The SGX had briefly introduced the requirements for detailed disclosures of individual directors’ remuneration, which were subsequently withdrawn. Under the Code of Corporate Governance, which became effective in January 2003, companies are to disclose the number of named directors, top five executives, and certain related employees who fall within bands of $250,000. There is no upper limit to the band disclosure. In addition, the percentage breakdown of total remuneration into base salary and various variable components (including stock options) is provided for under the Code.

References Business Times (1997). March 4. Business Times (1997). August 23. Fama, E. F. and Jensen, M. C. (1983). Separation of ownership and control. Journal of Law and Economics 26: 301–325. Goodwin, J. and Seow, J. L. (1998). Disclosure relating to board members: Shedding light to build investors’ confidence. SGX Journal (August): 6–12. Jensen, M. C. and Ruback, R. S. (1983). The market for corporate control: The scientific evidence. Journal of Financial Economics 11: 5–50. La Porta, R., Lopez de-Silanes, F., Shleifer, A. and Vishny, R. W. (1996). Law and finance. NBER Working Paper #5661, Washington D. C., USA. La Porta, R., Lopez de-Silanes, F., Shleifer, A. and Vishny, R. W. (1998). Agency problems and dividend policies around the world. NBER Working Paper 6594, Washington D. C. Li, J. (1994). Ownership structure and board composition: A multi-country test of agency theory predictions. Managerial and Decision Economics 15: 359–368. Lim, S. C. and Mak, Y. T. (1999). Ownership structure, board structure and corporate diversification. FBA Research Paper Series #99–83, National University of Singapore.

176 The Governance of East Asian Corporations Mak, Y. T. and Chng, C. K. (2000). Corporate governance practices and disclosures in Singapore: An Update, The OECD/World Bank 2nd Asian Roundtable on Corporate Governance on The Role of Disclosure in Strengthening Corporate Governance and Accountability, Hong Kong, May 31–June 2, 2000. Mak, Y. T. and Li, Y. (2001). Determinants of corporate ownership and board structure: Evidence from Singapore. Journal of Corporate Finance 7(3): 235–256. PriceWaterhouseCoopers (PWC) (1997). Survey of Corporate Governance in Singapore. PriceWaterhouseCoopers (PWC) (2000). Corporate Governance: 1999 Survey of Institutional Investors. Prowse, S. (1998). Corporate Governance in East Asia: A Framework for Analysis, Working Paper, Federal Reserve Bank of Dallas, Dallas, Texas. Shleifer, A. and Vishny, R. W. (1997). A survey of corporate governance. Journal of Finance 52: 737–783. Singh, K. and Ang, S. H. (1998). The Strategies and Success of government linked corporations in Singapore. Working Paper RPS #98–06, National University of Singapore. Straits Times (1998). May 15, p. 52. Vernon, R. and Aharoni, Y. (1981). State-Owned Enterprise in the Western Economies, St. Martin Press, New York, USA. Woon, W. (1997). Company Law, Pearson Professional Asia Pacific, Singapore.

9 Chaebols and Corporate Governance in South Korea Francis C. Kim, Chung-Ki Min and Christopher Maden

9.1

Introduction

The Korean economy has been one of the success stories of post-war economic development. Starting from the ashes of Korean War as a typical developing nation with per capita income of less than US$100 in 1960s, Korea transformed itself to a fast-paced industrializing economy and rose to become, by 1996, the eleventh-largest economy in the world with a per capita income of more than US$10,000. Essential features of the so-called Korean model of economic development are an export-led industrialization strategy, authoritarian rule, and a cultural emphasis on education and hard work.1 The key element in the successful progress can be credited to the successive five-year economic development plans which started in 1962 under Park Chung Hee. The first five-year economic development plan (1962–66) was to lay a foundation for industrialization. It initiated and accelerated a structural adjustment of industry from subsistence agriculture to modern manufacturing and export trade. During the second stage of the economic development plan, the government continued the expansion of mostly labor-intensive export industries. The annual growth rate averaged 10% and exports reached US$1,068 million in 1971. Agriculture made up only 31.1% of the Gross Domestic Product (GDP) in 1970 (down from 41% in 1965) while the proportion of industrial production increased from 24.1% in 1965 to 28.4% in 1970. The most important sector continued to be the food and beverage industry, accounting for 29.3% of the total manufacturing output in 1970, followed by the textile and leather goods industry (20.8%), chemicals (18.1%) and metal products/machinery (14.4%). Heavy industry made up 33.5% of the industrial production. 177

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The third five-year economic plan (1972–76) focused on internal and external structural adjustment. The heavy materials and chemicals industries (HCI) were targeted as the most important industrial sectors while more labor intensive industries were threatened by increased competition from other developing countries. The government turned to the private sector for these, arranging lines of credit for the favored companies that developed into today’s Chaebols. In July 1973, the construction of the iron and steel works in Pohang City was completed, followed by the inauguration of the first nuclear power plant in 1978. Thanks to the government-led economic development plan, which depended heavily on export-oriented policies, Korea had enjoyed an average annual growth rate of 8.6% over the past three decades and, in less than two generations, had established itself as one of the world’s leading shipbuilders and manufacturers of electronics and semi-conductors. When the government implemented the development plans, it provided large firms with capital at low interest rates through nationalized banks. It induced firms to grow, and the firms obliged by using cross-holdings and borrowing as much money as possible using crossdebt guarantees. As a result, several large conglomerate firms (called Chaebol) established themselves, but with huge, government-subsidized debt. The high debt-equity ratio itself does not cause a problem if firms yield higher rates of return than the interest rates of debt. However, after 1981 the interest rates increased substantially. As the market opened during the 1980s, the Chaebols’ comparative advantage began to erode and the resulting decline in exports sharply reduced their profitability. In addition, Chaebols’ poor corporate governance did not encourage firm managers to maximize firm value, and could not monitor controlling shareholders’ expropriation, thereby allowing low profitability to persist for long (Joh, 2003). This weakened debt-servicing capability of Chaebols worsened the ratio of non-performing loans, weakening the financial institutions. The Korean economy, therefore, struggled due to difficulties in the Chaebols and financial institutions, which came to the surface in the Asian crisis. In December 1997, Korea and the International Monetary Fund (IMF) reached an agreement on a financial aid package totaling US$58.35 billion. With a particular focus on the Chaebols, this chapter explains how poor the corporate governance of the financial and corporate sectors was; how that contributed to the financial crisis, and what improvements have been made since then. In addition, it introduces some empirical results on evaluation of the financial and corporate restructuring.

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9.2 9.2.1

Corporate governance in Korea: pre-crisis Financial sector

The nation’s financial sector, and in particular the banking sector, had been operating on inadequate capital bases without adequate risk management. Heavy non-performing loan problems and overexposure to risks without proper hedging became major structural weaknesses. The Korean government directly controlled the nation’s financial system and used it for facilitating exports and industrialization. Commercial banks in Korea were supposed to be commercial enterprises, but were so protected that, in fact, no major financial institutions in Korea went bankrupt before the financial crisis of 1997. The total borrowed from abroad by the end of November 1997 amounted to US$161.8 billion of which more than 60% was short-term debt with a maturity of less than one year. On the other hand, more than 83% of total outstanding loans for Korean financial institutions were longterm lending with maturity of more than a year. As Korean financial institutions made short-term borrowings from abroad for long-term projects, Korea became more vulnerable to a withdrawal of international lenders.

9.2.2 Corporate sector Chaebol economy Chaebols are conglomerates of many companies clustered around one holding company.2 Similar to the “Keiretsu” in Japan, Chaebols were given monopolistic access to resources, tax benefits, special bank credits, low interest rates, and preferential licenses for import and export in order to fuel economic growth. This policy was implemented during the third economic plan (the HCI period), and differed from previous policies in that only selected, specific companies were given access to these benefits. These firms prospered enormously and evolved into today’s Chaebols. The top four super Chaebols – Hyundai, Samsung, LG and Daewoo (Nam et al., 2001) – had sales that accounted for about 40% of Korea’s Gross National Product (GNP) in 1997. They differ from keiretsu, however, in being often run by one family. In many cases, they have yet to pass out of the founder’s hands. This led to very high concentrations of ownership. While individuals own some 40% of listed shares, Nam et al. (2001) also found that 68% of those investors owned less than 500 shares, accumulating to less that 3% of the market. Five per cent of investors, conversely, controlled

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82% of the market, and this figure represents the families that control the Chaebols. Nam et al.’s (2001) estimate that, with an ownership of 10% sufficient to establish control, 67.9% of listed companies can be considered family-held. Ten percent is a very small shareholding with which to control a large empire: the families that control the Chaebols therefore reinforce these small holdings by using a system of cross-holding similar to the Japanese Keiretsu system. While the Korean Commercial code does impose limits on direct cross-holding – a subsidiary may own no more than 40% of its parent – there are no restrictions on the extent to which A and B can own each other through company C. This is called “pyramiding” and, according to the Korean Fair Trade Commission, the proportion of shares owned in this way has held steady at around 43% for most of the period from 1990 to 1997. Some measure of the extent to which this device is used can be gauged from the fact that, in 1997, the top 40 Chaebol consisted of a total of 671 separate companies. The financial crisis can hardly be said to have changed this pattern: Wong (2003) found that 43 of the top Chaebols consisted of 728 companies. In the case of Samsung, the controlling family of which owns 4%, but controls 46%, of its shares. When ownership of shares by other parties cannot be avoided, it can be neutralized. In 1997, some 20% of the Chaebol’s stock was held by banks and other financial institutions. However, regulations were arranged so that the banks’ votes did not count, which left them with little interest in the governance of these groups. Furthermore, most were affiliates of the Chaebol, so they preferred not to rock the boat. With as much as 5% of a Chaebol owned by the controlling family, a further 43% (Wong, 2003; Chung and Wang, 2001) controlled by them, and 20% not allowed to vote, the remaining shareholders were subject to frequent expropriation. The most common form of this was in the form of loan guarantees between companies within the groups. Company A would guarantee a loan for company B and, when B went bankrupt, the shareholders of company A were left with the tab, in effect leaving shareholders to bank-roll the parts of the group that lost money, while the controlling families enjoyed the profits of the parts that made money. Bae et al. (2002a) further examined whether Chaebols benefited from acquisitions and showed that minority shareholders of Chaebol firms making acquisitions typically lose from the acquisitions, but the controlling shareholders of these firms gain from them. Given this form of inverse socialism, it is perhaps not that sur-

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prising, then, that the proportion of the population owning shares fell from 5% to 2.9% between 1990 and 1997 (Nam et al., 2001). Individuals, however, were not the only ones to lose out. In the 1972 oil crisis, high interest rates, a sluggish domestic economy, and the world slump, took many businesses to the wall. The government was forced to announce emergency measures that included low-interest loans to banks, and the forgiveness or re-scheduling of many debts. A similar massive bail-out in the early 1980s reinforced the impression that Korea Inc. was not about to let any of its banks or business go broke. In the absence of this ultimate market discipline, the external pressure needed to foster the creation of a culture of corporate governance was never created.

Corporate governance The issue of corporate governance has focused on the rights of shareholders, the treatment of stakeholders, disclosure and transparency and the duties of board members. Shareholder rights have to be protected, and shareholders should be able to exercise their rights through proper procedures. Gompers et al. (2003) found that firms with stronger shareholder rights had higher firm value, higher profits, and higher sales growth. In their research, an investment strategy that bought stocks of firms within the decile of the strongest democratic rights and sold those within the decile of the weakest rights would have earned abnormal returns of 8.5% per year during the sample period of 1990 to 1999. The directors and the board must perform their duties faithfully in the best interests of the corporation and its shareholders. However, in Korea, important corporate management decisions were usually made by the board of directors (BOD) in the best interests of the controlling family, with little input from shareholders: Chief Executive Officers (CEOs) are usually the chairman of the board, and the directors are normally senior managers. To make matters worse, outside directors have not been able to independently participate in these decisionmaking processes, nor to supervise and support the management as the board members. An especially pernicious institution was the “planning and coordination office” or “chairman’s office”, which were “legally informal” (Chung and Wang, 2001) entities that served as the personal courts of the “group chairman”. These were paid for by the subsidiaries, staffed by personnel of the subsidiaries, usually headed by a person with the rank of company president. The function of these entities was to devise

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group strategy – presumably the identification of which group of shareholders to fleece next.

Regulatory framework This woeful situation was underpinned by the Commercial Code (CC) which, together with the Securities and Exchange Act (SEA), Act on External Audit of Stock Companies and the Listing Rules constitutes basic laws regulating corporate conduct. As a former colony of Japan, which itself modeled its code on the German one, Korea does resemble the continental system; however, the differences are considerable, the main one being that, unlike the German and Japanese models, the Korean one has a single board. A minimum of three directors are required for companies with a total capital of more than W500,000, and are voted for a term of three years at a shareholders’ general meeting. Directors can be removed with a vote of 3% of the shareholders (5% prior to changes brought on by the crisis). The CC mandates that directors are to abide by the law, and by the company’s articles of incorporation; and also to keep secret the knowledge that they gain. Furthermore, a person who instructs a director is, under the new regulations, liable as if he were a director. Finally, by Presidential Decree with some exceptions, a minimum of a quarter of the directors must be non-executive. Directors are proposed by the nomination committee. In addition to this, since 1997, companies have been required to have audit committees. These consist of at least three directors. The chairman is required to be a non-executive director, and no more than one third of the committee’s members may be insiders. Perhaps surprisingly, the regulations governing audit are quite detailed. Root (1996) credits this to Park Chung Hee, the architect of modern Korea, who had a firm belief in making government policy decisions on the basis of accurate numbers. Shareholders’ meetings can be convened by a 3% shareholding (5% prior to the crisis), or 1.5% for companies having a capital stock of more than W100 billion. Proposals likewise may be made by shareholders having a cumulative holding of 3% (formerly 5%), and who have held those shares for at least six months. That percentage is 1% for listed companies, and 0.5% for large listed companies as defined above. Proxy voting is permitted under the code. The CC does not, however, stipulate the voting procedure.

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Prior to 1998, financial institutions – as stated previously – “were required to vote with other investors except on some important corporate issues like Mergers & Acquisitions (M&As)” (Nam et al., 2001). Under this rule, financial institutions could not credibly control and monitor the existing management. With a lifting of this regulation in September 1998, financial institutions now are able to take a more active role in corporate governance. Korea has two stock exchanges, with the Korea Stock Exchange (KSE) being the largest by far and Korean Securities Dealers Automated Quotations (KOSDAQ) being the smaller. Any company with a threeyear history, W5 billion of capital, W10 billion of equity, and W15 billion of sales, may apply for listing on the KSE. The requirements for KOSDAQ (modeled on NASDAQ) are more relaxed. While these markets did bring liquidity to Korea’s financial system, the government did not regard them as a mechanism for introducing market discipline. M&As, in particular, were basically rendered impossible by a web of legislation that, although intended to reign in the Chaebols, in fact made them impregnable. The Monopoly Regulation and Fair Trade Act (or Fair Trade Act), passed in 1980, was an attempt to reign in the power of the Chaebols. Like most half-hearted legislation, it made things worse, imposing successive restrictions on ownership that did nothing to loosen the control of the owning families, and everything to make it impossible to work out who they were. Although the 1980 Act had nothing targeted specifically at the Chaebols, the first wave of amendments in 1986 outlawed direct cross-holdings (hence the indirect holdings used), and holding companies. In place of the latter, a rather curious hybrid, the operating holding company, was created. Their investments in other companies were not allowed to exceed 50% of their assets. Limits were also placed on the stakes that banks and insurance companies could hold. The Capital Market Development Act of 1968, the Act to Expedite the Going Public of Corporations of 1972, and subsequent piecemeal amendments to this securities legislation did nothing to relieve the confusion. Any purchase that would result in a person holding more than 25% of a listed company obliged that person to acquire 50%. Before he got that far, however, he would already have fallen victim to the “5% rule”, which obliged anyone who was not the founder of a company, but whose shareholding had reached 5%, to make subsequent purchases by tender. Intended to prevent takeovers, the cumulative effect of this legislation was to force owners to conceal their

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ownership. The unnatural effect of this can be gauged by the fact that, after the whole lot was rationalized in the wake of the Asian Crisis, the family owning the SK group purchased 25% of SK Securities (Nam et al., 2001). That rationalization was forced by the financial crisis, in which reconstructing the insolvent financial and corporate sectors became a top polity priority. Among various measures for corporate restructuring, M&As received much attention because it was believed that they restructure firms in a more market-driven way, and are therefore more efficient than other government-led restructuring programs. Accordingly, the Korean government removed many M&A-related regulations since 1997. Anyone is now free to acquire more than 10% of a listed company’s stock. In May 1998, the investment ceiling imposed on foreign ownership of listed companies was abolished. In February 1998, the Labor Standards Law, which was perceived to be the biggest stumbling block to M&A activity, was overhauled to allow firms in financial difficulties and involved in M&A transactions to dismiss their employees (Choi, 2003). Korea has two codes on insolvency: the Bankruptcy Act for liquidation, and the Company Reorganization Act and Composition Act for protection from creditors. In addition, a procedure called an “informal workout” was available if the creditors were willing to be more flexible. In the first 34 years of its life, however, only 26 petitions were made under the Composition Act. Similarly low numbers of petitions were received under the other acts, until, of course, the collapse of 1997, which saw 1000% increase in the number of petitions – brisk business (see Table 9.1). This jump in the volume of bankruptcies forced the government to overhaul these acts, which had been criticized as time-consuming and expensive. Responding to these criticisms, the Korean government Table 9.1 Year 1994 1995 1996 1997 1998 1999

Number of Cases under Insolvency Laws Bankruptcy 18 12 18 38 467 733

Source: Bank of Korea.

Composition – 13 9 322 728 140

Reorganization 68 79 81 151 65 37

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amended the insolvency acts in February 1998 and again in December 1999. Important elements in the amendments are (Kim, 2003): (i)

The criterion for rehabilitation was previously consideration of public interest. This was replaced by an economic efficiency test: to be qualified for judicial insolvency procedures, the value of a going concern must exceed its liquidation value; (ii) To provide the courts with experts’ advice, a committee is established, composed of accountants and lawyers experienced in corporate reorganization; (iii) To speed up proceedings, time limits were introduced for critical steps in the proceedings; and (iv) Large firms with complicated capital structures are not allowed to enter composition. The composition proceeding was originally intended for small firms, but many large firms were allowed to file for composition around the crisis. In addition to the formal insolvency proceedings, a procedure called an “informal workout” was introduced in July 1998 for cases in which the creditors are willing to be more flexible and to negotiate rescheduling or restructuring. If the creditors representing more than 75% of a firm’s financial obligations approve the debt restructuring plan, it becomes binding for all creditors. During the crisis, most workouts were applied to medium-sized Chaebols, and more than 200 financial institutions signed ‘Corporate Restructuring Agreements.’

Accounting standards Accounting standards are set by the Korea Accounting Institute, and are based on the International Accounting Standards (IAS), supplemented first by the Generally Accepted Accounting Principles (GAAP) and, when that fails, home grown standards. The result is a standard consisting of 91 articles. While these are generally in line with international standards, there are important diversions in the areas of consolidated accounts and joint-venture accounting which, given the dominance of Chaebols, does rather undermine the effort. In an Asian Development Bank (ADB) survey referred to by Chung and Wang (2001), 49% of respondents confessed that they did not follow international standards at all, while a mere 10% had followed all international standards. The government is attempting to tackle the problem, and in January 1999 established separate standards for the combined financial

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statements for the 30 largest Chaebols designated by the Fair Trade Commission (Nam et al., 2001). The major elements are: (i)

Combined financial statements are to consist of combined balance sheets, income statements, and cash flow statements. Statement of changes in equity is to be disclosed in a footnote. (ii) The combined financial statements are prepared under the assumption that Chaebol affiliates under the common control constitute a single economic entity. Therefore, intragroup balances, intragroup transactions, and resulting unrealized profits and losses are eliminated in preparation of the combined financial statements, unless they are immaterial. The principle of “substance over form” is used in identifying intragroup transactions. (iii) The Standards require footnote disclosure of intragroup transactions, including intragroup ownership interests, cross guarantees, cross pledging, intragroup borrowings and intragroup sales. Especially, information useful for estimating the overall risk of a given Chaebol is provided in a matrix form showing relevant parties and amounts of intragroup transactions.

Auditing standards The CC requires at least one internal auditor to be elected at a shareholder’s meeting, with the vote of the largest shareholder to count for no more than 3% in such an election. Although in keeping with Park’s own integrity and his faith in using numbers to allocate funds (Root, 1996), most internal auditors were in fact appointees of the chairman, and dependent on him. Chung and Wang (2001) argue, moreover, that the internal auditor in the Korean system was inferior in power to his Anglo-American and German counterparts because his position was that of a monitor. Without the power to hire and fire managers, and without actually being a member of the board, the internal auditor could easily be marginalized. Combine this with the fact that the external auditor was appointed by the board, and the internal auditor becomes ornamental.

9.3 Financial crisis in Korea There are many differing explanations of the causes of financial crisis in Korea, but liquidity shortage has been believed to be a major cause. This liquidity shortage resulted from Korean financial institutions and Chaebols’ excessive borrowing of short-term hedge funds abroad and

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long-term investments. That was in turn, caused by structural weaknesses in banking and corporate governance. When Korean financial markets were liberalized early in the 1990s, foreign investors thought that stock prices in Korea were generally undervalued, considering the high interest rate of 12–13% in Korea and overall good economic performance. As a result, foreign portfolio investment, starting from almost insignificant amounts before 1990, increased rapidly and the cumulative total from 1991 to 1996 was about $48 billion. The Korean Stock Price Index (KOSPI) jumped from 400s to 1100s during that time.3 Financial Institutions and Chaebols took advantage of the liberalization of the capital markets. They took low-cost short-term loans abroad for long-term investments. Foreign creditors inevitably became concerned about Korea’s short-terms debts and eventually, started withdrawing their investments by selling stocks and bonds. The resulting capital flight drained the foreign exchange reserves of the central bank. While it would be going too far to say that contagion by the Asian Financial Crisis (AFC) was the cause of subsequent collapse, it did exacerbate it, and so exposed the structural and institutional weaknesses in the Korean economy. Hence, the IMF loan was made contingent on certain structural adjustments in the financial system as well as the corporate sector. In fact, the IMF conditionality helped the Korean government to the extent that they de-politicized some of the most politically sensitive reform areas, such as labor and Chaebols and, indeed, Korea has been successful in seizing the moment to turn the national misfortune into an opportunity for necessary reforms.

9.4 Corporate governance developments in Korea The Korean government tried to introduce a comprehensive strategy for structural reforms, designed to re-capitalize the financial sector while making it more transparent and market-oriented. The IMF also recommended that corporate governance should be restructured towards a more prudent management and a healthier relationship with the financial system. The major contents of the structural reform included: 1. greater independence of the central bank with the aim of promoting price stability; 2. establishing a consolidated supervisory body with jurisdiction over all financial institutions;

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3. requiring large conglomerates, Chaebols, to disclose audited and consolidated financial statements; 4. limiting the practice of cross guarantees among Chaebol member companies for loans from financial institutions; 5. easing M&As for both domestic and foreign firms; 6. further opening the financial market to foreign participation; and 7. legalizing layoffs of employees in case of merger, acquisition, and corporate restructuring.

9.4.1 Financial sector Financial supervisory service The Korean banking system has been troubled by a lack of independence from the government, a lack of accountability to shareholders, and lax regulatory regime. Problems in the banking system were made more serious when banks’ clients experienced severe difficulties. Bae et al. (2002b) found that adverse shocks to banks had negative effects not only on the value of the banks themselves but also on the value of their client firms. To remedy these institutional defects and unhealthy practices the government needed to change laws and regulations and set up a new supervisory body. The Financial Supervisory Service (FSS) was officially established by the Act on the Establishment of Financial Supervisory Organizations on January 2, 1999, as a special corporation with no capital. The FSS was created by integrating the four previously existing supervisory bodies – the Banking Supervisory Authority, Securities Supervisory Board, Insurance Supervisory Board and Non-bank Supervisory Authority – into a single, consolidated organization. The major functions of the FSS include the supervision, examination, investigation, and enforcement of financial institutions as well as other matters delegated by the Financial Supervisory Commission (FSC) and the Securities and Futures Commission (SFC).4 In addition to the establishment of the FSC, significant, structural changes were made to the regulatory environment. Ownership restrictions of banks were relaxed, while supervision was extended to owners of significant stakes. Restrictions on class-action suits by minority shareholders were eased. In practice, the FSS was forced to go beyond the boundaries of traditional supervision from the very beginning, and act as caretaker for the entire financial system. In the aftermath of the 1997 financial crisis, which brought about a chain reaction of corporate bankruptcies,

Francis C. Kim, Chung-Ki Min and Christopher Maden 189

rapidly deteriorating loan assets, and a near-collapse of the financial system, the FSS simply had no choice but to assume this role. In pursuit of this, the FSC was given sweeping powers. The Act Concerning the Structural Improvement of the Financial Industry gives it the power to write-off the equity of a shareholder it deems responsible for causing a loss. It can impose civil and criminal sanctions on the directors, and can furthermore impose claims for damages not only on those responsible for the insolvency, but on the auditors and supervisory bodies that neglected to identify the problem. Using massive public funds, the government then took over distressed loans, covered depositors on behalf of failed banks, injected new capital into financial institutions, and demanded business mergers, downsizing and closures.5 The financial reform efforts were primarily directed towards eradicating past legacies of non-performing assets, and restructuring financial institutions. As of 2000, the number of commercial banks had been reduced to 17 from 27 and their staff was slashed by one-third. Of the 30 merchant banks and 31 investment trust companies operating in 1997, 19 and seven have been either closed or merged, respectively. Sorting out a mess is one thing; avoiding it in the future is another. To help ensure that history will not repeat itself, capital adequacy standards have been simplified, disclosure standards raised to IAS levels and made twice-yearly (formerly annual), with particular attention paid to load classification with the aim of identifying bad debts sooner. A three-step corrective system has also been devised for institutions that are showing signs of distress. However, despite huge progress in this area, the actual enforcement is still weak. Wong reports that, during 2000 and 2001, only two cases of suspension and four of reprimand and nine of other punitive actions were reported.

9.4.2 Corporate sector Policies against Chaebol The Chaebol system has been evaluated as a cornerstone of early economic development; however the Chaebols also played an important role in causing the financial crisis. The government imposed five rules for Chaebol reform: 1. capital structure improvement; 2. business consolidation into core competence areas;

190 The Governance of East Asian Corporations

3. elimination of cross-debt guarantees; 4. enhancement of management transparency; and 5. improvement of management accountability. Later, the government added three more rules: 1. reduction of indirect cross ownership; 2. prevention of anti-competitive intra-group transactions and unlawful insider trading; and 3. prevention of the evasion of inheritance and gifts taxes. Among these issues, the core issue in capital restructure is to make the Chaebols reduce their debt-equity ratios from the current average of more than 400% to 200%. This has been agreed in principle between the Chaebols and their main banks. Under this agreement, the Chaebols were required to sell off some of their member companies as well as real assets, including land. In 2000, the average debt-to-equity ratio for the nation’s manufacturing sector as a whole was down to around 240% from 400% (1997), with the ratio of the top 30 Chaebols declining to around 164% from 300% (1997). In order to improve the capital structure, the cross-debt guarantees totaling 10 trillion won – or about 30% of all such guarantees among the top 30 Chaebols – were terminated by the end of March 1998, and new cross-debt guarantees were prohibited in 1998. To enhance the real competitiveness of Chaebols, they were also encouraged to concentrate on their core-competence areas by spinning off their non-core business units. For example, Samsung is giving up its automobile unit to Daewoo and taking over Daewoo’s consumer electronics unit. LG is giving up its semiconductor unit to Hyundai. The top 5 Chaebols (Samsung, Hyundai, Daewoo, SK, and LG) sold 549 companies during 1998 and the first half of 1999.6 During the restructuring process, there were some notable changes in the corporate sector. Among the top 5, Daewoo collapsed and Hyundai affiliates were divided among the sons of the founder. Some groups had the founder-head of the group step down and their offspring take over. Nonetheless, the Chaebols continued to be a major force in the Korean capital market.

Corporate governance A good direction was needed for better corporate governance to render companies more credible, domestically and internationally, and en-

Francis C. Kim, Chung-Ki Min and Christopher Maden 191

hance transparency and efficiency of the management. The year 1998 saw major overhauls in a number of important areas. The takeover and listing codes were simplified and rationalized. Holding companies were legalized and restrictions on foreign ownership swept away. Cross-guarantees of debt between member subsidiaries of Chaebol were outlawed, and credit institutions prohibited from requiring guarantees from affiliates when they extended new loans. The 30 largest Chaebols were required to present “combined” financial statements (Chung and Wang, 2001) as a first step to consolidated accounts. Listing rules were amended to require independent directors. At least a quarter of the board must have no ties with owning family, and no business of substance with the company. Annual reports must disclose the frequency of board meetings and the attendance of independent directors. Internal auditors are now required to be full-time and listed firms are recommended to have outside auditors. Furthermore, the external auditor is to be appointed by a committee consisting of the internal auditor, independent directors, and creditors. The code of best practice recommends an audit committee, and the Securities and Exchange Act has recently been amended to require one for companies with total assets exceeding W2 trillion. In March 1999, the Korean government established the Committee on Corporate Governance (CCG) to treat problems on corporate governance. The Committee was composed of 14 members from the fields of business, finance, accounting, law and academia, along with an Advisory Group of 13 law, securities, and financial specialists. The CCG developed Code of Best Practice to guide corporations in establishing proper corporate governance structure, and requested corporations to follow it. The Committee endeavored to inform all related parties of the development of the Code of Best Practice and tried to gather a wide range of opinions from individuals and institutions in the related areas. The Committee also attempted to take into consideration the unique managerial circumstances faced by Korean corporations, and to include in the Code the principles and standards that are the internationally governing practices for corporations. However, industry sectors such as the Federation of Korean Industries (FKI)7 were dissatisfied with the Code of Best Practice, insisting the Code is too far from the real business world to apply. The purpose of the Code was to maximize corporate value by enhancing the transparency and efficiency of corporations for the

192 The Governance of East Asian Corporations

future. The contents of the Code consist of five sections of recommendations: Shareholders, BOD, Audit Systems, Stakeholders, and Management Monitoring by the Market. Important improvements have been made in many areas such as: • the protection of minority shareholders’ rights; • the appointment of external board members; • more transparent corporate decision-making process by disclosing important materials to shareholders, creditors and other interested parties; • more independence of auditors and supporting sufficient information; • participation of interested parties in corporate governance; • monitoring BOD for better performance on their duties; and • corporate financial status. Even with formal institutional reforms, however, the unique corporate culture which existed for many years is not expected to change within a short-time span. Chaebols, not without a certain irony, have embraced the new order by re-branding their “planning and co-ordination offices” as “re-structuring offices” – which they refuse to close. Therefore, continued institutional reforms and a stronger implementation of reform policies are required to upgrade the nation’s corporate governance to the global standard.

9.5

Evaluation of recent developments

IMF Directors noted that Korea’s economic performance was impressive with high growth, low inflation, and a decrease in unemployment. Furthermore, Korea was praised for laying the groundwork necessary for future growth. Substantial progress was achieved during the 3-year IMF standby arrangement, most notably, the IMF pointed to Korea’s success in two fundamental areas: the sharp improvement in macroeconomic fundamentals resulting in the economy’s ability to better withstand external shocks, and the structural reforms that made the economy “more open, competitive, and market driven”. After the crisis, which led to a record low –5.8% of GDP growth rate, the rate recovered to 10.9% in 1999 (9.3% in 2000), although it dropped to 3.0% in 2001. Unemployment rate peaked at 6.8% in the beginning of financial crisis but decreased to 4.1% in 2000. The loan from the IMF was paid back earlier than scheduled, and foreign

Francis C. Kim, Chung-Ki Min and Christopher Maden 193

reserves increased from US$8.87 billion in late 1997 to US$96.2 billion in late 2000 (US$102.8 billion in 2001). Table 9.2 also shows improvements in other economic indicators such as non-performing loans and debt-equity ratio. In the process of overcoming the 1997 financial crisis, the Korean government made every effort to address accumulated fundamental economic defects in the financial and corporate sectors. The goal was to transform a government-led system of economic growth into a market-disciplined system. To do this, the government tried to enhance transparency and accountability, thereby allowing market discipline to work more efficiently. With this strategy in mind, Korea focused its attention on restructuring the corporate, financial, public, and labor sectors. With an injection of public funds and significant restructuring, the financial sector has grown healthier. During the restructuring, 631 non-viable financial institutions were shut down while the Korean government pumped approximately 157 trillion won of public funds into other ailing institutions. The speedy and resolute settlement of bad loans reduced nonperforming loans in the banking sector from 61.0 trillion won at the end of 1999 to 18.8 trillion won by the end of 2001 (Table 9.2). To ensure no recurrence of a similar financial crisis, the government has since been implementing policies which guarantee independent and responsible management. In addition, by adopting advanced corporate credit risk evaluation standards and additional responsibility for credit decisions, financial institutions are more soundly supervised. However, Wong (2003) reports that only two cases of suspension, four of reprimand and nine of other punitive actions were reported during 2000 and 2001. Thus, stronger enforcement of the reform plans is desirable. In the course of corporate restructuring, the ‘too-big-to-fail’ myth was discredited and even large enterprises were allowed to fail if they Table 9.2

Economic Indicators

GDP growth (%) Foreign reserves (US$ billion) Non-performing loans (trillion won) Debt-equity ratio (%) (Manufacturing sector only) Source: Ministry of Finance and Economy.

1998

1999

2000

2001

–6.7 48.5 –

10.9 74.0 61.0

9.3 96.2 42.1

3.0 102.8 18.8

303.0

214.7

210.6

182.2

194 The Governance of East Asian Corporations

were not competitive. The government policies aimed at the Chaebols have improved their financial structures and profitability by having the Chaebols concentrate on core competence areas rather than expansion. Rules for obligatory publication of combined financial statements and for appointment of outside directors are expected to result in transparent and responsible management. Debt leverage improved dramatically through large scale capital increases, while cross debt guarantees were completely eliminated by the end of 2000. The top 70 Chaebols reduced the debt leverage at a more rapid pace than non-Chaebols: the ratio of total borrowings to total assets for the Chaebols decreased from 55% in 1997 to 28% in 2002 while the ratio for non-Chaebols decreased from 48% in 1997 to 32% in 2002. However, there still exists a large number of financially weak firms as measured by the interest payment coverage ratio (IPCR). As can be seen in Table 9.3, the total number of firms with IPCRs of less than one reached 1,957 in 2002, accounting for 25.2% for all the sample firms, even though the economy was in a boom in that year (Kim, 2003). If IPCRs of less than one continue for several consecutive years, the firms will face severe credit crunches. From 2000 until 2002, Table 9.3 Firms with Interest Payment Coverage Ratio (IPCR) below 1 (unit: Number of firms, trillion won) IPCR<1 2002

Top 70 Chaebols

NonChaebols

No. of firms Borrowings No. of firms Borrowings No. of firms

Total Borrowings

Two consecutive Three consecutive years (2001, 2002) years (2000, 2001, 2002)

113 (21.1%) 19.5 (17.5%)

76 (7.1%) 14.8 (13.3%)

51 (10.5%) 8.7 (7.8%)

1,844 (25.6%) 44.2 (32.8%)

995 (13.8%) 31.8 (23.6%)

499 (6.9%) 14.9 (11.0%)

1,957 (25.2%) 63.7 (25.9%)

1,071 (13.8%) 46.6 (18.9%)

550 (7.1%) 23.6 (9.6%)

Note: Figures in parentheses indicate the share of firms and the share of total borrowings in each group. Source: Kim (2003, p. 65, Table 3–4).

Francis C. Kim, Chung-Ki Min and Christopher Maden 195

550 firms (or 7.1% of all the sample firms) recorded IPCRs of less than one for three consecutive years. The proportion of such firms is higher in the top 70 Chaebols (10.5%) than in non-Chaebols (6.9%), indicating that the financial structures and profitability of many firms, especially of the Chaebols, are still insecure. Since the crisis, the government has reformed laws associated with corporate governance, especially for the Chaebols: adopting advanced accounting standards, mandating outside directors and audit committees, strengthening the responsibility of majority shareholders, strengthening minority shareholders rights, etc. However, problems with the Korean Chaebols are not only institutional, but also arise from unique features of the Korean society. Thus, legislation reforms alone might not be sufficient to eliminate the Chaebols’ problems. Nonetheless, with these changes, it would appear that corporate governance and management transparency have improved. The number of professional managers and foreign CEOs increased and stiffer penalties for irresponsible management practices resulting in bankruptcy or insolvency were imposed. Increasingly frequent M&As involving domestic and foreign companies also helped improve the financial structures and managerial practices of these companies. Even with many improvements in the rights of minority shareholders, the actual exercise of their rights was very sluggish. Jang (2000) suggests that corporate governance does not operate as well as expected with the legislative changes. The controlling shareholders still have a significant influence on the corporate management. According to his survey of 465 listed companies, 343 companies (73.8%) appointed outside directors on the recommendation of the controlling shareholder. When appointed, an agenda approval rate of 99.3% by outside directors implies a rather less than active participation in board affairs. According to another survey, 61.4% of respondents evaluating the current accounting system said that it did not provide sufficient information, while only 7.7% responded affirmatively. In addition, Table 9.4 shows changes in the ownership structures of the top 30 Chaebols. Although the shares of family declined significantly after corporate laws were reformed, the total shares including the ones of their affiliates have remained unchanged.

9.6

Conclusion

Since the Korean War, the Korean economy was successful with the Chaebol system. Under the successive five-year economic develop-

196 The Governance of East Asian Corporations Table 9.4

Shares (%) of Stock Holdings in the Top 30 Chaebols

Year

Family

Affiliates

Sum

1995 1996 1997 1998 1999 2000 2001

10.6 10.3 8.5 7.9 5.4 4.5 5.6

32.8 33.8 34.5 36.6 45.1 36.6 39.4

43.3 44.1 43.0 44.5 50.5 41.1 45.0

Note: Family share is a sum of shares held by an owner and his or her family. Source: Korea Fair Trade Commission (2002).

ment plans, the Korean government implemented its strategies and successfully moved to the next step. Chaebols became the center of an export-led strategy. However, Chaebols also induced many problems in the Korean economy, and the corporate governance in Chaebol system was distorted by chain-ownership of its member companies. Shareholder rights were not properly protected. Most important decisions were made by BOD entirely controlled by owner-family members. After the financial crisis, the Korean government set up the CCG to monitor those problems. A new supervisory body FSS remedied distortions in the financial system and established strong policies against Chaebols. Labor was not reluctant to reduce their salaries and tried to be in line with managers. As seen in Section 9.5, the economy improved in major economic indicators as well as the corporate sector. However, while institutional reforms may have improved the form of corporate governance, the substance of Korea’s unique corporate culture has changed little. Until the owners of the Chaebols perceive the need for this change, prospects for improvements in corporate governance remain dim.

Notes 1. During the periods, the Korean government actively encouraged exports by giving preferential rights. Thus, the Korea’s export-led growth differed from other Asian economies such as Taiwan and Hong Kong. 2. Unlike Japanese “Keiretsu”, Korean Chaebols cannot own financial institutions in Korea by law. 3. The Bank of Korea, Economic Statistics Yearbook, 1997. 4. The FSC, established in 1998, has played a pivotal role in restructuring the financial and corporate sector since 1997. All financial institutions are sub-

Francis C. Kim, Chung-Ki Min and Christopher Maden 197 ject to the supervision of a single supervisory body, the FSC and its executive arm, the FSS. In addition, the SFC was set up under the FSC to oversee securities and futures markets. Its principle function is to investigate market abuses, such as insider trading and market manipulation in the securities and futures market. 5. IMF requested the Korean government to make public fund for structural reform of financial and corporate sectors. 6. The Korean government has allowed hostile takeovers since 1999. 7. Founded in 1961, FKI aims to develop the national economy efficiently, to achieve stronger industrial competitiveness, and to respond to the requirements of globalization. Its major activities include cooperation between small and big businesses, supportive programs for business abroad, international management exchange program, and recommendations for regulatory reforms.

References Bae, K., J. Kang and J. Kim (2002a). Tunneling or value added: evidence from mergers by Korean business groups. Journal of Finance 62: 2695–2740. Bae, K., J. Kang and C. Lim (2002b). The value of durable bank relationships: Evidence from Korean banking shocks. Journal of Financial Economics 64: 181–214. The Bank of Korea (1997). Economic Statistics Yearbook. Bank of Korea, Annual Report, various years. Choi, Y. S. (2003). The role of M&A in restructuring Korea’s distressed firms, in S. Claessens and D. Kang (eds), Empirical Evaluation of Corporate Restructuring, Ch. 5, 133–156. Chung, K. S. and Y. K. Wang (2001). Republic of Korea. In Ma. Virginita Capulong, David Edwards and Juzhong Zhuang (ed.) Corporate Governance and Finance in East Asia, A Study of Indonesia, Republic of Korea, Malaysia, Philippines and Thailand. Vol. II, Asian Development Bank. Financial Supervisory Service, Financial Statistics, various issues. Gompers, P., J. L. Ishii and A. Metrick (2003). Corporate governance and equity prices. Quarterly Journal of Economics 118: 107–155. Jang, H. S. (2000). Changes in the structure of Chaebol companies after the economic crisis, paper presented at the KDI seminar on Lessons from the economic crisis. Joh, S. W. (2003). Corporate governance and firm profitability: Evidence from Korea before the economic crisis, Journal of Financial Economics 68: 287–322. Kim, J. K. (2003). Assessment of progress in corporate restructuring in Korea since the 1997–98 crisis, in S. Claessens and D. Kang (eds), Empirical Evaluation of Corporate Restructuring, Ch. 3, pp. 47–92. Korea Fair Trade Commission (2002). Press Release on the 30 Largest Chaebols Ownership Structure. (www.ftc.go.kr). Ministry of Finance and Economy, Economic Issues, various issues. Nam, I. C., J. K. Kim, Y. Kang, S. W. Joh and J. I. Kim (2001). Corporate governance in Korea. Corporate Governance in Asia: A Comparative Perspective. OECD.

198 The Governance of East Asian Corporations Root, H. L. (1996). Small Lessons Big Countries, Governance and the Rise of East Asia. Asian Development Bank. Wong, C. R. (2003). Corporate governance in Korea. Standard & Poor’s Corporate Government Score.

10 Relationship-Based Business Enterprises and Recent Corporate Governance Reforms in Taiwan Ben-Hsien Bao, Chen-En Ko and Yin-Hua Yeh

10.1

Introduction

The impact of the Asian Financial Crisis (AFC) has made corporate governance an important policy issue for many countries in the Asian region and Taiwan is no exception. The government and business communities in Taiwan have been alerted by several corporate failures resulting from inadequate governance structures in the domestic financial market. Similar cases have also occurred in other markets and made it even more urgent for the government in Taiwan to do something about corporate governance (Backman, 2001; Ko et al., 2001; Wu, 2003a). Although the Securities and Futures Commission (SFC) in Taiwan has long developed laws and regulations governing corporate behavior and information disclosure, irregularities still occur. The lack of a comprehensive framework of corporate governance has made it difficult for the government to integrate various regulatory policies into a consistent approach in the past. The establishment of the Organization for Economic Cooperation and Development (OECD) corporate governance principles (OECD, 1999) provided a useful guideline for the government to review current corporate governance practice and act upon its improvement.

10.2

Legal framework

In Taiwan, incorporated shareholding companies fall into three categories: the ordinary companies, the quasi-public companies, and the listed companies publicly traded in the Taiwan Stock Exchange (TSE) or Over-The-Counter Stock Exchange (Gre Tai Securities Markets – a NASDAQ type market; GTSM). All companies are regulated by 199

200 The Governance of East Asian Corporations

the Company Law with quasi-public and listed companies further regulated by the Securities and Exchange Law. When a company is incorporated, it has to comply with the Company Law under the jurisdiction of the Ministry of Economic Affairs (MOEA). The Company Law provides the basic legal construct for incorporated companies. It specifies a two-tiered board structure along the lines of the German model, but with the modifications made by the former colonizer, Japan. The board is therefore two-tiered, with a directors’ board and supervisors’ board. The directors’ board is empowered to make important corporate decisions, while the supervisors’ board is the overseers of the directors’ board and authorized to take independent investigative actions individually. When a company reaches a certain size (capital of NT$200 million), it is required to file to become a quasi-public company. As such, it has to offer a certain percentage of shares for purchase by its employees even though it is not publicly traded. It also has to comply with the Securities and Exchange Law and related regulations under the jurisdiction of SFC, Ministry of Finance (MOF) (SFC, 2002). A quasi-public company satisfying the listing requirements of the TSE or Over-TheCounter Stock Exchange can apply for an Initial Public Offering (IPO) via these two exchanges and become listed. Quasi-public and listed companies, in addition to complying with the Company Law, have to comply with the Securities and Exchange Law and related regulations. The Securities and Exchange Law specifies additional requirements for information disclosure and provides a broad legal authority for the SFC to issue related regulations affecting the governance structure and behavior of quasi-public and listed companies as well as the intermediaries and other agents operating in the capital market. Although the SFC has jurisdiction over both listed and quasi-public companies, since quasi-public companies do not have their shares publicly traded, it generally focuses on the compliance of listed companies in the TSE and Over-TheCounter Stock Exchange. Laws other than the Company and Securities and Exchange Laws regulate specific corporate behavior. For example, Banking Law stipulates that no single shareholder can own more than 5% of the shares of a particular bank. It also stipulates that no single shareholder together with its related parties can have more than 15% of the shares. Related parties of a shareholder include the spouse, parents and children, brothers and sisters, as well as the business having the shareholder or his/her spouse as chairperson. These stipulations are to prevent a

Ben-Hsien Bao, Chen-En Ko and Yin-Hua Yeh 201

bank from falling into total control of a particular business group. Furthermore, for a financial holding company, when the shareholding of any shareholder or its related parties reaches 10%, 25%, 50% or 75%, the shareholder has to obtain approval from the regulatory agency each time a threshold is exceeded. The Commercial Accounting Law and the Accountants’ Law regulate accounting procedures and accountants’ conduct, and provide the legal infrastructure for transparency regulations. The SFC via its regulatory rules and interpretations, together with the accounting and auditing standards issued by the Financial Accounting Standards Committee (FASC) and Auditing Standards Committee (ASC) of the Accounting Research and Development Foundation provide a comprehensive disclosure system, although there is room for improvement. The listing requirements of the TSC and the OverThe-Counter Stock Exchange have additional requirements affecting the board structure and internal control systems. The most recently amended listing regulations require that the number of directors should be no fewer than five, and independent directors no fewer than two. The number of supervisors should be no less than three and at least one should be independent. In essence, therefore, Taiwan does have the legal infrastructure for a corporate governance regime that, in the view of Solomon et al. (2003), offers at least the same degree of protection to minority interests as the U.K. regime. Indeed, in some respects, more protection is offered: for example, article 32 of the listing requirements extends the liability for false or misleading information in a circular to employees, underwriters, accountants and attorneys; section 4 protects investors from insider trading. Nonetheless, Solomon et al. argue that although the framework outlined above “mirrors or exceed[s] those found in common law jurisdictions, a distinction must be drawn between legal formalism and cultural adherence, … the question remains as to the extent to which these have become entrenched in the attitudes and cultural norms of both investors and investee companies.”

10.3

Accounting and auditing regulations

Currently, accounting and auditing standards in Taiwan are mainly developed by the Accounting Research and Development Foundation (ARDF) established in 1984. The ARDF has two important standard setting committees: the FASC and the ASC.

202 The Governance of East Asian Corporations

10.3.1

Accounting standards

FASC is charged with the responsibility of developing accounting standards, guidelines, procedures, and practices in recording and reporting the accounting information in audited financial statements. By 2000, 31 standards had been developed with the intention of providing users with timely, relevant and accurate information (FASC, 1985–2000). In addition, the SFC requires both annual and semi-annual audits. The standards are closely aligned with the Generally Accepted Accounting Principles (GAAP), however, there are a number of areas where the levels of disclosure required by the standards are in need of review: 1. short-term assets and inventory are valued using the lower-of-costor-market value method, but fixed assets are valued at the cost of acquisition or construction, not the market cost; 2. the standards do not require mark to market accounting for securities and liquid assets; and 3. intangible assets such as patents can only be valued at the cost of registration, not at market value. In general, therefore, the value of the company’s assets recorded in the books will not be true and accurate. The disclosure of ownership is no more adequate. Although the SFC requires consolidated statements to disclose information on both subsidiaries and owners, this extends to neither non-listed companies nor to subsidiaries of subsidiaries (i.e. where A is a parent of B, B of C, and A holds shares directly in C). This, in combination with the very complex ownership structures of many companies, serves to undermine transparency of ownership. Recognizing these shortcomings, the government has taken a number of steps to improve the regulatory environment. Broadly speaking, these have brought the regime in line with international norms, with a particular focus on untangling ownership of banks by business groups, and on electronic means of disseminating financial information. The independence of the SFC has been enhanced, and its status within government raised.

10.3.2

Auditing standards

The ASC has a similar organizational structure with committee members including academics, practitioners and government officials.

Ben-Hsien Bao, Chen-En Ko and Yin-Hua Yeh 203

The ASC is charged with the development of standards and procedures for auditing, and other functions performed by public accountants. As of December 2000, it had issued 35 Statements of Auditing Standards. As capital markets in Taiwan have developed rapidly since mid1980s, existing disclosure requirements by the authorities intend to provide users with timely, accurate and relevant information. In addition to an annual audit, the SFC requires that corporate financial forecasts be reviewed by independent auditors and disclosed in a timely manner. The SFC regulations also require semi-annual financial statements be audited, not just reviewed by independent auditors. Although financial accounting standards are generally considered adequate for market participants, the increasing complexity of business organizations and transactions has created urgent demand to develop more timely authoritative accounting standards. For example, accounting for financial instruments, off-balance-sheet transactions, asset impairment, and financial restructuring for troubled companies all need further development. Also, the disclosure of cross-shareholdings is still not adequate for revealing the ultimate owners of public companies. Corporate failures since the AFC deepen the urgency in this respect.

10.4 Corporate governance mechanisms A sound corporate governance system includes several internal and external governance mechanisms, such as ownership by institutions, balanced composition of corporate directors, efficient markets for corporate control, transparent accounting disclosure system, etc. The existence of these mechanisms provides strong incentives for corporate managers to maximize shareholders’ interests in their pursuit of business profits. Indeed, empirical results (CLSA, 2002) showed that firms with high Corporate Governance (CG) scores have outperformed the market index (TAIEX) in 2001 and over a five-year period from 1997 to 2001. The top quartile CG stocks earned an average return of 31% while the TAIEX gained a return of 17% in 2001. For the 1997–2001 period, the top quartile CG stocks reported an impressive average return of 383% vs. a return of 15% earned by TAIEX (CLSA, 2002). Taiwan’s listed companies are characterized by a high degree of ownership concentration and are predominantly family-controlled. This is similar to the characteristics of those in most countries surveyed in this book – shareholders have fewer rights in Taiwan than in the U.S., but approximately the same number as the average of a group of

204 The Governance of East Asian Corporations

49 countries as reported in La Porta et al. (1998). Unlike more developed markets, such as the U.S., however, the presence of institutional ownership is relatively low and the market for corporate control is less active in Taiwan; hence a major concern is the expropriation of minority shareholders by large shareholders (Burkart et al., 1997; Claessens et al., 1999; Holderness and Sheehan, 1988; Shleifer and Vishny, 1986, 1997). A survey of the Top 100 companies shows that individual investors constitute the largest group of shareholders with 58.58%, followed by corporate investors of 17.7%, foreign institutional investors of 11.32%, other institutional investors of 7.68%, government of 3.17% and banking institutions of 2.33%. For family-controlled companies, the average shareholding by the largest family and its related parties is 23.74%. The banks show a different pattern of their shareholding. In this sector, individual investors have 42.36% of shareholding, corporate investors of 22.19%, and others the remainder. For those banks under family control, the shareholding by the largest family and its related parties is 29.03%. For the board of directors (BOD) of the top 100 companies, about 18.47% of shareholdings are owned by the executive directors, and 6.42% owned by non-executive directors. There is no audit committee, remuneration committee, and nomination committee as the current corporate governance regulations only recommend but do not require these committees be set up for listed companies (TSE and GTSM, 2002). For the top 100 companies, 90% retain Big 5 accounting firms as their auditors, with 10% being audited by non-Big 5 accounting firms. There is a requirement for the disclosure of compensation of corporate executives that includes salaries, bonus (cash and stock), automobile or housing subsidies. However, the stock bonus is disclosed at its face value, which may be quite different from its market value.

10.5 Obstacles and difficulties in improving corporate governance mechanisms There are several difficulties that hinder the improvement of corporate governance in Taiwan. They include pyramid and cross-shareholding ownership structure, lack of independence of directors and supervisors, inadequate separation of ownership and management, lack of major institutional investors, ineffective enforcement of law and an inactive takeover market.

Ben-Hsien Bao, Chen-En Ko and Yin-Hua Yeh 205

10.5.1

Ownership structure

Family-controlled companies dominate the corporate landscape of Taiwan. Su et al. (1998) find that 78% of listed companies in 1994–5 were controlled by one family or another, with an average holding of 27.4%. These already substantial holdings are further reinforced by pyramiding. Ko et al. (2001) describe the case of a family that owns, “through family members, affiliated foundations, a university [sic], investment and other companies, 29.12% of textile company E, 9.8% of a cement company F, 14.36% of department store G, 10.9% of a shipping company H and 10.31% of a chemical company I.E holds 24.97% of F while F owns 25.74% of E.” It is difficult to imagine what synergies arise between the textile and cement businesses so, rather than await the outcome of this innovative experiment, non-controlling shareholders tend to move on – and very quickly. Taiwan has by far the largest turnover of the markets surveyed in this book: trading volume in 1998 was the fourth in the world, and the turnover was nine times that of Japan’s. With the ownership controlled by powerful shareholders or their family members, these shareholders or their representatives are likely to serve as the chairpersons of the board with dominant executive authority. Although companies will also retain a capable management team for running the business, the owner/executives usually have dominant decision making power over key corporate decisions. When the divergence between cash flow right and control right becomes acute, the potential for expropriation increases. A uniquely Taiwanese form of this arises when the controlling family uses shares as collateral for bank loans. The amount of the loan is tied to the market value of the shares (typically 50%). If the market falls, the borrower must either top up his shareholding, or watch as his bank unloads his stock for him (further depressing its price). This provides a particularly acute combination of temptation and opportunity: temptation to inflate assets to maintain the share price, and the opportunity to use one listed company holding shares in a second one to borrow against those shares and have the minority shareholders pay when it all unwinds. In 1998, 12 companies had to file for suspension of trading for this reason. Given such easy access to other people’s money, it is perhaps not very surprising that most family owner/managers do not see the need for more disciplined governance systems even despite the many corporate failures that occurred during the AFC as a result of poor governance. The cost of establishing independent directors, the restraints that are placed on

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corporate decisions, limited availability of qualified persons, etc., are also perceived as difficulties in implementing and integrating corporate governance systems in family owned companies.

10.5.2

Institutional investors

Another characteristic is the lack of active major institutional investors in corporate governance. Ownership by foreign institutional investors is about 10.35% while domestic institutional investors own only about 1.82%. Both foreign and domestic institutional investors are more active in short-term trading than playing the role as a long-term shareholder. As a result, institutional investors are not effective in monitoring listed companies. Ownership by corporations or other juridical persons are mainly affiliated companies or private investment companies associated with corporate family members. Although the government has a policy to increase the role of institutional investors, their share of ownership is still too small to allow them to play an effective role in corporate governance. There are also a number of systematic obstacles. Regulations on the insurance industry, for example, place a limit on equity investment up to a certain percentage of their net worth; while government employee pension funds have restrictions over their investments, allowing only a minor percentage to be invested in stocks. Although mutual funds make their investments based on corporate performance, pension funds are directed by the guidelines in making their investment, usually with a more conservative approach. Most important, perhaps, mutual fund invested shares are required by securities regulations to cast their votes in favor of candidates or proposals recommended by corporate boards with the exception of when current corporate boards are not acting in the interest of the company or stockholders. With the insignificant ownership and enforced “default support” for corporate boards, mutual fund or pension fund investors are not able to play an active role in corporate governance. With institutional investors sidelined, and other investors who are predominantly transaction-driven, there is little external pressure on companies to improve their governance. This is very clearly reflected in the constitution of their boards.

10.5.3

Board independence

Although the two-tiered approach should provide some level of independence, the Company Law has no concept of the independent director. Indeed, as recently as 2000, board directors were in fact required to

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be shareholders before they could be elected as directors. This requirement was only recently amended in the Company Law to allow for non-shareholders to be elected as directors. Currently, the roles of independent directors and supervisors are being developed with more specific functions and legal liabilities. As things stand, however, the dominant family held more than half of the board seats in 57.6% of family-controlled companies (Su et al., 1998). This is reflected in both the supervisory and directors boards, leaving the former to perform a decorative rather than a functional role in most Taiwanese companies. Another notable feature is the large shareholdings of directors, estimated at 20.1% in 1998 (Su et al., 1998). In terms of protecting minority shareholders, therefore, the directors and supervisors generally take passive roles. There are, however, clear signs that the mood is changing. A recent survey (Solomon et al., 2003) of directors of listed companies found an encouraging awareness of corporate-governance related issues. There was strong support both for “international harmonization of corporate governance standards,” and for a much more active role for what the survey called “outside” directors. The same survey, however, showed that 65% of directors responded that “directors are selected by family members”. More tellingly, the survey does offer cause for concern that the motivation in improving corporate governance is not to improve shareholder value, but to encourage foreign investors to invest. If this is the mindset, there remains the danger that the implementation of reforms will be a matter of form over substance.

10.5.4

Ineffective legal enforcement power

Legal enforcement is another issue. It usually takes a longer than expected period of time to get court judgment for violators of securities related laws. A shortage of well-trained judges and efficiency in dealing with securities laws has delayed the completion of trials in such cases. The judicial branch has been criticized for not being responsive to the demand for quality and speedy trial and has taken steps to improve its efficiency. However, it requires additional resources and reform programs in the judicial branch to meet the increasing demand (SFI, 2003; OECD, 2003).

10.5.5

Absence of takeover market

According to a survey by Ko et al. (2001), takeovers occur rarely and only when there are internal conflicts between family owners or when

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major stockholders dilute their holdings through the market. An inactive takeover market limits the ability of the market forces to penalize inefficient management. Until recently, business culture and regulations did not encourage takeovers. Therefore, there is less market pressure for good corporate performance.

10.6 Recent corporate governance reforms in Taiwan The importance of corporate governance in the public and private sectors has been recognized since the AFC. The government in Taiwan has also taken major steps for its improvement and specific rules are being developed. The SFC, together with TSE, GTSM, and Corporate Governance Association (CGA), introduced a system of independent directors and supervisors, established and promoted Taiwan Corporate Governance Best-Practice Principles for business entities (Corporate Governance Codes in Taiwan), established an internet data filing system for publicly-held companies and an information disclosure rating system, and enacted the Securities Investors and Futures Traders Protection Law (which has been passed by the parliament in July 2002 and enacted on 1 January 2003), among others. A Taskforce for Reforming Corporate Governance was also established on 7 January 2003 by the Executive Yuan. Its report, titled “Accountability of Companies in Taiwan: Policy Agenda and Action Plan to Strengthen Corporate Governance”, was reviewed and passed by the Executive Yuan in November 2003. However, as the system of corporate governance is still at its developmental stage, the business community has not fully understood its importance and is, in general, less enthusiastic about corporate governance reforms than the government and shareholders. A small number of influential companies, especially in the high-tech industries, are taking the lead to implement good governance systems, which is hoped will set examples for other companies to follow (CLSA, 2002; UMC, 2003; Wu, 2003b). Some of the recent major corporate governance reforms are discussed below.

10.6.1

Accounting information disclosure and transparency

Two of the major disclosure issues are concerned with related party transactions and ownership structures of business groups. The Statement of Financial Accounting Standards No. 6 on Related Party Transactions has specific rules to report related party transactions by a specific business entity. Traditional disclosure requirement of ownership structures is not sufficient to reveal the complex business relation-

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ship of entities in a business group. The AFC and corporate failures in Taiwan prompted the SFC to take and require, starting in 2000, three separately filed annual documents from publicly-traded companies for their business activities and ownership structure with their related business entities (SFI, 2003). These three documents are: (1) consolidated operations report by business group, (2) consolidated financial statements of business group, and (3) business relationship report. As many publicly-traded companies in Taiwan have used pyramid or cross-shareholding structure to form business groups, such disclosure requirements will provide more transparent information so as to provide better understanding of the nature of transactions between and within business groups. Also, companies subject to the regulations by SFC can disclose company information through an internet data filing system for investors’ and other users’ easy reference (the Market Observation Post System established by TSE and GTSM available at website: http://emops.tse.com.tw). This system has been active since 1 August 2002. Another innovation initiated by TSE and GTSM, and established by SFI, a semi-public organization engaged in doing research, training and other activities on corporate governance issues and personnel, started an Information Disclosure Ranking System since 2003. This system was established to promote corporate information transparency and develop evaluation criteria to examine local accounting disclosure practices and in line with international disclosure standards. For listed firms, based on publicly available information such as their annual reports, information disclosed through the Market Observation Post System, and company websites, a disclosure ranking is given for each of the five categories: compliance with the mandatory disclosure requirements, timeliness of reporting, transparency regarding forecasted financial reports, transparency of annual reports (including ownership structure, board structure, and transparency of financial and operating review by management), and transparency regarding information disclosed through company websites.

10.6.2

Independent directors and independent supervisors

Independent directors and supervisors on corporate boards are being gradually accepted, starting with those firms applying for IPOs in the stock exchange. However, the role and the responsibility of independent directors have yet to be fully defined. Corporate management is concerned with availability of qualified persons, the costs of retaining

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independent directors, dissension from independent directors, interference with management decisions etc. The potential independent directors are concerned with their legal liabilities, coverage of liability insurance, proper roles in the board room, meeting procedures, and information they receive, etc. Apparently, there is a need for guidelines for the company and independent directors so that these various expectations can be met. Since 2002, all public companies applying for listing in the TSE or GTSM should have at least two independent directors and one independent supervisor. While a clear definition of independence is not given, TSE does provide a definition on the “lack of independence”. It means that a BOD that has less than five directors, and more than twothird of them are affiliated. Affiliations exist between spouses; direct relatives by blood within the second degree of relationship; collateral relatives within the third degree of relationships; representatives serving the same corporate shareholder; or affiliates (Listing Rules, TSE, 2003). Also, listed firms should disclose in their annual reports whether or not their independent directors and supervisors comply with the independence guidelines set by TSE and GTSM. These companies are also recommended to disclose information regarding corporate governance framework structure and rules, ownership structure and shareholders’ equity, structure and independence of the BOD, responsibilities of the BOD and management, and composition, duties and independence of supervisors, among others (Corporate Governance Best-Practice Principles for TSE/GTSM Listed Companies, TSE and GTSM, 2002). The SFI also has been entrusted by the SFC to establish a database of independent directors and supervisors (the Independent Directors/ Supervisors Registry System). The qualifications to register in the database include both professional and independence criteria. Publicly-held firms therefore can search for potential independent directors and supervisors either by themselves or through the database (SFI, 2003).

10.6.3 Orientation and continued education for directors and supervisors The SFC has required those serving as directors and supervisors to take continuing education in corporate governance related subjects. Currently SFI is appointed by SFC to provide orientation and continued training courses for all of the new or experienced directors and supervisors. The purpose is to increase the awareness of directors and supervisors of their roles and responsibilities when participating in corporate

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board activities. Although cases like Enron and Worldcom have raised questions about the effectiveness of board directors and supervisors, the trend toward developing a sound corporate board system is only now beginning to take hold in Taiwan.

10.6.4

Shareholders’ rights and their protection

One-share one-vote has long been the rule as the shareholder’s most basic right. However, as a great majority of investors in Taiwan are individual investors, trading of shares is primarily short-term in nature. Although initially the SFC issued several regulations for the protection of shareholders’ rights with respect to the use of proxy, rules on shareholders’ meeting, tender offers, etc., shareholders are generally reluctant to take action against the management in the court due to the cost of the legal process, which is normally long drawn out. To overcome these problems, the government in collaboration with the securities industry has established a non-profit organization, the Securities and Futures Development Foundation, to provide training and education for securities professionals as well as to act as agents for ordinary shareholders wishing to bring legal suits against corporate offenders. The SFC has enacted the Securities Investors and Futures Traders Protection Law (which has been passed by the parliament in July 2002 and enacted on 1 January 2003 (SFC, 2002/2003)). The major part of the law is the enhancement of mechanisms for securities class action. Moreover, based on the Law, a new organization, the Securities and Futures Investors’ Protection Center (SFIPC) was established in January 2003 with more government resources aimed at protecting investors should their legal rights be violated by corporate management and other personnel. The main functions of SFIPC are to provide consulting, mediating and other services regarding class-action lawsuits, compensation and other related activities to investors. In addition, class action suits are now being established as a legal means for the shareholders to protect their interests through the courts.

10.6.5

Corporate governance codes in Taiwan

The TSE, together with GTSM, issued a document titled “the Corporate Governance Best-Practice Principles for TSE/GTSM Listed Companies” (the CG Principles) in October 2002. It is divided into seven chapters and 65 articles. The contents of the CG Principles consist of protection of shareholders’ rights and interests, structures of corporate boards, functions and duties of directors and supervisors, independence of directors and supervisors, roles of stakeholders and their rights,

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improvement of information transparency, and disclosure of information on corporate governance. In general, listed companies are recommended by the CG Principles to adopt the best practices of corporate governance in the following major areas: increase board independence, separation of board chairperson and general manager (no CEO duality), set up special committees under the Board for various functions stipulated in the articles of corporation (such as audit committee, remuneration committee, nomination committee, etc.), select an independent external auditor and engage legal counsel, and appropriate disclosure of corporate governance practices. While the CG Principles are optional, and not compulsory, firms listed in TSE or GTSM are expected to follow them to achieve the objectives of good corporate governance practices. In addition to the CG Principles for TSE/GTSM listed firms aforementioned, Corporate Governance Best-practice Principles for other types of entities, such as securities companies (by CGA, TSE and GTSM, 2003), futures commission merchants (by Taiwan Futures Exchange), securities investment trust enterprises and securities investment consulting enterprises (by Securities Investment Trust and Consulting Association), have also been prepared or are in the process of being considered.

10.6.6

Major amendments of the Company Law

The Company Law has seen some major amendments, especially in 2001. Revisions relevant to corporate governance issues are: corporate board members hold the legal liability if their acts on behalf of the firm breach the trust of stakeholders; board members are no longer limited to being shareholders of the firm; public disclosure through media such as the Internet has been strengthened, supervisors are permitted to attend the board meetings and express opinions (MOEA, 2001).

10.7 Conclusion Corporate governance has become the government’s policy to advance corporate reform in Taiwan. The business communities are beginning to reluctantly accept the concept of external directors. Large shareholders are generally in control of family or group business and are not used to having “independent” outside directors on the corporate board. Although the Best Practice of Corporate Governance issued by the stock exchange requires companies applying for IPO to have at least two independent outside directors and one independent super-

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visor, the selection process is left to the company to decide and needs to be revised to ensure independence in that process. In order for the corporate community to appreciate the value of independent directors, more empirical evidence is required to substantiate the value of corporate governance. In addition to the corporate reform, the government regulators have taken steps to improve transparency, especially for disclosures regarding ownership structures and related party transactions. More transparent disclosures will mitigate the agency cost and enhance the monitoring capability of the market and regulatory agencies. Institutional investors have not been able to exercise their full influence in corporate governance issues. However, with the growth of domestic pension funds and more participation of international institutional investors, corporate governance will become a criterion for their investment decisions, and will create more incentives for the business community to enhance their governance structure. In addition to regulatory approach, education and market forces need to play a role. To convince the business community of the value of corporate governance, a broad education on the role of board directors, their legal liability, accounting transparency, and other related subjects should be directed at business leadership, executives and professionals. Also, via the institutional investors or governance rating agencies, the premium of corporate governance can be revealed in their share prices, thus establishing the market incentive for publiclytraded companies to improve their governance system. Legal enforcement is critical for effective implementation of governance system. The legal system needs to be further improved to provide timely and efficient procedures to pose a real deterrent for violators. With regulatory requirements, education, market incentive and legal enforcement in place, issues on corporate governance in Taiwan is expected to remain hot topics on the business agenda in the coming years.

References Auditing Standards Committee (1985–2000). Statements of Auditing Standards, No. 1–35, Accounting Research and Development Foundation. Backman, M. (2001). Asian Eclipse: Exploring the Dark Side of Business in Asia. Revised edition. Wiley. Burkart, M., D. Gromb and F. Panunzi (1997). Large shareholders, monitoring, and the value of the firm. Quarterly Journal of Economics 112(2): 693–728. Claessens, S., S. Djankov, J. Fan and L. Lang (1999). Expropriation of minority shareholders in East Asia. Working paper, World Bank.

214 The Governance of East Asian Corporations Credit Lyonnais Securities (2002). Make me holy…but not yet. CG Watch: Corporate Governance in Emerging Markets. CLSA. Corporate Governance Association, Taiwan Stock Exchange and Gre Tai Securities Market (2003). Corporate Governance Best-Practice Principles for Securities Firms. Taiwan. Financial Accounting Standards Committee (1985–2000). Statements of Financial Accounting Standards, No. 1–31, Accounting Research and Development Foundation. Holderness, C. and D. Sheehan (1988). The role of majority shareholders in publicly traded companies. Journal of Financial Economics 20: 317–346. Ko, C. E., K. W. Ding, C. C. Liu and Y. H. Yeh (2001). Corporate governance in Chinese Taipei. Corporate Governance in Asia: A Comparative Perspective: 423–449. OECD. La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R. Vishny (1998). Law and finance. Journal of Political Economy December. Reprinted in Empirical Corporate Finance, The International Library of Critical Writings in Financial Economics, Richard Roll(series editor) and Michael J. Brennan (editor), 2000. Ministry of Economic Affairs (MOEA) (2001). Company Law (Amended). Ministry of Economic Affairs. Taiwan. Organization for Economic Cooperation and Development (OECD) (1999). Principles of Corporate Governance, OECD. Organization for Economic Cooperation and Development (OECD) (2001). Corporate Governance in Asia: A Comparative Perspective, OECD. Organization for Economic Cooperation and Development (OECD) (2003). White Paper on Corporate Governance in Asia. Asian Roundtable on Corporate Governance, OECD. Securities and Futures Commission (SFC) (2002). Securities and Exchange Law (Amended). Securities and Futures Commission, Ministry of Finance, Taiwan. Securities and Futures Commission (2002/2003). Securities Investors and Futures Traders Protection Law. Securities and Futures Commission, Ministry of Finance, Taiwan. Securities and Futures Institute (SFI) (2003). Corporate Governance in Taiwan. Securities and Futures Commission, Ministry of Finance, Taiwan. Shleifer, A. and R. Vishny (1986). Large shareholders and corporate control. Journal of Political Economy 94: 461–488. Shleifer, A. and R. Vishny (1997). A survey of corporate governance. Journal of Finance 52: 737–783. Solomon, J. F., S. W. Lin, D. N. Norton and A. Solomon (2003). Corporate governance in Taiwan: Empirical evidence from Taiwanese company directors. Corporate Governance 11(3): 235–248. Su, Y. H., H. Yeh and C. Ko (1998). Auditor choice in the Asian emerging market for the conglomerates and family-controlled companies. Asian-Pacific Conference on International Accounting Issues. California State University – Fresno, Maui, Hawaii, October. Taiwan Stock Exchange (2003). Listing Rules. TSE. Taipei, Taiwan. Taiwan Stock Exchange and Gre Tai Securities Market (2002). Corporate Governance Best-Practice Principles for TSE/GTSM Listed Companies. Taiwan.

Ben-Hsien Bao, Chen-En Ko and Yin-Hua Yeh 215 Taskforce for Reforming Corporate Governance (2003). Accountability of Companies in Taiwan: Policy Agenda and Action Plan to Strengthen Corporate Governance. The Executive Yuan, Taipei, Taiwan. Wu, Z. X. (2003a). Gong si zhi li de di yi ben shu (The First Book on Corporate Governance). Sheng Zhou Publishing. Taipei, Taiwan. Wu, Z. X. (2003b). Tai ji dian: Gong si zhi li (Corporate Governance at the Taiwan Semiconductor Manufacturing Company). Sheng Zhou Publishing. Taipei, Taiwan. United Microelectronics Corporation (UMC) (2003). UMC Corporate Governance Statement. UMC. Taipei, Taiwan.

11 Problems of Corporate Governance Reform in Thailand Deunden Nikomborirak

11.1 Introduction Part of the Asian Financial Crisis (AFC) has been attributed to bad corporate governance. This includes reckless lending by commercial banks, risky investment by managers, expropriation of company’s funds by directors, managers or large shareholders, shady business deals and poor audits. While it would be somewhat far-fetched to attribute this crisis to bad corporate governance per se, weaknesses in governance certainly rendered the economy much more vulnerable to economic imbalances. The bubble in the real estate and property sector would not have been as large if banks, finance and securities companies had been more cautious about their lending. The Bank of Thailand and the Stock Exchange of Thailand (SET) would have been better able to implement timely corrective measures should financial accounting and auditing have properly exposed the dire financial straits most banks and companies were in. But it is moot to talk about what could have happened. What is more interesting is that all of a sudden Thailand is shouldering the cost of inherent weaknesses in its corporate governance. In picking itself up from the financial crisis, Thailand has put great efforts in building better corporate governance. A series of economic reform laws have been passed, including a new, improved bankruptcy law, foreclosure law, money laundering law and anti-trust law. Institutions such as the bankruptcy court, the small claims court and the Corporate Debt Restructuring Agency Committee (CDRAC) have been established. The state has made tremendous progress in laying the legal and institutional framework for good corporate governance. The companies themselves are also making progress on building good governance as a result of both sheer necessity, and in response to 216

Deunden Nikomborirak 217

the increasing demands of the regulator and the public. As domestic capital dried up, many Thai companies that were in urgent need of injections of new capital to alleviate their heavy debt burdens had to resort to foreign sources. Many have taken “road shows” to advertise and sell their new equity issues overseas. Indeed, good corporate governance is one of the key features that potential foreign investors look for. Since the crisis, the number of cross-border mergers and acquisitions has surged. Between the period 1 January 1998 and 1 March 1999, at least 49 local companies were acquired by foreign companies such as American International Assurance, Toyota and Samsung. A large part of the M&A activities was in the financial, retail, petrochemical and construction material (steel, cement, glass, etc.) industries that were hit hard by the sudden economic downturn. The presence of reputable foreign shareholders of many Thai companies has helped promote better governance. However, the task is far from over. There are many problems that have yet to be tackled. Corporate governance is molded by the local culture, the market environment and the legal framework formed over generations. It cannot be easily reformed.

11.2 11.2.1

Legal and regulatory framework Protection of investors’ and creditors’ rights

A study by the World Bank1 revealed that the law in Thailand does not offer sufficient protection for investors, and to a lesser extent, creditors. Judicial enforcement is also weak and the court process is slow. An index measuring the relative degree of creditor and investor protection as well as the effectiveness of judicial enforcement constructed for cross-country comparative studies by La Porta et al. (1997, 1998) shows that Thailand, like many East Asian countries, lacks sufficient investor protection (although Thailand fares better than Latin American countries). Thailand’s score of three out of six for investor protection reflects the fact that Thai shareholders are unable to vote by mail and one-share, one-vote is not mandatory. The minimum percentage share of capital required to call a meeting is relatively high: 10% if the number of shareholders requesting a meeting is greater than 25, otherwise, the required share is 20%. In terms of creditor protection, it scored three out of four with one of the key features being an automatic stay on collateral of companies undergoing restructuring. Thai court procedures are notoriously slow,

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reflected by such a score for judicial enforcement of only 5.9 out of 10. The problem stemmed mainly from defendants’ delaying tactics, which include not showing up at hearings and submissions for further appeals even in cases where the defendant is clearly at fault. Related to this problem is the fact that legal costs in Thailand are comparatively low. However, with the creation of a bankruptcy court, the amendment of the bankruptcy law, and revisions of civil court procedures concerning foreclosures and attendance at hearings, the judicial procedure is likely to be shortened significantly.

11.2.2

Regulation of the financial sector

The financial system in Thailand has always been dominated by commercial banks. The relatively high interest rates on deposits, sustained by an oligopolistic banking industry, inhibited the development of bond and equity markets. Chronic fiscal surpluses during the period of rapid economic growth also precluded issuance of government bonds, without which the market would have been too thin to support a secondary market. In the absence of alternative sources of financing, rapid economic expansion was afforded by expansion in banks’ credit extensions. Consequently, the average unweighted debt/equity ratio, or the leverage ratio, among Thai companies rose dramatically from 1.5 in the fourth quarter of 1994 to 4.05 in the fourth quarter of 1999. A survey of the top 100 listed companies shows that the leverage ratio for the entire year was 5.23 if unweighted and 8.36 if weighted, reflecting the fact that larger companies are deeper in debt (see Table 11.1). Corporate abuse is most damaging when the business involves dealing with other people’s money. Connected lending is probably the most prevalent and damaging form of abuse in the financial sector. This, again, stems from a local culture that gives importance to personal ties. To bankers, lending to someone you know is less risky than to those who you do not know. This logic may seem rational in a way, but it does not hold true during hard times. These so-called “clean loans”, i.e., loans with only a personal guarantee and no collateral, have been most difficult to recover. The practice of connected lending is not only risky but also inhibits the bank’s development of a sound lending policy. Because of the long-standing reliance on personal ties or individuals’ reputations, Thai banks failed to acquire solid technical skills in project appraisal. Thus, the lending policy of commercial banks has always been intransparent, arbitrary and unpredictable, and thus conducive to abuse.

Deunden Nikomborirak 219 Table 11.1

Leverage Ratio among Listed Thai Companies

Period 2000: annual 1999 : Q4 1999 : Q3 1999 : Q2 1999 : Q1 1998 : Q4 1998 : Q3 1998 : Q2 1998 : Q1 1997 : Q4 1997 : Q3 1997 : Q2 1997 : Q1 1996 : Q4 1995 : Q4 1994 : Q4

Number of firms 100 360 390 386 397 400 414 416 421 356 356 357 353 354 354 352

Leverage ratio* 5.23 (8.36)** 4.05 3.11 2.61 2.85 2.94 3.18 3.48 2.96 2.95 2.95 2.12 2.01 1.9 1.67 1.5

Source: (1) Before 1998: Q1 (Alba et al., 1998). (2) From 1998: Q1–1999: Q4 (Nikomborirak, 2000). (3) The year 2000 (Survey of 100 largest listed companies). Note: * the ratio is calculated on an unweighted basis ** the ratio is calculated on a weighted basis

The Commercial Banking Act (B.E. 2505) states that no person may hold more than 5% of the total amount of a commercial bank’s shares. Exceptions are granted where shareholders are governmental agencies, state enterprises as defined in the Budget Procedures Act, the Financial Institutions Development Fund established by the Bank of Thailand Act, or juristic persons established under a specific law. In addition, three quarters of a commercial bank’s equity shares must be held by Thai nationals. Consequently, the same proportion of the number of directors on the Board must be of Thai nationality. As a result of the crisis, however, the rule was temporary relaxed to allow 100% foreign ownership of local banks for a period of 10 years after which the foreign investors will have to divest a portion of their shareholding to satisfy the rule. Commercial banks are also not allowed to hold more than 10% of equity share in any limited company. In practice, however, insiders – i.e., large shareholder, directors, or high-ranking executives – set up their own companies and ensure that the bank provides an ample source of funds for these companies.

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Another set of commercial banks’ regulations concern the board of directors (BOD). According to the Bank of Thailand rules, commercial banks’ directors shall not (1) be a government official, (2) hold a political position, (3) be a former director or manager of a commercial bank whose license has been revoked unless permission is granted by the Bank of Thailand.

11.2.3 Regulations governing the duty and accountability of the Board of Directors As representatives of shareholders, the BOD is entrusted with the duty of overseeing management to ensure that the company is managed in a manner that is consistent with the interest of all shareholders. In companies where ownership is concentrated, however, directors do not necessarily represent all shareholders but are instead merely shadows of large shareholders whose interests may not be aligned with those of minority shareholders. There is thus a need for rules and regulations that can ensure that directors will not pursue the interests of any particular shareholder or to further their own gains, but will perform their duties in furthering the interest of the company as a whole. That is, the law needs to spell out the fiduciary duty, liability and the “conflict of interest” of directors. The adequacy of the legal provisions in each of these areas is discussed below.

Fiduciary duty The Public Company Act (PCA) states that directors are jointly responsible for “performing their duty according to the law, the objectives and rules of the company and the decisions made at shareholder’s meetings, with honesty to protect the interest of the company”. With such a statement, bar fraud and clear violations of the written rules and regulations, it would be difficult to prove whether a director has performed his duty adequately and in good faith to protect the interest of the company. The court has had very little experience in dealing with such cases, and much is subject to interpretation. Thus, it may be necessary to codify directors’ fiduciary duties.

Liability According to section 85 of the PCA, directors who fail to perform their duties with honesty and prudence are individually liable. Other directors who are not aware of the violation cannot be held liable. Directors can also be held individually liable for misinformation, which is considered a criminal violation. However, it must be proven that the indi-

Deunden Nikomborirak 221

vidual director has the “intention” of falsifying the information and prove that damages have been done, which is often difficult. While the law provides ample opportunities for shareholders’ to file lawsuits against directors for compensation, the burden of going through a court process in terms of both time and money pose formidable obstacles for shareholders in exercising their rights. It has been recommended that to save time and money, class-action filing should be allowed and that the director or directors bear at least some part of the cost if found guilty. Alternatively, a foundation for small shareholders may be set up. Small shareholders may deposit shares with this notfor-profit organization that will monitor boards and management or even undertake lawsuits against directors on behalf of shareholders. Indeed, The Securities and Exchange Commission of Thailand (SEC) may partially contribute funding to support such an organization

“Conflict-of-Interest” The PCA provides the basic content regarding potential conflict of interests of directors. Some of the rules include barring directors from borrowing funds from the company and requiring various types of dealings between the company and directors to be approved by shareholders. However, some loopholes in the law remain. First, connected transactions require approval from the BOD. This would be futile if most or all directors are associated with the same group of block shareholders – which is exactly the case for many listed companies in the SET. Second, most connected transactions are negotiated not by the directors themselves, but through nominees. Since the prohibitions do not cover cases when directors have indirect interest in the connected transactions, connected dealings negotiated by a middleman are beyond the reach of the law. Third, large shareholders are not considered as a party whose interests may be in conflict with that of the company. That is, doing business with large shareholders does not constitute a connected transaction. The SET realized the shortcoming of the PCA, and thus established rules that demand greater disclosure of connected dealings as follows: • all connected dealings must be published in a newspaper (1 Thai, 1 English) and recorded with related size of transaction in annual reports; • dealings with large shareholders or with legal entities in which large shareholders own a controlling share must also be disclosed; and

222 The Governance of East Asian Corporations

• all connected dealings with substantial value must obtain approval from three-quarters of shareholders. In addition, in calling a shareholder meeting to request for such resolution, the company has to provide an opinion of an independent financial advisor on the suitability of the transaction. While the more stringent SET rules are likely to be able to better deter undesirable connected transactions, it is not clear, however, whether failure to comply with the SET requirements constitutes a violation of the law. However, directors can be held jointly liable should the company be delisted from the Stock Exchange. But delisting is not an attractive form of sanction for the SET since it would potentially hurt small shareholders. While the latter can file for damages in court, the cost and the time involved in filing a case often, as has been noted, deters a shareholder from pursuing a court case. Thus, class actions need to be facilitated and the burden of the cost must be borne at least in part by the guilty party. It is recommended that the PCA be amended to provide clearer and more extensive definitions of connected transactions. Strengthening of the role of the audit committee may also help deter fraud cases arising from connected dealings.

Insider trading Insider trading is a serious problem in Thailand. In the Institute for Management Development (IMD) World Competitiveness Report (2000)2 Thailand ranked 41 out of 46 countries surveyed in terms of prevalence of insider trading. On the eve of the collapse of major equity write-downs of many banks and financial and securities companies after the crisis, major shareholders managed to sell off their equity shares to uninformed investors. While there are legal provisions in both the PCA and the Securities and Exchange Act (SEA) to deter insider trading, there is again room for improvement. First, the maximum fine, set at double the amount of gain generated from trading information, is not sufficiently severe to deter such behavior, in particular when the risk of being caught is not high. Second, although securities transactions conducted by insiders are to be reported to the SEC, few companies do. Third, most insiders arrange to have transactions involving insider information conducted through a nominee.3 It is therefore necessary to increase fines, improve enforcement and redefine “an inside person” to include nominees. All these measures will contribute to increasing the expected

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cost of exploiting inside information. Additionally, the SEC should consider an amendment to the SEA to prohibit directors and executive officers from dealing in the securities of the company during a certain period of time before a financial report is announced to the public.

Shareholder protection The PCA law offers some basic shareholders’ rights but the wording of the legislation remains vague. For example, the right to call an emergency shareholders’ meeting requires 20% of the total eligible votes, or at least 25 shareholders together holding not less than 10% equity share. However, the law also states that only the chairman of the board can call a meeting. Thus, if the chairman does not respond to shareholders’ request, the meeting cannot be carried out and the chairman is subject to a small fine. At this point small shareholders will have little choice but to ask the court to order an injunction, which can be rather time-consuming. The most serious omission in the provisions for shareholder’s rights protection, however, is a mandatory approval by shareholders of interested transactions, the most common means by which corporate funds are expropriated in Thailand. Here, the law requires that only directors report interested transactions to the BOD – not shareholders. In practice, there are also many loopholes in even these minimum requirements. For example, in the case that the required quorum is not met, decisions are made during the meeting and recorded regardless. To validate these decisions, management later calls up several brokers and asks them to ask their clients (shareholders) to send a back-dated letter authorizing their proxy votes. Where soliciting voting shares through brokers is not sufficient to meet the minimum equity share requirement, large shareholders simply distribute a single share to friends, families or employees and ask them to show up at these meetings in order to meet the minimum number of voters present as required by the law. As a result of these regulatory loopholes, corporate decisions are rarely made at general shareholders’ meetings. Minutes of shareholders’ meetings are often drafted prior to the meeting and can take up to one year to be circulated. Thus, small shareholders are minimally involved in corporate decision-making and seldom informed of corporate decisions. But shareholder’s lack of participation in corporate management can also be a matter of choice rather than dictation of circumstances.

224 The Governance of East Asian Corporations

11.2.4

Regulations concerning accounting standards

Accounts are mirrors to the corporate souls. Good accounting should be able to fairly represent the underlying health of the business entity. Bad accounting does not tell investors anything about the company and thus ceases to be of any use for investment decisions. The Thai accounting standard (Thai Generally Accepted Accounting Principles (GAAP)) adopts basic standards of the International Accounting Standards (IAS), but does not cover certain key issues such as accounting standards for derivative instruments, impairment of assets, taxation, etc. Although the international standards can be applied, most Thai companies do not have qualified accountants to apply these standards. After the crisis, many companies revalued their assets to escape being declared bankrupt (debt exceeds equity). Moreover, enforcement is not as strict as it should be. According to the study by Rahman (1998), only half of the listed companies surveyed disclosed the amount of connected transactions as required by the SEC. Most failed to comply with the IASs with regard to the recognition and reporting of foreign currency gains/loss. No companies disclosed any information on commitments in support of off-balance sheet financing. The survey also revealed that the financial statements of commercial banks hardly complied with the specific disclosure requirements for banks set by IASs. Another problem with the existing accounting rules and regulations concerns consolidated accounting. Siphoning off funds from a widely held public company to a family-held private company is one of the most widespread corporate abuses in Thailand. The accounting standard on consolidation of financial statements requires consolidation between the parent company and its subsidiaries. However, under the standard, the term “subsidiary” is defined as an entity of which the parent company holds more than 50% in shares. This is a rather high threshold considering that a 5% equity share can easily provide corporate control in a widely held company where equity holding is very dispersed. Moreover, companies that are indirectly controlled by the parent company (e.g. through nominees) are not required to be consolidated. Thus, transfers of funds between the parent company and these companies are not subject to regulatory scrutiny. The SEC should be more stringent in monitoring and enforcement for companies whose financial statements do not conform with GAAP. The SEC should also cooperate with the Institute of Certified Accountants and Auditors of Thailand (ICAAT) in developing new accounting standards that have a more expansive coverage. The IAS principles

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should be adopted where available, otherwise other internationally accepted standards, e.g. Financial Accounting Standards Board (FASB), can be used. Finally, the accounting standards on consolidation of financial statements should be amended so that consolidation of accounts is not based on the size of equity share, but rather on the extent of corporate control through direct and indirect means.

11.3

Governance mechanisms available

While proper and effective laws and regulations no doubt provide the necessary foundation for good corporate government, they are not sufficient to guarantee results. Non-violation of corporate laws represents a mere minimal corporate governance standard. A company’s own internal control system is the key determinant of its governance. It is therefore important to examine the internal control system of the average Thai company, including various financial stakeholders of the company. This starts with the BOD that (supposedly) represents its shareholders, the board’s committees (i.e., the audit committee, the remuneration committee, and the nomination committee), and institutional shareholders, large creditors, and minority shareholders.

11.3.1

The Board of Directors (BOD)

Most boards in Thai companies are still dominated by executive directors, most of whom have personal ties with large shareholders. Foreign directors are rare, unless the company has a significant foreign equity share. However, with the need to mobilize capital from overseas, many Thai companies are beginning to look for professional directors in order to satisfy commitments to, and expectations of, foreign investors. The appointment of an internationally recognized director can provide an immediate boost to the image of the company. High-ranking bureaucrats – some retired, some still in the middle of their career – are also a popular choice for directors of Thai companies, in particular for companies that operate in a heavily regulated environment. Indeed, connections can prove much more valuable than competence in a culture of patronage and in an environment where the rule of law is unclear and not properly enforced. Independent directors are a relatively new phenomenon in Thailand and it was only in 1999 that the SEC mandated that every listed company must have two independent directors on their board, and most companies are still struggling with whether to shun or welcome them, while regulators are struggling with how to legislate “independent”.4

226 The Governance of East Asian Corporations

Approximately half of the largest 100 listed companies surveyed adopt the minimal requirement of two independent directors and approximately one third has three independent directors (see Figure 11.1). Such a number is relatively small considering that the average BOD consists of 12.29 members. There is an on-going discussion about whether the number of independent directors on a board should be increased to at least half of the total number of directors so that these directors will not be easily outvoted. Such a proposal should be considered carefully, however, for several reasons. First, the expected role of outside directors should be reconsidered. Their role is to offer impartial and independent views and oversight that can be valuable to the company’s management. It is not to dominate the decision making process of the BOD. Moreover, it is common business practice that no real voting takes place in board meetings anyway. Attention should thus be focused instead on ensuring that the environment is conducive to these independent directors contributing to the company – i.e., access to accurate, timely and sufficient information. If the two independent directors can fulfil their expected role effectively, the company will no doubt recognize their contribution and may voluntarily choose to recruit more independent directors. Second, there is a severe shortage of qualified directors in the market. The crisis has indeed disqualified many prominent executives and

5%(5) 2%(6) 7%(4)

49%(2) 37%(3) Figure 11.1 the Board

Percentage of Firms with (x number) of Independent Directors on

Source: From a survey of top 100 listed companies in the SET conducted as part of this study.

Deunden Nikomborirak 227

directors, in particular those involved in failed banking and finance companies. These people have been marked by the public as those from the “old regime”, where cronyism and nepotism prevailed. Third, most outside directors are prominent persons, whose capability and integrity are well recognized by the public. But these people are already heavily over-committed with both private and public tasks. Good reputation is of little use if the amount of time these directors can dedicate to the company is very limited. As can be seen in Table 11.2, there are some directors who sit in more than 10 boards at the same time. It is unlikely that these persons are able to perform their duties properly. The Bank of Thailand recognized this specific problem and thus imposed a rule that directors of commercial banks may not sit on more than three boards beginning in January 2001. Table 11.2

Frequency of Multiple Directorships of Listed Companies, 1998

No. of director(s)

No. of boards they sit on

1 2 2 3 2 3

16 14 13 12 11 10

No. of directors 6 5 13 17 39 81

No. of boards they sit on 9 8 7 6 5 4

Source: Nikomborirak (2000).

Fourth, outside directors are often not familiar with the management of the company and so have to rely on executive directors and management for information. Their decisions, though impartial, well intentioned and independent, may not necessarily be optimal for the company. To have outside directors controlling the decisions of the board is therefore not necessarily preferable.

11.3.2

Board committees

The SEC and the SET require that every listed company have an audit committee, but other committees, e.g. remuneration and nomination committees are not popular. However, several companies that have a significant foreign holding, including the Bank of Asia, whose major shareholder is the ABN Amro, are voluntarily introducing remuneration committees for greater transparency and efficiency in personnel management.

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According to the PCA, remuneration of directors requires 3/4 of shareholders vote. But since the small shareholders normally do not attend the annual shareholders’ meeting, the remuneration of directors is often decided by block shareholders without much scrutiny. Since the total amount of compensation of both executives and directors are disclosed in an aggregate figure in the company’s annual report, it is not possible for outsiders to assess the level of compensation of each director or executive. Thus, large shareholders are able to provide excessive compensation to friends and families that represent “shadow directors”. A nomination committee is rare among Thai companies. As mentioned earlier, ownership among Thai companies tends to be rather concentrated, with corporate control under a particular family or group of families. As a result, directors and high-ranking executives, most of whom are friends or family of large shareholders, often have their term automatically renewed with little concern for performance. The story is different for companies with a significant foreign equity stake. These companies often establish a nomination committee that will assess the performance of directors and senior executives, as well as screen potential applicants to assist the board in its decisions concerning personnel.

11.3.3

The role of institutional investors

As discussed above, small shareholders cannot expect to rely on the board to monitor management when directors themselves are appointed by a single controlling shareholder. An alternative would be to invest in mutual funds and have the fund manager watch over the portfolio for you. Similarly, bank deposits, insurance plans and pension plans can also be seen as an individual’s indirect investment in corporate equity shares. The only difference is that the individual is guaranteed a fixed return, while the financial intermediaries bear the investment risk. With their pool of resources and the size of their investment funds, institutional investors are perceived to be the ideal candidates to perform a corporate-monitoring role. Countries with relative good corporate governance often have large institutional investors: commercial banks in Germany,5 mutual funds in the US, or pension funds in the UK. In Thailand, however, institutional investors play only a minor role as corporate investors. As can be seen in Table 11.3, the shares of the turnover value of securities transactions contributed by institutional investors during the first and second quarter of the year 1998 were only 5.80% and 6.42% respectively.

Table 11.3

The Role of Institutional Investor in the Thai Stock Market

Groups of investors

Buy (mil. baht) 1998

Sell (mil. baht) 1998

Turnover value * (mil. baht)/(%) 1998 1998

Q1**

Q2**

Q1**

1. Foreign investors 2. Institutional investors 3. Others

127,682.43 14,422.20 122,560.31

48,845.46 5,762.56 42,712.24

97,044.36 16,253.71 151,367.00

49,302.07 6,744.37 41,273.81

224,726.79 30,675.91 273,927.31

42.45 5.80 51.75

98,147.53 12,506.93 83,986.05

50.43 6.42 43.15

Total

264,664.94

97,320.26

264,665.06

97,320.25

529,330

100

194,640.51

100

Q2**

Q1**

Q2**

Source: SET (1999). Note: * Turnover value = buying value + selling value ** The turnover of foreign investors is defined as all securities transactions by foreigners. The turnover of institutional investors before March 2, 1998 is defined as all transactions by securities companies and mutual funds. The turnover of institutional investors since March 2, 1998 is defined as all transactions by securities companies, finance firms, banks, mutual fund management companies, mutual funds, insurance companies, provident funds and juridical entities. The turnover of other investors is defined as all transactions by Thai national investors who are not institutional investors.

229

230 The Governance of East Asian Corporations

The promotion of institutional investors in the case of Thailand should be made with much caution for two reasons. First, institutional investors themselves do not have good corporate governance. After all, is it not because of the reckless lending by financial institutions that we are where we are today? How can then one expect to rely on these institutions to raise the standard of our corporate governance? On this particular issue, one cannot help but wonder why commercial banks, or finance and securities companies – as creditors – were not more involved in monitoring the companies to which they lend extensively, as most “Hausbanks” such as those in Germany and Japan often do. This may be due to two reasons. First, a large portion of the loans extended by commercial banks were secured through personal connections. Thai banks rarely scrutinize the feasibility of the projects; rather they rely on personal relationships or reputation of the owner or the company. Hence most banks’ loans are either unsecured or secured only by personal guarantees. Second, lending was extremely competitive. Everyone was willing to handout credits. Thus, if a bank imposed too many conditions on loans, a company could simply take its business elsewhere. During the euphoria, prudence seemed unnecessarily costly. With insufficient regulatory supervision and inadequate internal control, there was a race to the bottom in terms of quality of loans extended. Reckless lending was contagious. The second reason why institutional investors are suspect is that they often have a vested interest in the companies in which they invest. In June 1998, the SEC temporarily withdrew professional licenses from four executives of the oldest mutual fund in Thailand. Two charges were laid: one for investing with “conflict-of-interest”, and the other, imprudent investment. To conclude, unless the corporate governance of financial institutions and other institutional investors markedly improves, one cannot pin much hope on either the board of directors or institutional investors in promoting the interests of small shareholders. After a lengthy analysis, we are back to square one: for the time being, shareholders themselves will have to make greater efforts in monitoring the corporations. In order to encourage shareholders to become more involved in a company’s management, long-term equity holding will have to be promoted. This includes the introduction of corporate debentures and corporate bonds. Because the government experienced fiscal surpluses for

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almost a decade before the crisis, the bond market is still underdeveloped in Thailand. Now that the government has come to rely heavily on debt issues to raise required funds to rehabilitate and stimulate the economy, there is great potential for the development of such a market.

11.3.4

Role of minority shareholders

In the past, few minority shareholders were aware of their rights and duties as a corporate owner, and so rarely exercised them. Moreover, retail investors were driven mainly by speculative motives during the boom years. Most were looking for a quick profit and few paid any attention to corporate fundamentals such as governance. As long as money kept flowing in, there was little incentive to monitor management. Small shareholders’ apathy is an insider’s license to misappropriate corporate funds. If minority shareholders do not show up at shareholders’ general meetings, a block holder with a mere 20% ownership share can easily dominate decisions made – perhaps with a little help from his friends. Thus there is an urgent need to push for shareholders’ activism in Thailand. On the other hand, this crisis may have given birth to shareholder activism. When money dries up, it is fingerpointing time. Investors are now demanding accountability on the part of management and directors for corporate failure. News reports of small shareholders protesting at general shareholders’ meetings have begun to appear. This nascent shareholders’ activism should be nurtured not only by protection of their rights, but also by a guarantee of access to accurate and timely corporate information.

11.4 Obstacles in improving corporate governance Thailand has invested great efforts in trying to improve the governance of listed companies by various means, including better enforcement, black listing, disclosing identities of those who have violated the law, and amendments of rules and regulations. However, the battle against corporate fraud and abuse remains particularly difficult.

11.4.1

Corruption in the public sector

The corporate world does not stand in isolation. As mentioned earlier, good governance requires good political governance and a strong civil society that in turn demands good governance from both the government and the private sectors. If government officials and politicians

232 The Governance of East Asian Corporations

are corrupt, how can the businesses that must abide by their rules, regulations and policies keep their hands clean? Will a construction company that refuses to bribe ever win a project from a corrupt government? Can a company that had paid large bribes to secure a government contract have an honest financial report? Thus, good governance in the public sector is an important prerequisite for building better governance in the private sector. Thailand still has a long way to go in combating corruption. In June 2001, the country was ranked 62nd out of 91 countries surveyed by the Transparency International (the larger the figure, the worse the corruption).

11.4.2

The lack of reliable information on unlisted companies

The big push for better corporate governance is concentrated mainly among the listed companies under the initiation of the SEC and the SET. Yet most widespread corporate abuse, which involves interested transactions and siphoning funds off between parent company and their subsidiaries, involves unlisted companies. The existing database on unlisted companies has much room for improvement. First, it is impossible to tell what kind of business a registered company is actually involved in since most companies register an array of businesses so as to avoid having to re-register in case the nature of business activities change later. Second, many companies have ceased operation but never reported the fact. Third, many companies do not have a physical presence at the address registered, but merely submit annual financial statements. Finally, the accounting standard of unregistered companies is appalling. In the year 2000, a new Accounting Act was passed with the objective of improving the accountability of accountants and raising the disclosure standard. The lack of data has kept unlisted companies in the twilight zone. On this matter, the Department of Business Registration of the Ministry of Commerce has taken steps to improve the quality and accessibility of the database of registered companies. A private company, namely Business on-line Co., Ltd was permitted to provide online information about registered companies. This included companies’ registration, financial statements, lists of executives and boards of directors, names of external auditors, and even industrial competitive analysis and business news via the Internet. The Department of Commercial Registration plans to launch its own on-line access to the registered companies’ database free of charge by the end of the year 2001. With improved access to information, greater attention can be paid to corporate governance and listed companies will need

Deunden Nikomborirak 233

to make greater efforts to try and improve the standard of corporate governance.

11.4.3

The absence of an independent regulator

The SEC has been spearheading the drive for better corporate governance. Its efforts, however, have been frustrated by frequent political interventions. This is because the Minister of Finance assumes the position of the chairman of the Commission. Having a politician as the head of the commission can spell serious trouble for two major reasons. First, the government has a different agenda than does the regulator. During times of economic downturn, the goal of the government is to boost the economy and hence, its popularity. This may involve measures to stimulate stock prices by relaxing listing rules. The SEC is thus caught between two different mandates: one to stimulate the market, the other to regulate the market. In trying to meet political demands, the SEC has little choice but to compromise the desired corporate governance standard. Second, business and political interests are deeply interrelated in this country. Large businesses often have strong political connections. Lack of independence implies that the SEC may run into trouble when trying to investigate violations of corporate rules and regulations that involve well connected businesses. After all, it is the Minister of Finance who chairs the commission. An independent regulatory body is a prerequisite for effective enforcement of corporate rules and regulations and for building better corporate governance.

11.5 Future developments and conclusions Traditional family-run companies in Thailand have yet to adapt themselves to the new corporate environment. In private companies, absolute corporate control no doubt lent much managerial flexibility and adaptability, allowing the business to flourish. As a listed company with public ownership, however, such absolute control runs against the basic concept of accountability, equity and transparency, the three pillars of good corporate governance. Where should the reform begin? At the heart of any good governance is access to reliable information. Without adequate and accurate data, we cannot penetrate the corporate veil. And, with unreliable information, there is little rationale in promoting greater disclosure. Thus, accounting standards and practices should be the very first target for reform. Once good accounting is in place, abusive

234 The Governance of East Asian Corporations

behavior by insiders will be much more easily detected and dealt with. The next step would be to ensure effective enforcement of the law so that abusers are held accountable for their misconduct and are duly punished. The SEC plays a major role trying to elevate the corporate governance standard and its independence is badly needed. Last but not least, speaking of building good governance, one must realize that good or bad governance is not a question of ethics, but economics. Gresham’s Law of bad money chasing out good money also applies here. If bad corporate governance is allowed to prevail and prosper, good corporate governance will never be born. If your competitor can get away with manipulating or even falsifying financial reports to make the company look better than it actually is, then why should you submit a verifiable report that may make your company look worse than your competitor’s? Similarly, if the factory next door pollutes the river, dodges taxes, does not abide by safety laws, and gets away with it, why should you practice good governance? Thus, bad corporate governance must be sufficiently penalized so that good corporate governance pays. Government efforts should thus be focused on strengthening regulatory supervision and ensuring that penalties are made much harsher for corporate abuse and professional liability. At the same time, companies with good corporate governance must be rewarded, if not in terms of allocation of investment funds then maybe in terms of special relief from certain rules and regulations imposed by the SEC. Indeed, if good governance pays, then building it will be a much simpler task.

Notes 1. Alba, P., S. Claessens and S. Djankov (1998). Thailand’s corporate financing and governance structures: Impact on firm’s competitiveness. Country Economics Department, The World Bank. 2. The report compared nine countries in terms of a number of corporate governance attributes including insider trading. The best ranked was Singapore and the US while the worst were the Philippines, Indonesia and Thailand. 3. In the United States, both the nominee and the insider can be charged for benefiting from misappropriation of information. 4. The definition of independence according to the SEC is as follows (1) not an employee of the company, its subsidiaries or part of the same conglomerate; (2) do not own more than 0.5% of equity share and (3) not a relative or have special relations with insiders that may obstruct impartiality in forming duty. Indeed, it is difficult to legislate “independence”, as one can never exclude all types of personal ties, especially in an environment where patronage is a way of life.

Deunden Nikomborirak 235 5. German banks exercise corporate control through custodianship of shares deposited therewith.

References Alba, P., S. Claessens and S. Djankov (1998). Thailand’s corporate financing and governance structures: Impact on firm’s competitiveness. Paper presented at Conference on Thailand’s Dynamic Economic Recovery and Competitiveness, 20–21 May, 1998, Bangkok, Thailand. Institute for Management Development (IMD) (2000). IMD: World Competitiveness Report. National Centre for Policy Analysis. La Porta, R., F. Lopez-De-Silanes, A. Shleifer and R. W. Vishny (1998). Law and finance. Journal of Political Economy 106(6): 1113–1155. La Porta, R., F. Lopez-De-Silanes, A. Shleifer and R. W. Vishny (1997). Legal determinants of external finance. The Journal of Finance 52: 1131–1147. Nikomborirak, D. (2000). Building better governance: A challenge facing the Thai economy. The Thailand Research Institute (TDRI) report submitted to the United Nations Development Programme (UNDP). Rahman, M. Z. (1998). The role of accounting disclosure in the East Asian financial crisis: Lessons learned? Paper prepared for the UNCTAD. The Stock Exchange of Thailand (SET) (1999). Enhancing good corporate governance of Thai listed companies. SEC Research paper, http://www.sec.or.th

Index Aaker, D. 99 Abegglen, J. C. 113 AFC see Asian Financial Crisis Agarwal, R. 66 Aharoni, Y. 160 Aharony, J. 43 Alba, P. 235 Alexander, A. J. 104 Allen, F. 113 American Chamber of Commerce in Japan (ACCJ) 105, 113 American Institute of Certified Public Accountants (AICPA) Statements on Auditing Standards 82, 85 American International Assurance, M&A activities 217 Anderson, C. W. 98–9, 103, 111 Ang, S. H. 160 Anwar 125, 128, 131–2 Aoki, M. 114 Arayama, Y. 105 Asian Corporate Governance Association (ACGA) 67 Asian Development Bank (ADB) 83, 185 survey of Philippines borrowing 141 Asian Financial Crisis (AFC) 1997 xii, xiv, 1–2, 19, 20, 24, 72, 85, 104–5, 117, 119, 184, 209 contagion 164 Japan 104 Korea 178, 187–8 Malaysia 19, 126 in the Philippines 138, 149 Singapore 156, 164 Taiwan 22, 199 Thailand 216 Asian Wall Street Journal 117 Australia 156

Babcock, B. A. 104–5 Backman, M. 199 Badawi, A 20 Bae, K. 180 Bangkok Bank of Commerce xii Bank Bumiputra/BMF scandal 134 Bank Indonesia 77 Bank of Asia 227 Bank of Thailand 216, 220 Bank of Thailand Act 219 Bank Rakyat scandal 134 banks 56, 81, 118, 183, 200 audit committees 77–8, 88 chaebols and 22 governance role provided by 98–9 relationship-based systems 2 Bao, B. H. 199 Bapepam (Indonesian Capital Market ExecutiveAgency) 74, 77–8, 81–5 see also Malaysia Barisan Nasional (Malaysian multi-party coalition) 122–3, 124 see also Malaysia Bayoumi, T. 105 Blair, M. M. 118 Board committees 227 board of commissioners (BOCs) 76–7, 80, 86–8, 90–1 board of directors (BODs) 3, 23, 46, 76–7, 90–1, 97, 225–7 accountability 14 independence 14, 19 membership 7 requirement to disclose material interests 13 responsibilities of 12 structures 6–7, 18 board structure of companies 6–10 comparing common law and civil law countries 6

236

Index 237 dual 7 unitary 7 bonds 23, 28, 90, 187, 218, 230–1 bonuses 141–2, 204 booms 139, 194 borrowing 90, 98 cross-debt guarantees 178 excessive, short-term hedge funds 186 intra-group 186 ratio to assets 194 short-term 42, 179 British military bases in Singapore 155 Bumiputera people see Malaysia Burkart, M. 204 Burt, R. S. 129 Cadbury Report, United Kingdom 6, 10 Campbell, T. L. 103, 111 Canada, Dey Report in 10–11 Capital Market Executive Agency 74 Carlile, L. E. 111 CEOs see Chief Executive Officers Cha, L. 45–6, 48–50 Chaebols in Korea xii, 2, 24 system of cross-holding 180 Chen, C. 43 Cheong, S. 10 Chief Executive Officers (CEOs) 7 appointment and removal in Japan 109 average tenure in Philippines 142 foreign, in South Korea 195 in Hong Kong companies 63–7 China see PRC China Securities Regulatory Commission (CSRC) 41, 46–7 Chinese in Malaysia 19, 121–4, 126–7, 129 equity ownership 120 Chng, C. K. 169 Choi, Y. S. 184 Chung, K. S. 180–1, 186, 191 civil law systems 4, 54 dual board structure 7 lower levels of investor and creditor rights 5–6

Claessens, S. 10, 54, 66, 204, 213 Collyns, C. 105 Commercial Codes Dutch 73 Japanese 96–7, 105, 107, 109, 110 Korean 180, 182, 186 common law system 3, 4–5, 54, 67, 97, 201 countries comparing corporate governance 5–7 fiduciary duties 58 principles 55, 61 rule of law score 6 Company Law Hong Kong 55 Indonesia 73, 78, 81, 83 People’s Republic of China 32, 38–9, 43, 45–7, 50 Taiwan 200, 206–7, 212 United Kingdom 55 conglomerates 89, 128 family-owned 21, 140 politically-linked 117 rise of 124–7 see also chaebols consensus economics forecasts, comparison of different countries on 16 Cooke, T. E. 100 corporate governance 2–3 best practice in 10 definition 2–3, 118–20 guidelines 10–11 Hong Kong 17, 60–5 Indonesia 17–18, 76–80, 88 Japan 18–19, 39, 97–104 key elements of 7 Korea 181–2, 187–92 Malaysia 19–20, 118–20 People’s Republic of China 37–41, 44–52 Philippines 20–1, 138–53 reforms and changes 10 Singapore 155–74 standards of 4, 21 Taiwan 22–3, 203–12 Thailand 23, 216, 231–3 voluntary code of conduct for 6

238 Index Corporate Governance Best-Practice Principles for TSE/GTSM Listed Companies 211 Corporate Transparency Index (CTI) by the Business Times 172 Craig, V. V. 112 cross-holdings 71–96, 99–101, 103, 105, 106–7, 128, 178, 180, 190, 204, 209 Daewoo 179, 190 Daily, C. M. 66 Daim, Finance Minister of Malaysia 123, 125–6, 128, 131–2, 134 debt 81, 231 crises 117–18, 132 cross-guarantees of 191 SOEs struggling to restructure 80 debt-equity ratios 22, 90, 178, 190, 193, 218 Development Bank of Singapore 155 Dey Report in Canada 10–11 directors 200 appointment of 55, 79, 99, 109, 141, 225 career incentives 102 duties of 55, 58, 61, 76, 144, 157, 211 executive 7, 64, 101, 121, 169, 204, 225, 227 functions of 20, 211 independent directors 23, 48, 56–9, 65, 67, 169, 208, 225–6 INEDs (independent non-executive directors) 58–9, 65, 67 interlocking directorships 90, 108, 118–19, 122, 128–30, 144–5 non-executive 3, 14, 58–9, 65, 67, 168–9, 182, 204 orientation and continued education for 210–11 outside 101, 108, 181, 194, 195, 207, 227 remuneration of 60, 118, 144, 228 training programs for 142 see also board of directors

disclosure 12, 13, 23, 59–60, 65, 75, 89, 147, 162, 168, 201, 203 international standards of 21, 164, 209 legal foundation of 81–2 see also information disclosure Doe, J. 67 employee share option schemes (ESOS) 169 Enron 211 entrepôt trade 155, 161 European civil law 4 Fair Trade Commission 186 Fama, E. F. 175 family ownership 10, 17, 24, 54–70, 89, 90, 140, 141, 149, 151, 179–80, 203 Field, G. 98, 104, 112 financial statements 77, 110, 147, 158 annual 83, 232 audited 81, 152, 188, 202, 203 combined 185–6, 191, 194 commercial banks 224 concerns relating to credibility of 85 semi-annual 83, 203 foreign investors 2, 45, 78–9, 139, 149–50, 155 Gale, D. 113 GATT see General Agreement on Tariffs and Trade GCCG see German Code of Corporate Governance General Agreement on Tariffs and Trade (GATT) 100 Generally Accepted Accounting Principles (GAAP) xiv, 59, 185, 202, 224 German Code of Corporate Governance 7 Germany 182 code law tradition 97 essential tasks of supervisory board 7 two-tiered board system 89, 200

Index 239 Gilson, R. J. 99–100 Goldschmidt, C. 71 Gomez, E. T. xv, 128, 135 Gompers, P. 181 Goodwin, J. 163 Gre Tai Securities Markets (GTSM) in Taiwan 199, 204, 208–9 Greenbury Report in the U.K. 11 Growth Enterprise Market (GEM) in Hong Kong, F. A. 1 57–8 Guo, Z. W. xv Hampel Committee in the U.K. 11 Hart, O. 71 Hassan, A. E. 136 Hattori, I. 101–2 Heavy Industries Corporation of Malaysia (HICOM) see Malaysia Higgins, H. N. 96 Hirschmann, A. O. 66 HKEx see Hong Kong Exchanges and Clearing Co Ltd Holderness, C. 204 Hong Kong accounting standards and disclosure 59 Banking Ordinance (BO) 56 Companies (Amendment) Bill, proposed 60 Companies Ordinance (CO) 55 challenges for reform in 65–7 recent developments 60–5 Corporate Governance Watch survey 68 corporations, governance in family-owned 54 Futures Exchange of Hong Kong Ltd. 57 Growth Enterprise Market (GEM) 57–8 legal and regulatory environments 3, 55 Monetary Authority 59 ownership 54 Protection of Investors Ordinance 56 regulatory framework 17, 55, 57 Securities (Disclosure of Interests) Ordinance 56

Securities (Insider Dealing) Ordinance 56 Securities and Futures Commission (SFC) 56, 59 Securities and Futures Ordinance (SFO) 17, 55–6 Special Administrative Region (SAR) 54 Standing Committee on Company Law Reform (SCCLR) 17, 55, 58, 60–1 Statements of Standard Accounting Practice (SSAPs) 59 Stock Exchange of Hong Kong Ltd (SEHK) 57 Hong Kong Exchanges and Clearing Co Ltd (HKEx) 56 Growth Enterprise Market (GEM) 57–8 proposals for listing rules amendments by 64 Rules Governing the Listing of Securities issued by 59 Hong Kong Institute of Directors (HKIoD) 60 Hong Kong Monetary Authority (HKMA) 56 Hong Kong Securities Clearing Company Ltd (HKSCC) 57 Hong Kong Society of Accountants (HKSA) 59 Horiuchi, A. 101 Husnan, S. 72, 86 Hyundai 179, 190 Ibrahim, A. 124 independent non-executive directors (INEDs) see directors Indonesia 7, 74 Accounting Principles 82 Bank Indonesia 77 Bankruptcy Law 73–4, 93 Bapepam (Badan Pengawas Pasar Modal) 74, 77–8, 82–5 Board of Directors and board of commissioners 76–7, 90–1 accounting disclosure rules 83–4, 91–2 audit committee 77–8

240 Index auditing standards and practices 84–6 socioeconomic issues 88–9 two-tier board system vs. single board system 89–90 business regulatory framework 73–6 Capital Market Law 78, 83 Capital Market Structure 75 Capital Market Supervisory Agency see Bapepam civil law system 4 Code for Good Corporate Governance (CGE) 73 Code of Professional Ethics of Indonesian Accountants 82 Company Law 73, 81, 83 Composite Stock Price Index (CSPI) 75 corporate governance 76–80 survey by PricewaterhouseCoopers 83 of top 100 listed companies 86–92 development of accounting standards in 82 Directorate General of Financial Institutions of MoF 85 disclosure rules and regulations 81–6 family controlled firms 24 Jakarta Stock Exchange (JSX) 75, 84 National Committee for Corporate Governance (NCCG) 72–3, 77 ownership structures 86–8 political patronage, cross-holdings and corporate governance in 71 securities market regulations 74–5 share ownership 78 Statements of Financial Accounting Standards or Pernyataan Standar Akuntansi Keuangan (PSAK) 82 state-owned enterprises (SOEs) 24, 73, 79–80, 91 Supervisory Board for Finance and Development (Badan Pengawas

Keuangan dan Pembangunan – BPKP) 85 Indonesia Bank Restructuring Agency (IBRA) 79 Indonesian Institute of Accountants (IAI) 81, 84–5 Initial Public Offering (IPO) 32, 35, 37, 42, 44–6, 79, 200, 209 insider trading 13, 56, 142, 146, 148, 190, 201, 222–3 Institute for Management Development (IMD) World Competitiveness Report 222 institutional investors foreign 167, 204, 206 PricewaterhouseCoopers (PWC) survey (2000) 156 quality 49–50 role of 228–31 underdeveloped 35–7 International Accounting Standards (IAS) 18, 59, 151, 158, 185 International Accounting Standards Board (IASB) 82 International Accounting Standards Committee (IASC) 158 International Federation of Accountants (IFAC) Code of Ethics for Professional Accountants 159 International Monetary Fund (IMF) 1, 22, 178, 187 International Organization of Securities Commissions (IOSCO) 152 International Standards on Auditing (ISAs) 64 investors protection to 4–6, 19, 56, 61, 65, 83, 97, 217 rights of 4–6, 120 see also foreign investors; institutional investors IPOs see Initial Public Offerings Jackson, K. D. 2 Jacobson, R. 99 Jakarta Stock Exchange (JSX) Jang, H. S. 195

75, 84

Index 241 Japan “Amakudari”, or “descent from heaven”, practice of 101 Asian financial crisis 104 banks, governance role of 98–9 board of directors independence 108 insider dominated 101 structure 101, 109 Commercial Code 96–7, 110–11 Company Code 19 corporate auditors 109–10 corporate governance economic pressures and reforms 104–10 environment, legal framework and traditional characteristics of 97–104 practices, regulatory framework and 18–19 reforms 105 and role of banks, keiretsus and Japanese traditions 96 traditional characteristics of 98 Corporate Income Tax Law 97 corporate management, weak external monitoring of 102–4 cross-holdings 103, 106 mutual, practice of (keiretsu) 18, 98 cultural tradition 103 economic crisis 104–5 Federation of Economic Organizations (Keidanren) 105 Financial Services Agency 106 Foreign Exchange and Foreign Trade Control Law 103 “gyosei shido”, or administrative guidance 101 industrial policies 98 keiretsu see cross-holding legal system, civil law system 4 Management Buy-Out (MBO) 106 Mergers and Acquisitions (M&A) activity 103, 105–6 Ministry of Finance (MOF) 97 Ministry of International Trade and Industry (MITI) 98 Ministry of Justice 97

Ministry of Postal Savings 98 Nippon Kaidanren 110 Securities and Exchange Law 97–8 shareholders litigation 107–8 weak position of 103 stock options 107 US Section 301 of Sarbanes–Oxley Act of 2002 zaibatsu 18 Japan Corporate Governance Forum (JCGF) 107, 112 Japan External Trade Organization (JETRO) 106 Jensen, M. C. 159 Jiang, Q. 42, 45 Joh, S. W. 178 Johnson, L. 100 Johnson, S. xii, xvi, 2 Jomo, K. S. 128, 135 JSX see Jakarta Stock Exchange Kamiyama, T. 106 Kaplan, S. N. 114 Kato, T. 102 Katz, R. 104 Keidanren see Japan keiretsu cross-holdings in Japan 2, 18, 24, 98–101 Kester, W. C. 100 Kigyo Group keiretsu 99 Kim, F. C. 177 Kim, J. K. 184, 194 Kindelberger, C. P. xvi KLSE see Kuala Lumpur Stock Exchange Ko, C. E. 199, 205, 207 Korea Accounting Institute 185 Act on Establishment of Financial Supervisory Organizations 188 Act to Expedite the Going Public of Corporations of 1972 183 Act on External Audit of Stock Companies and Listing Rules 182 Asian Financial Crisis (AFC) of 1997 178, 187–8 auditing standards 186

242 Index Korea – continued banking system 188 Bankruptcy Act for liquidation 184 Capital Market Development Act of 1968 183 chaebols 21–2, 25, 179–81 corporate governance in 177–97 policies against 189–90 civil law system 4 Commercial Code (CC) 182 Committee on Corporate Governance (CCG) 191 Company Reorganization Act and Composition Act 184 corporate governance 181–2, 190–2 in chaebols 177–97 developments in 187–92 pre-crisis 179–86 corporate sector 179–81, 189–90, 196 debt leverage 194 economic indicators 193 evaluation of recent developments 192–5 family-owned conglomerates see chaebol Federation of Korean Industries (FKI) 191 financial crisis in 186–7 financial markets 187 financial sector 179, 188 Financial Supervisory Commission (FSC) 188 Financial Supervisory Service (FSS) 188 Five-Year Economic Development Plans 177–8, 195 heavy materials and chemicals industries (HCI) 178 Interest Payment Coverage Ratio (IPCR) of firms 194 International Monetary Fund (IMF) 22, 187 Labor Standards Law 184 model of economic development, essential features 177

Monopoly Regulation and Fair Trade Act (Fair Trade Act) 183 regulatory framework 182–6 and corporate governance practices 21 Securities and Exchange Act (SEA) 182, 191 Securities and Futures Commission (SFC) 188 takeover and listing codes 191 Korean Securities Dealers Automated Quotations (KOSDAQ) 183 Korean Stock Exchange (KSE) 183 Korean Stock Price Index (KOSPI) 187 Korean War 177 Kuala Lumpur Stock Exchange (KLSE) 19, 118, 124, 132 Kuala Lumpur-Kepong (KLK) group 128, 130 La Porta, R. 5, 54, 65–6, 71, 89, 97, 157, 160–1, 204, 217 legal and regulatory environments 3–4 legal framework 3, 96, 97–104, 199–201, 217–25 legal protection and enforcement in different countries, summary of 8–9 legal systems and investor rights and protection 4–6 Levy, J. 104 LG Group 25, 179, 190 Li, B. 48 Li, D. 35 Li, J. 156 Li, Y. 161 Licht, A. 71 Lim, M. H. 121–3, 130 Lim, S. C. 175 London Stock Exchange 11 Combined Code 14 listing rules of 6, 10 Low, C. K. 135 Lynn, S. G. 66, 138 M&A see mergers and acquisistions Maden, C. 177

Index 243 Mahathir, M. 20, 123, 125, 132–4 Mahathir–Daim factor in Malaysia 123–4 Mak, Y. T. 155, 161, 169 Makhija, A. K. 98–9 Malayan Banking 136 Malayan Chinese Association (MCA) 122 Malayan Indian Congress (MIC) 122 Malaysia Arab-Malaysian groups 127 Bank Bumiputra/BMF 117 Bank Rakyat scandal 117 Barisan Nasional 124 Bumiputera people 19, 120, 122–4, 127 Chinese see Chinese in Malaysia Code of Corporate Governance, Principles and Best Practices of 20 corporate governance 118–20 practices, regulatory framework and 19–20 corporate ownership and control 117–34 study of major firms in preIndependence Malaya 121 top 100 firms 127–32 focus on public governance 119 Gross Domestic Product (GDP) growth Heavy Industries Corporation of Malaysia (HICOM) 127, 135 interlocking stock ownership, interlocking directorship, corporate decline 128–32 Kuala Lumpur-Kepong (KLK) group 128, 130 Kuala Lumpur Stock Exchange (KLSE) 19 118, 124, 132 Ministry of Finance (MOF) 19 National Development Policy (NDP) 120 New Economic Policy (NEP) 118, 123, 128 ownership of share capital of limited companies 121 Pan-El/Multi-Purpose Holdings scandals 117, 134

paradoxes of governance 132 state of capital, corporate development 1970–2000 120–7 state power, patronage and the rise of conglomerates 124–7 state-owned enterprises (SOEs) 24, 126 Surabaya Stock Exchange 75 United Malays’ National Organization (UMNO) 122, 124, 126 Malaysia Airlines (MAS) 117, 131 Manila Electric Company (MERALCO) 140 Marcos, Ferdinand 138 see also Philippines market manipulation 37, 40, 97 pricing system 2 see also securities markets; stock exchanges MBO (Management Buy-Out) deals 106 McConnell, J. J. 67 mergers and acquisitions 50, 102–3, 105–6, 118, 180, 184 cross-border 217 Milhaupt, C. 107 Min, C. K. 177 minority shareholders 17, 20, 38–41, 78, 205, 225 protection 22–3, 45, 47, 55, 65, 66, 77, 118, 145, 150, 157, 192, 207 Monetary Authority of Singapore (MAS) 159, 164–6, 174 Montes, M. F. 138–9 Morck, R. 99 Mourdoukoutas, P. 105 Nakamura, M. 99 Nakatani, I. 100 Nam, I. C. 179–80, 183–4, 186 Neave, E. H. 100 Neptune Orient Lines 155 Nikomborirak, D. 216 OECD see Organisation for Economic Co-operation and Development

244 Index Okubo, S. 115 Organisation for Economic Co-operation and Development (OECD) 11 “Principles of Corporate Governance” 11–15, 199 board responsibilities 14–15 disclosure and transparency 13–14 shareholders, rights of 12 Oversea-Chinese Banking Corporation (OCBC) in Singapore 136 Over-The-Counter Stock Exchange in Taiwan see Gre Tai Securities Markets (GTSM) ownership 27, 78–9 bank 18, 90 concentration 7 and control 12, 120, 121, 126, 127–32, 145 government 161, 166–7 institutional 204 interlocking 118, 119, 121, 128–30 SOEs 17 structures 7–10, 86–8, 161–2, 166, 205–6, 209 Pacific Economic Cooperation Council (PECC) 12 Palepu, K. 115 Park Chung Hee 177, 182 Pauly, L. W. 113 People’s Bank of China (PBOC) 49 People’s Republic of China (PRC) 7, 27 Accounting Law, new 48 bankruptcy and de-listing mechanism 41 Company Law 38–9 IPO 32, 45–6 corporate governance adopted and proposed measures 44–52 problems of equity structure of listed companies 37–41 corporate takeovers 40 China Securities Regulatory Commission (CSRC) 41, 46–7

corporate governance 29–30 practices, regulatory framework and 15 external monitoring mechanisms 40–1, 49 Guidelines for Article of Association of Listed Companies 38, 47 institutional investors 35 issues highlighted by analysing financial information 41 joint stock company formation, main characteristics for IPO 32–3 law enforcement 51 Provisional Rules on Qualified Foreign Institutional Investors (QFII) 49–50 Shanghai Stock Exchange 15, 28 shareholding structure of listed companies main characteristics of 33–7 shares for residents (A) 28 overseas stock markets (H) 28 Shenzhen Stock Exchange 15, 28 State Economic and Trade Commission (SETC) 45 state owned stocks in listed companies, percentage of 36 stock market statistics 31 Yue Jinman company 42 Philippine Long Distance Telephone Company (PLDT) 150 Philippine Stock Exchange (PSE) 21, 142 Philippines accounting and auditing 151–2 Accounting Standards Council (ASC) 152 Asian Development Bank survey 141 Auditing Standards and Practices Council (ASPC) 152 banking sector 139, 149 Central Bank (Bangko Sentral ng Pilipinas or BSP) 149 Corporate Code 143–5

Index 245 corporate governance in legal and institutional aspects and impact on 1997 financial crisis 138–53 mechanisms 139–42 practices, regulatory framework and 20–1 country-specific obstacles and difficulties 150–2 Directors, Officers, Shareholders and Related Interests (DOSRI) 139, 149 Directors’ Training Institute 153 family ownership 140 Insolvency Law 148–9 legal and regulatory influence 142–50 Manila Electric Company (MERALCO) 140 ownership pattern 139–41 Philippine Stock Exchange (PSE) 21, 142 Presidential Decree (PD 902-A) 20, 142 Professional Regulatory Commission (PRC) 151 response to Asian Financial Crisis (AFC) 149 Revised Securities Act 21 Securities Act or Commonwealth Act 145 Securities Exchange Commission 20, 142 Code of Corporate Governance 20, 153 Reorganization Act (PD 902-A) 145–8 Securities Regulation Code (SRC) 20, 142, 145–8 Philippines Airlines Inc. 150 Poe, M. 105–6 Price Waterhouse Coopers survey of companies 156 Prowse, S. 156 PSE see Philippine Stock Exchange Puthucheary, J. J. 121 Rahman, A. R. 71 Rahman, M. Z. 85–6, 224

Rajan, R. G. 2 Ramos, President F. 139 Rao, R. P. 66 Regala, A. 148–9 Regala, T. 148–9 regulatory environment 3–4, 5, 55, 73, 156–9 regulatory framework 3, 27, 57, 73–6, 83, 89, 182–5, 217–25 Reich, S. 113 Reid, T. 2 relationship versus market-based systems 1–2 Report on the Observance of Standards and Codes (ROSC) see World Bank Roe, M. J. 99–100 Roesler, K. F. H. 97 Root, H. L. 138, 182 Ruback, R. S. 159 rules and regulations 3–5 enforcement of 6 Saldaña, C. G. 20, 149, 151, 153 Samsung 179, 190, 217 Samsung Electronics xiii Samsung Motors of Korea xiii San Miguel Corporation 150 Saywell, M. 103 Schwartz, S. 71 SCMP (South China Morning Post) 54, 66 securities markets Indonesia 74–6 Japan 109 Philippines 146 People’s Republic of China 37–51 Seow, J. L. 163 Servaes, H. 67 SGX see Singapore Exchange Shanghai Stock Exchange 15, 28 shareholders activism 17, 67, 108 litigation 105, 107–8 protection of 47, 55, 181, 192, 211 rights 5, 6, 11–12, 13, 14, 17, 64, 203–4 Sheard, P. 99

246 Index Sheehan, D. 204 Shenzhen Stock Exchange 15, 28 Sherman, H. D. 104–5 Shieh, T. 54 Shimizu, K. 101 Shleifer, A. xii, xvi, 65, 71, 93, 162, 204 Sibbitt, E. C. 103 Sieh-Lee, M. L. 130 Sinar Mas Group in Indonesia xiii Singapore Accountants Act of 1987 158 board composition and leadership 168 classified Newly Industrialized Economy (NIE) by United Nations 156 Code of Corporate Governance 21, 159, 167 Code on Take-overs and Mergers 21, 157 Commercial Affairs Department 159 Companies Act 157 companies and securities legislation, changes to 165 Company Directors Course (CDC) 171 corporate governance barriers to improvements in 172–4 past, present and future 155–74 practices in 168–70 pre-crisis 156–63 recent developments in 164 Corporate Governance Committee (CGC) 167 corporate ownership 21 Corporate Regulation and Governance Policy Committee 164 development of fund management industry 166 disclosure and accounting practices 162–3 disclosure and accounting standards 168 Disclosure and Accounting Standards Committee (DASC) 168

divestment of government ownership 166–7 divestment of non-financial activities by banks 166 Economic Development Board (EDB) 174 external auditing 170 family controlled firms 24 financial sector regulation 159 foreign direct investment (FDI) policy 156 foreign share ownership limits 162 Government Investment Corporation (GIC) 166 government-linked corporations (GLC) 160–1 Inland Revenue Authority (IRA) 174 Institute of Certified Public Accountants of Singapore (ICPAS) 158 Statements of Recommended Accounting Practice (RAP) 158 Monetary Authority of Singapore (MAS) 159, 164–6, 174 ownership structure 161–2 Public Accountants Board (PAB) 158 Registry of Companies and Businesses (RCB) 157, 159 regulation of accounting and auditing 157 regulation of takeovers 157 regulatory environment 156–7 Securities Industry Council (SIC) 157, 159 Securities Investors Association of Singapore (SIAS) 171 Share Ownership Limits, changes to 167 Statements of Accounting Standards (SAS) 158, 162 Stock Exchange Listing Manual and Companies Act 158 stock options 169–70 structural environment 159 Takeover Code 157, 159, 165

Index 247 Singapore Airlines 155 Singapore Exchange (SGX) 157–9, 162, 171 Best Practices Guide (BPG) 163 Listing Manual of 157 Singapore Institute of Directors (SID) 171 Singh, K. 160 SingTel 166 SK Group 184, 190 SOEs see state-owned enterprises Solomon, J. F. 201, 207 South Korea see Korea Standard & Poor, proposed development of Corporate Governance Scorecard 172 state-owned enterprise (SOE) 15, 73, 79–80 in People’s Republic of China 27 listed companies transformed from 32 significant feature of business environments 24 stock market dominated by 17 unlisted 17 Stock Exchange Commission of Thailand (SEC) 221 Stock Exchange of Hong Kong Ltd (SEHK) 57 Stock Exchange of Thailand 216 stock exchanges 18 enforcement 5 regulation 5 see also Hong Kong Exchanges and Clearing Co Ltd; Jakarta Stock Exchange; Kuala Lumpur Stock Exchange; London Stock Exchange; Philippine Stock Exchange; Stock Exchange of Thailand; Singapore Exchange; Shanghai Stock Exchange; Shenzhen Stock Exchange; Surabaya Stock Exchange; Toronto Stock Exchange; Taiwan Stock Exchange Stott, V. 54 Su, Y. H. 205, 207 Suharto 72

Sukarno 71 Surabaya Stock Exchange

75

Taiwan Accountant’s Law 201 accounting and auditing regulations 201–3 information disclosure and transparency 208–9 Accounting Research and Development Foundation (ARDF) 201 Auditing Standards Committee (ASC) of 201 Asian crisis corporate failures since 203 Commercial Accounting Law 201 Company Law 200, 212 Corporate Governance (CG) codes in 211–12 mechanisms 203–4 obstacles and difficulties in improving 204–8 practices, regulatory framework and 22–3 recent reforms in 199, 208–12 scores of firms 203 Corporate Governance Association (CGA) 208 Corporate Governance Best-Practice Principles for business entities 208 for TSE/GTSM Listed Companies 210 family controlled firms 24, 205 Financial Accounting Standards Committee (FASC) 201 Gre Tai Securities Markets (GTSM) 199, 204, 208–9 Independent Directors/Supervisors Registry System 210 Information Disclosure Ranking System 209 Initial Public Offering (IPO) 200 legal framework 199–201 Market Observation Post System 209 Ministry of Economic Affairs (MOEA) 200

248 Index Taiwan – continued ownership structure 205 quasi-public and listed companies 200 relationship-based business enterprises 199 Securities and Exchange Law 200 Securities and Futures Commission (SFC) in 199, 208–9 Securities and Futures Investors’ Protection Center (SFIPC) 211 Securities Investors and Futures Traders Protection Law 208, 211 shareholders’ rights and their protection 211 Taskforce for Reforming Corporate Governance 208 Taiwan market index (TAIEX) 203 Taiwan Stock Exchange (TSE) 199, 204, 208–9 Tan, T. W. 130 Taylor, L. 102 Temasek Holdings 160 Teramoto, Y. 99 Thailand Bangkok Bank of Commerce xii Bank of Asia 227 Bank of Thailand 216, 220 Bank of Thailand Act 219 board of directors in companies 23 Budget Procedures Act 219 Business on-line Co., LTD 232 Commercial Bank Act 219 commercial banks 219–20 Conflict-of-Interest 221, 230 connected lending 218 Corporate Debt Restructuring Agency Committee (CDRAC) 216 corporate governance practices, regulatory framework and 23 reform, problems in 216, 231–3 corruption in public sector 231 Department of Business Registration of Ministry of Commerce 232

Department of Commercial Registration 232 family controlled firms 24, 233 Financial Institutions Development Fund 219 German commercial banks 228 governance mechanisms 225–31 insider trading 222 Institute of Certified Accountants and Auditors of Thailand (ICAAT) 224 institutional investors, role of 228–31 legal and regulatory framework 217 leverage ratio among listed companies 219 protection of investors’ and creditors’ rights 217 Public Company Act (PCA) 220 regulation of financial sector 218–20 of accounting standards 224 Securities and Exchange Act (SEA) 222 shareholder protection 223–5 Stock Exchange Commission (SEC) 23, 222, 230 Stock Exchange of Thailand 216 “tiger” economies 1 Tilton, M. C. 111 Tjager, I. N. 93 Toronto Stock Exchange 10 Toyota 217 Transparency International 232 Tricker, B. 66 TSE see Taiwan Stock Exchange Tsui, J. S. L. 54, 66 Tumbuan, F. B. G. 95 United Engineers (Malaysia) Bhd. xiii United Kingdom 15, 125, 156 Combined Code 11, 168 company law 55 enterprises 121 external monitoring mechanisms 40 model for regulating mergers and acquisitions 165

Index 249 pension funds 228 see also Cadbury; Greenbury; Hampel; London Stock Exchange United Nations 1, 156 United Nations Development Programme (UNDP) 1 United States 97, 99–100, 110, 125, 138, 156 California Public Employees Retirement System (CalPERS) 174 external monitoring mechanisms 40 Management Discussion and Analysis 151 mutual funds 228 Section 301 of Sarbanes–Oxley Act of 2002 Securities Act of 1933 97 Securities Exchange Act of 1934 97 Structural Impediments Initiative (SII) 100 separation of supervision and oversight 101 Vernon, R. 160 Vishny, R. W. xii, xvi, 65, 71, 93, 162, 204 voting rights 12–13, 55, 63, 129, 147

Walker, G. 2 Wang, Y. K. 180–1, 186, 191 Warr, P. G. 26 Watanabe, S. 100, 104 Wei, G. 35, 44, 48 West, M. 107 Williamson, O. E. 71 Wong, C. R. 180, 189, 193 Woon, W. 176 World Bank 20, 139, 147, 151, 217 high performing Asian economies 1 Report on Observance of Standards and Codes (ROSC) 147–8, 150–1, 152 World Trade Organization (WTO) 45, 51 World War II 105 Worldcom 211 Wu, Z. X. 199, 208 Wulandari, E. R. 71 Yafeh, Y. 10 Yamamoto, I. 100, 104 Yamashita, A. 106 Yeh, Y. H. 199 Yoost, D. 106 Yuan, H. 44 zaibatsus 18 Zhang, W. G. 27 Zhou, X. 50 Zingales, L. 2