Gul tsui the governance of east asian corporations; post asian financial crisis (2004)

Higgins 5.2 The Legal framework and traditional characteristics of 5.3 Economic pressures and corporate governance 6.3 The state of capital: corporate development... List of Tables and F

The Governance of East Asian Corporations Post Asian Financial Crisis

Ferdinand A Gul and Judy S.L Tsui

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

Judy S L Tsui

Individual chapters © Contributors 2004

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Governance of East Asian corporations: post Asian financial crisis/edited by Ferdinand A Gul, Judy S L Tsui

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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

Printed and bound in Great Britain by

Antony Rowe Ltd, Chippenham and Eastbourne

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Ferdinand A Gul Dedicated to my dad, my husband and my three children for all

their love and support.

Judy S L Tsui

List of Tables and Figures xi

About the Contributors xviii

1 Introduction and Overview

Ferdinand A Gul and Judy S L Tsui

2 Shareholding Structures, Related Party Transactions

and Corporate Governance in China

Wei Guo Zhang

2.3 Main characteristics of joint stock company formation

2.4 Main characteristics of the shareholding structure of

2.5 Corporate governance problems arising from the above

vii

3 Governance in Family-Owned Hong Kong Corporations

Judy S L Tsui and Vanessa Stott

3.3 Challenges for corporate governance reform in Hong Kong 65

4.6 Corporate governance of the Top 100 listed

5 Corporate Governance in Japan: Role of Banks,

Keiretsus and Japanese Traditions

Huong N Higgins

5.2 The Legal framework and traditional characteristics of

5.3 Economic pressures and corporate governance

6.3 The state of capital: corporate development

7 Corporate Governance in the Philippines: Legal and

Institutional Aspects and Impact on the 1997 Financial

Crisis and its Aftermath

Stephen G Lynn

8 Corporate Governance in Singapore: Past, Present and Future

Yuen Teen Mak

8.3 Recent corporate governance developments in

9 Chaebols and Corporate Governance in South Korea

Francis C Kim, Chung-Ki Min and Christopher Maden

10 Relationship-Based Business Enterprises and Recent

Corporate Governance Reforms in Taiwan

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

10.5 Obstacles and difficulties in improving corporate

11 Problems of Corporate Governance Reform in Thailand

Deunden Nikomborirak

List of Tables and Figures

2.1 Development of PRC Stock Market and Promulgation

of Laws and Regulations Related to Corporate Governance 29

2.3 Market Value of Publicly Traded Stock of Listed

2.4 Percentage of State Owned Stocks in Listed Companies

6.1 Malaysia: Ownership of Share Capital (at par value) of

9.3 Firms with Interest Payment Coverage Ratio (IPCR)

9.4 Shares (%) of Stock Holdings in the Top 30 Chaebols 196

11.2 Frequency of Multiple Directorships of Listed

11.3 The Role of Institutional Investor in the Thai

List of Figures

11.1 Percentage of Firms with (x number) of Independent

xi

The 1997 Asian Financial Crisis (AFC) was perhaps the most ing economic event of the 20th century It saw East Asian stockmarkets plummet by an average of 40% while currencies throughoutthe region lost 50% of their value The crisis involved both publicand private institutions and, broadly speaking, the problems in theprivate sector can be attributed to excessive or unrealistic investoroptimism (Shleifer and Vishny, 1997) The explanation proceedsalong the following lines Throughout the 1980s and 90s East Asiangovernments became involved in the corporate sector through “stateled development” Japan’s Ministry of International Trade andIndustry, for example, selected industries for development, and the

devastat-South Korean government (through chaebols – similar to keiretsus in

Japan) followed the Japanese model Similar patterns of governmentinvolvement may also be observed in Singapore, Malaysia andIndonesia This “state led development” also meant that govern-ments became involved in aiding troubled firms, or participating inother forms of political patronage, giving investors the impression ofsome kind of a government guarantee Indeed, some investors got theimpression that companies could succeed because of their politicalconnections rather than through their own innate efficiency, but itassisted the “Asian miracle” (Shleifer and Vishny, 1997).1Eventually,however, some large investors started looking a little deeper anddoing their own sums It became apparent that many companieslacked “economic fundamentals”: a term used broadly to describelow levels of debt and accruals and high levels of operating cashflows In addition, there were several instances of company manage-ment expropriating the interests of shareholders Johnson et al.(2000) cited some examples of this behavior in various countriesaround the time of the AFC One example which epitomizes theproblem is the Bangkok Bank of Commerce in Thailand – a casewhich the Asian Wall Street Journal called “patient zero” of the crisis.During the early 1990s and leading up to the crisis, the BangkokBank of Commerce extended loans to prominent politicians, and com-panies owned by bank officers, for the purpose of buying stakes in Thailisted companies As the previously rapid growth of the stock marketslowed, it became increasingly difficult for loans to be repaid Around

xii

the same time, evidence suggested that the bank officers were movingfunds to offshore companies that they personally controlled When theproblems of the bank became public, depositors began withdrawingfunds, compounding the bank’s difficulty

Another, and possibly the most common type of expropriationduring the AFC was the diversion of funds, profits, or losses from onecompany to another connected company, for example to a parentcompany, or other group member Reasons for doing this includedimproving the results of an underperforming company or covering acash shortage resulting from misappropriated assets The biggestproblem with this kind of activity is that the ownership of the compa-nies involved was probably not the same, so it was likely that theshareholders of one company would suffer for the benefit of differentshareholders of the other company (i.e., a shareholder has been expro-priated) Another problem associated with these types of transactionswas that the financial results would not accurately reflect the actualresults of the individual companies Three good illustrations of thiskind 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 thenable to obtain a waiver from the regulators so that they would nothave to offer the same deal to the minority shareholders of theparent company The parent company was in financial trouble andneeded the cash;

• In 1997–98, managers of the Sinar Mas Group in Indonesia shiftedforeign exchange losses from a manufacturing company to a group-controlled bank This effectively expropriated the bank’s creditorsand minority shareholders;

• Samsung Motors of Korea incurred huge debts in order to financestartup costs until they could begin generating revenues by sellingautomobiles These debts were guaranteed by Samsung Electronicsand other related companies without the required disclosures.Around 1997, it also appeared that Samsung Electronics was funnel-ing 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 atwo year period around the time of the financial crisis, Korea’sbiggest five chaebol (conglomerates) siphoned a combined amount

of nearly US$12 billion to subsidiaries

Johnson et al (2000) points out that the management of companies inemerging markets is typically the controlling shareholder, so transferssuch as the ones described above are easy to achieve Compoundingthis problem is that in many cases, the controlling shareholders do nothave to break local laws to expropriate!

All these factors led to the beginning of the loss in investorconfidence that may be seen as the single largest factor precipitatingthe crisis Investors also realized that in many markets, there was inad-equate financial disclosure, poor financial transparency, high levels ofdebt, and too much discretion allowed in the choice of accountingmethods under Generally Accepted Accounting Principles (GAAP) Inother words, investors were concerned with “poor corporate govern-ance” They realized that they could not get a clear picture of theirinvestments, decided their money was not safe, and left the market in

a panic The exit by investors resulted in a loss of foreign capital thathas still not been replaced, and many economies in the Asian regionare 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 tion that poor financial disclosure and transparency have their roots inpoor corporate governance

realiza-During and immediately after the AFC, mainly to stem the tide of anerosion of investor confidence, several countries instituted corporategovernance reforms Unfortunately, as chapters of this book will illus-trate, some of the same characteristics of corporate governance prior toAFC can still be found: the outlook still has the potential to be bad.Even in countries such as the United States, where corporate gov-ernance is considered to meet very high standards, financial disasterssuch as Enron and WorldCom are still occurring If the safeguards are insufficient to prevent or warn of such failures in developedmarkets, the potential for large companies to fail without warning inless 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 countryhave evolved and the extent to which corporate governance reformshave been implemented What are the key institutional and regulatorycorporate governance features in each of these countries? Of the coun-tries which have instituted reforms, some have been more successfulthan others Which countries instituted reforms and what impact did

these reforms have? This book is an attempt to answer some of thesequestions and better understand the characteristics and features of cor-porate governance in selected East Asian countries

In this book we examine the corporate governance landscape of tenEast Asian jurisdictions: China, Hong Kong, Indonesia, Japan, Malaysia,the Philippines, Singapore, South Korea, Taiwan and Thailand Ourfocus is on developments after 1998, the year the financial crisis wassupposed to have ended The descriptions therefore cover the years

1999 and 2000 Of particular interest are the legal and regulatory works, and whether there were pre-existing characteristics that weresignificant in terms of contributing to the impact of the crisis in thatmarket The most important aspect of this survey will be the examina-tion of what measures governments and regulators have made since thecrisis, and whether or not they were effective in improving corporategovernance

frame-Since there is much diversity in the way political reform and porate governance has evolved based on different institutional/legalframeworks in East Asian countries, the issues and emphasis of topics

cor-in the different country chapters naturally are different A case cor-in pocor-int

is Edmund Gomez’s chapter on Malaysia where he emphasizes the role

of the state and political parties in the corporate sector and, in somecases, going to great lengths to outline the role of various politicalfigures in corporate governance China is an interesting showcase ofeconomic reform in a socialist system and Zhang Wei Guo providesinsights on the difficulties of implementing capital market reforms butkeeping the state economic control apparatus in place These insightsprovide an interesting and contrasting view to other systems wheresuch political patronage in the corporate sectors is less pronounced orabsent or where capitalism has its roots firmly entrenched The divers-ity in the approaches that different authors have brought into this set

of readings provides contrasting emphasis on the way corporations aremanaged and function

The conclusions of these country investigations should providefuture guidance on what steps governments and regulators should take

to improve corporate governance in their region, learning from thecombined experience of East Asian countries, and benefiting from the failures and successes of the years since the crisis A limitation ofthe book is that it covers development up to the year 1999 (including

in some cases up to 2003) and many developments in corporategovernance reform have taken place since then The dynamic nature ofthe corporate sector requires constant changes/modifications to corpo-

rate governance and as such this is an ever-changing scenario A finalcaveat relates to the fact that the views of the authors in each chapterare not necessarily the views of the editors

Ferdinand A GulJudy S L TsuiNotes

1 An extreme view of this interpretation is that investors are partially rationaland they are prone to extremes of “euphoria” and “revulsion” (seeKindleberger, 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

We acknowledge the financial support of the Accounting andCorporate Governance Centre, the Department of Accountancy and anApplied Research Grant, of City University of Hong Kong We wouldalso like to thank Eric Cherneff and Chris Maden for editorial sug-gestions The editorial assistance of Amy Kwan and Jenny Low is grate-fully 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 CorporateGovernance 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 ofSingapore, and Council Member, Singapore Institute of Directors

Chung-Ki Min – Professor, Department of Economics, Hankuk

University of Foreign Studies, Korea, and Visiting Fellow, School ofAccounting 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

Judy S L Tsui – Chair Professor of Accounting, Dean of Faculty of

Business and Director of Graduate School of Business, The Hong KongPolytechnic 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

Introduction and overview

Ferdinand A Gul and Judy S L Tsui

In the late 1970s it seemed evident that U.S corporations were losingtheir global competitive edge as the Asian economies grew far morerapidly than any other region in the world The World Bank referred to

a number of countries in the region as “high performing Asian nomies.”1Most notable amongst these was Thailand, which was des-cribed as the fastest growing economy, and which both the InternationalMonetary Fund (IMF) and the United Nations Development Programme(UNDP) regularly used as a model for other nations to follow.2Othercountries that received favorable assessments from these agencies includeIndonesia, South Korea, Taiwan, Singapore and Malaysia China andPhilippines also saw higher Gross Domestic Product (GDP) growth thanthe rich industrial countries between 1990–1996 While the rich indus-trial countries including the U.K and the U.S posted an average annual2% GDP growth between 1990 and 1996, the Asian countries surveyed inthis book showed higher levels of GDP growth for the same period Allthe countries except the Philippines (2.8%) posted more than 5% annual

eco-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 economiesand the severity of the Asian Financial Crisis (AFC), we turn to

an important stream of theoretical literature that has emerged incorporate governance research

1.1 Relationship versus market-based systems

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

con-1

custom, politics and values This thinking has spawned several ical frameworks of which the Rajan and Zingales (1998) framework isthe most appealing They classify economies as either “market-basedsystems”, such as that found in the U.S., or “relationship-basedsystems”, such as those found in many East Asian markets The market-based or “arms length” system depends more on the explicit contractsthat are formed between parties On the other hand, the relationship-based system is based largely on implicit guarantees and trust betweenthe individuals involved Because of the reliance on relationships, anelaborate system of formalized corporate governance rules does nottypically emerge in markets where this system is prevalent

theoret-The relationship-based systems have their roots in the close linksbetween banks, businesses and government through family, political,and ownership connections Chaebols in Korea, Keiretsus in Japan, andpolitical patronage in Malaysia are some prime examples of suchsystems However, this system suppresses the market pricing systemand can result in the inefficient allocation of large external capitalinflows that come from predominantly arm’s length lenders (forexample, European Union banks) As Jackson (1999, p 6) argued: “theabundance of inexpensive capital, in combination with local banksbased on personal relationships rather than real business plans,resulted in widespread misallocation of capital into speculative andnoncompetitive sectors and enterprises” Since foreign investors areaware of misallocation and other abuse, they minimize their risk bykeeping their claims short-term in order to exit at the first sign oftrouble The Rajan and Zingales (1998) argument implies that thecontact between the relationship based system and the arm’s lengthsystem of foreign investors create a “fragile hybrid” which works well

in normal times, but is prone to shocks such as the AFC (Walker andReid, 2002)

Some evidence supporting the relationship versus market basedsystems is that although both these systems are found in the Asianregion, the markets with relationship-based systems (i.e., Indonesia,Malaysia, Thailand, and Korea) were generally harder hit by the crisisthan more market-based countries (i.e., Hong Kong and Singapore) asmeasured by exchange rate depreciation (Johnson et al., 2000)

1.2 What is corporate governance?

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

between a company’s owners, managers, board of directors (BOD), andother stakeholders Agency theory provides a theoretical perspective inwhich to discuss these relationships Specifically, in order for owners toget what they want (i.e., increased value of their investment), theymust contract with non-owner managers to run the company, andwith the BOD to oversee the management of the company The con-tracts attempt to regulate behavior to achieve the desired investorobjectives However, a concept which quickly becomes apparent is that

of incomplete contracting, which suggests that contracts will neveradequately cover all aspects of the complex set of relationshipsinvolved The development of corporate governance is an attempt tooversee these relationships, and beyond the scope of formal contracts,

to regulate behavior so as to achieve the desired outcome and ate rewards for all parties involved

appropri-Corporate governance can be addressed at many levels It may beconsidered on a broader scale in terms of the rules and regulationsmaking up the regulatory and legal framework of a country However,

it is not just a “big picture” issue; it is also considered on a muchsmaller scale within individual companies: the setting of a mandatoryretirement age of directors, appointments of non-executive directors,how managers are appointed and remunerated and so on would beconsidered corporate governance issues A thorough examination ofcorporate governance must include all of these areas, along with themechanisms for ensuring that rules and regulations are not only inplace, but are also enforced It is therefore best to start with the rulesand 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 andregulatory environments Malaysia, Singapore, and Hong Kong havesimilar backgrounds as former colonies of the U.K Malaysia was estab-lished in 1957, composed of Singapore and Malaya, however, Singaporeseceded in 1965 Until 1997, Hong Kong had a long history as a Britishcolony In July 1997, it was returned to China, but continues to operateunder a “one country, two systems” policy which essentially means thatits legal system and regulatory environment continue largelyunchanged from what they were under British rule (that is, a commonlaw system prevails) Singapore and Hong Kong have sophisticatedfinancial systems and stock markets and are widely considered to have

the highest standards of corporate governance amongst Asian countries.After a long history as a Spanish colony, The Philippines was ceded tothe U.S in 1898, and achieved independence in 1946 Its legal system isbased 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 SouthKorea Thailand was never colonized, but the legal system was heavilyinfluenced by the civil law system from Europe, and Japan’s legalsystem, is itself based on European civil law, with some influence fromEnglish-American common law China’s legal system is somewhat dif-ferent from the others, but is basically civil law, with many adjust-ments in the past two decades, especially in the areas of civil,administrative, commercial and criminal law The recent changesreflect the dynamic state of the legal and regulatory frameworks andthe relatively immature capital market in China Taiwan’s legal systemoriginated from traditional China and adopted Western law when itwas occupied by Japan in the 19thcentury

The common law system is based on judges’ previous decisions incourt cases, dating back many years, often referred to as precedents.Rather than referring to statutory laws, a judge tries to decide a case byreference to similar cases in the past Common law is undergoing con-stant, albeit slow, change and evolves to adapt to new situationsbrought about by technology, etc Common law fills the spaces in areasthat written law (statute) does not cover, and includes broad areas oflaw, including those related to property, torts and contracts In con-trast, a civil law system attempts to establish written rules (or legalcodes) that provide a basis for making judgments A judge is bound bythe existing codes or statutes

The reason legal systems are relevant to the evaluation of corporategovernance is that they offer different degrees of protection forinvestors, and affect the ability of investors to exercise their rights It isalso important to note that for rules to be effective, they must beaccompanied by predictable enforcement If there are no negative con-sequences for breaking rules, then there is little or no incentive forthem to be followed The following paragraphs describe why thismatters

1.4 Legal systems and investor rights and protection

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

gov-systems result in varying degrees of legal protection for investors Thesecond major factor is corporate ownership concentration, which isdiscussed in Section 1.6 La Porta et al (1997) found evidence that thebreadth and depth of a country’s capital market was dependent on thelegal environment, particularly the country’s laws and their enforce-ment In surveying both common law and civil law countries, theyfound that common law countries generally had better investor protec-tion and more developed capital markets when compared to civil lawcountries (La Porta et al., 1997, 1998) These studies suggest thatcommon law countries offer better investor protection through lawsand 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 highestlevel of rules and regulations in any jurisdiction usually comes fromthat country’s corporate legislation, which sets out the basic law thatall corporations must follow Enforcement of these rules is typically theresponsibility of the government or a quasi-governmental body Forcompanies that have publicly traded securities, and for the entitiesinvolved with the trading of securities (i.e., securities exchanges, secur-ities dealers, other market participants), there are additional rules thatmust be followed These are usually contained within the country’ssecurities laws, and are monitored and enforced by the country’s secu-rities authority (or equivalent) The lowest level of regulation andenforcement is found within the individual stock exchanges Oftenself-regulated, the exchanges are responsible for setting rules and regu-lations for market participants, and also for the enforcement of theserules The authority of these rules generally arises from the explicitagreement of participants as a condition of their participation in theexchange as a listed company The rules at this level often go hand-in-hand with the country’s securities laws, and the exchanges will oftenwork closely with the securities commission to ensure smooth opera-tion of the market

The level of legal infrastructure is an important factor that hasinfluenced the development of relationship-based systems Emergingeconomies often have insufficient legal frameworks in place, andfrequently are ill-prepared to deal with the complexities of moderncorporations and their ownership

La Porta et al (1997) analyzed a number of countries (including all ofthe countries in this book except China) and assessed them in the threeareas of shareholders’ rights, creditors’ rights, and rule of law Theyfound that, in general, countries with civil law systems offered lower

levels of investor and creditor rights, as well as a lower rating of rule oflaw This distinction can be clearly seen in the summary comparisontable (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 forcommon law countries and 5.9 for civil law countries In addition tothe lower numerical score, a much wider range of values is seen amongthe civil law countries The average shareholders’ and creditors’ rightswere 3.3 and 3.5 respectively for common law countries, and 2.8 and2.2 respectively for civil law countries The difference is even moreapparent if the Philippines shareholders’ rights and Indonesia’s credit-ors’ rights scores are omitted Since these two countries have the lowestrule of law scores of the group, it is more likely that even though rightsexist, it will be more difficult for shareholders and creditors to enforcethem Corruption and expropriation of shareholders’ interests are otherissues that have a bearing on legal protection and enforcement Asshown in Table 1.1, Philippines and Indonesia also have the highest(worst) corruption and expropriation scores, thus further exacerbatingthe poor level of shareholders’ protection

Compounding this problem is lax enforcement of the existing rulesand regulations: a rule alone is worthless – it must be properly enforcedfor it to be taken seriously and obeyed The same things are true ofcorporate governance A formal approach to corporate governance was something few emerging economies’ governments had expendedmuch time on Even within the so-called “developed markets”, aformal approach to corporate governance was a fairly recent develop-ment One of the earliest significant investigations into corporate gov-ernance 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 ate failures in the late 1980s, and resulted in the formalization of avoluntary code of conduct for corporate governance which was subse-quently incorporated into the Listing Rules of the London StockExchange

corpor-1.5 Board structure

When comparing corporate governance in common law and civil lawcountries, one of the first differences that becomes apparent is thestructure of a company’s board Companies in civil law systems gener-ally have a dual board structure while, under common law systems, aunitary board is the norm Regardless of the board structure, the objec-tives are the same: to run the company and increase company value

Legal system Largely Common Civil law Civil Common Common Common Civil Civil Civil

criminal law (Roman- law, with law law law law, with law law, with

(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.

Note 2:

Indices of corruption and expropriation, with a maximum score of 10 Lower scores indicate higher levels of corruption and expropriation.

However, the two different board structures have different strengthsand weaknesses which have implications for corporate governance 1.5.1 Unitary board structure

Under the common law legal system, management conducts the to-day running of the company, with a BOD overseeing them and con-ducting long-term planning for the company Senior members ofmanagement, such as the Chief Executive Officer (CEO) are likely to bemembers of the board as well When directors occupy managementpositions in the company, they are considered to be executive direct-ors, and insiders with respect to the company Membership in theboard is achieved through recommendation by the existing board (pos-sibly through a subcommittee), and confirmation through an electionprocess by shareholders

day-1.5.2 Dual board structure

In civil law countries such as China and Indonesia, companies will ically have a dual board structure The two boards are the managementboard and the supervisory board The management board is responsiblefor the day-to-day running of the business (much like managementunder the unitary board system) The supervisory board has an over-sight role, similar to the role of the board in a unitary board system

typ-In Germany (a civil law country), the German Code of CorporateGovernance (GCCG, 2000), states that the essential tasks of the super-visory board include supervision, advising, and composition of the man-agement board Membership of the supervisory board is determined byshareholders, with recommendations for potential candidates comingfrom the shareholders themselves, or from the supervisory committee InGermany, as in some other countries, other stakeholders, such as employ-ees, may be permitted to have representation on the supervisory board.From its membership, the supervisory board will elect a chairman Themanagement board is responsible for running the company The success

in filling this role depends directly on the membership of the board, andthe skills and qualities the individuals bring to the company The supervi-sory board is responsible for appointing and dismissing the managementboard 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 thelegal system and ownership concentration Ownership concentration is

important because without a large shareholder, or unified block ofshareholders, management and the directors have no one to answer to.Ownership concentration can be seen as a corporate governance mech-anism in terms of monitoring management (see Shleifer and Vishny,1997).

Corporations in Southeast Asia follow different patterns of ship concentration, with some unique examples in the countries weexamine For example, companies in Japan often exhibit concentratedand stable ownership by banks (Yafeh, 2000) In Malaysia, the govern-ment has a large ownership in more than half the listed corporations(Cheong, 1997) More commonly in Southeast Asian companies wefind a pattern of ownership that is often described as family basedownership This pattern of ownership often shows a “pyramid” typestructure, where one owner controls several entities, which in turncontrol other entities and so on The complex web of ownership can bedifficult to follow, but a study by Claessens et al (2000) found that themajority of companies in Southeast Asia3were affiliated to a group,controlled by entities that controlled other entities, and ultimately hadone owner at the top Most of the time the ownership was linked tofamily members, and hence the term “family owned corporations”(e.g., in Hong Kong) Clearly, the complexities and patterns of owner-ship affect the corporate governance systems in any one country andmust be considered in any corporate governance reforms

owner-1.7 Corporate governance guidelines – Cadbury and others

Many of the reforms and changes in corporate governance in Asiancountries find their genesis in several reports that have appeared inwestern countries in the last 15 years or so The most famous andearliest is the Cadbury Report published in the U.K in 1992 The report provided guidelines for financial reporting, and reviewed theroles of the board and the external auditor The main objectives were

to provide “best practice” for corporate governance while allowingenough flexibility for companies to adjust to their own circumstances.Although it was established as a voluntary code of conduct, it waseventually incorporated in the Listing Rules of the London StockExchange

In 1994, the Dey Report was published in Canada It contained a fullset of corporate governance guidelines and was noteworthy because itwas one of the first set of guidelines to become mandatory Companieslisting on the Toronto Stock Exchange must explain any differences

between their corporate governance practices and the Dey Reportguidelines The impact of this requirement of listed companies wassignificant – for the first time, companies had to make explicit state-ments about their corporate governance, side by side with best prac-tice 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 areport on executive remuneration, and addressed certain issues thatwere not covered extensively by the ground-breaking Cadbury Report

In 1998, the Hampel Committee was formed to consolidate dations of the Cadbury Report and the Greenbury Report, as well asdevelop additional guidelines for areas that were not covered by thesereports Another part of this committee’s review was to examine theextent of compliance with the earlier guidelines The Hampel commit-tee’s report stressed the importance of substance over form whenaddressing corporate governance guidelines and identified the “box-ticking” mentality as being a serious problem They advised that com-panies and boards should be prepared to apply informed judgment,flexibility and common sense to the individual circumstances of thecompany Departures from corporate guidelines may be justifiable, andshareholders and other stakeholders should be prepared to show flex-ibility and judge on their own merits departures from best practice In

recommen-1998, the guidelines in the final report of the Hampel Committee werepublished as the Combined Code While the Code was not law itself, alisting rule of the London Stock Exchange made it mandatory for listedcompanies to comply with the Code, or explain departures from itsrecommendations

The Combined Code was, of course, tailored to the needs of a single,advanced economy The Organization for Economic Cooperation andDevelopment (OECD) recognized the need for more universal guide-lines that could be applied to any country or market These have pro-vided guidance and influenced the various regulatory bodies in EastAsia

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 verynature, in order to be generic, the guidelines had to be very broad andavoid going into great detail The main topics addressed are rights and

equitable treatment of all shareholders, disclosure and transparency,and the responsibilities of the board Because they are not sufficient ontheir own, the Guidelines are intended to be a starting point for localregulators and if followed they will provide a uniform basis for cor-porate governance in different countries Building on this OECDcorporate governance foundation, the Pacific Economic CooperationCouncil (PECC)4released guidelines for its member countries in 2001.The intention was to build on the OECD Guidelines with considera-tion 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 ernance accepted in all markets There are simply too many variations

gov-in the legal systems, regulatory environments, company laws and localcustoms for it to be practical Even within one market, there is greatvariation 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 popularapproach to corporate governance guidelines has been to develop prin-ciples, rather than rules, that can be used across different countries andmarkets The “Principles of Corporate Governance” are a good example

of this approach, and cover five broad areas, namely the rights ofshareholders, the equitable treatment of shareholders, the role of stake-holders, disclosure and transparency, and the responsibilities of theboard

Rights of shareholders

Rights of shareholders address the basic rights that all shareholdersshould have, regardless of their extent of ownership of a company.These rights include the right to secure methods of ownership regis-tration, to convey or transfer shares, to obtain information about thecompany on a timely basis, to participate and vote in general share-holder meetings, to elect members to the board, and to share in theprofits of the company In addition to participation in general share-holder meetings, shareholders should have the right to be involved

in decisions concerning fundamental corporate changes such asthose affecting the statutes or articles of incorporation of thecompany 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

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

trans-Equitable treatment of shareholders

The OECD principles stress the equality of shareholders, regardless ofthe size of their shareholding, and regardless of whether they aredomestic or foreign shareholders All shareholders should have a right

to obtain redress for the violation of their rights This means that allshareholders of the same class should have equal voting rights andaccess to information Insider trading and self-dealing should be pro-hibited and members of the board and managers should be required todisclose material interests in the company or transactions with thecompany

Role of stakeholders

The OECD has recognized that it is not only the shareholders whohave an interest in the company, but also the stakeholders, whobenefit from job creation and wealth from the sustainability of finan-cially sound corporations They recommend that the corporate govern-ance framework assures that the legal rights of stakeholders arerespected, and effective redress is available to those whose rights havebeen violated It was also recommended that the framework permitperformance-enhancing mechanisms for stakeholder involvement, andwhen 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 andtransparency The OECD principles state that the corporate governanceframework should ensure the timely and accurate disclosure of allmaterial matters relating to the financial situation, performance, own-ership and governance of a company Specifically, disclosure shouldinclude:

• 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

All information must be prepared, audited and disclosed to a highstandard In addition, an external and objective annual audit should beconducted by an independent auditor, and all information should bedisseminated in a way that provides fair, timely and cost efficientaccess 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 thecompany and the shareholders for effective monitoring of manage-ment The corporate governance framework should ensure theseresponsibilities are met, and that the company is guided strategically.The guidelines in this section are designed to help the board accom-plish these goals, while at the same time protect the rights of share-holders and stakeholders Key functions that the board should fulfillinclude:

• Reviewing and guiding corporate strategy, as well as major short andlong term decisions;

• Selecting, compensating, and monitoring key executives;

• Reviewing and ensuring transparency of the board nominationprocess and remuneration;

• Monitoring potential conflicts of interest of board members, agement, and shareholders;

man-• Overseeing the accounting and financial reporting system, ing internal controls, risk management, and independent audit;

includ-• 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 ment To improve independence, the board should consider usingnon-executive board members for issues where there are potentialconflicts of interest Examples of such issues include remuneration ofboard members and executives, nomination of board members and keyexecutives, and financial reporting

manage-Although there is only space for a summary of the key principlescontained in the OECD corporate governance guidelines, it can be seenthat they are general in nature and avoid being so specific that theywould be difficult to apply in different markets or countries By way of

a comparison, the London Stock Exchange’s Combined Code providesspecific recommendations for corporate governance They go furtherthan the OECD recommendations by providing guidance on

specifically how a company can help realize the OECD

recommenda-tions Readers interested in the OECD recommendations and theCombined Code should consult the OECD (www.oecd.com) and theU.K Financial Services Authority (www.fsa.gov.uk) websites and searchfor these documents.5

1.9 Country overviews

The individual chapters in this book will show that there is considerablediversity amongst the East Asian countries in terms of regulatory frame-works and corporate governance practices While it is not the intention

of this book to focus on differences in economic performance across thecountries, it is worth noting that these differences are also considerable.For example, as shown in Table 1.2, while China, South Korea andThailand have posted impressive economic figures, other countries such

as Indonesia are expected to lag behind As will become evident, the ferences in economic performance are likely to have their roots in thequality of the legal system and corporate governance

dif-1.9.1 China

From a standing start in 1984, when China first de-nationalized a owned enterprise (SOE), through the creation of the Shenzhen andShanghai stockmarkets in 1990, China has made astounding progress

state-in the implementation of a regulatory and economic framework whichwill encourage transparency, disclosure, and protection of minorityrights

At the time of going to press, some 90% of the companies listed inChina’s stock markets were former SOEs A large part of China’s transi-tion to a market economy is mirrored in the voyage these companieshave made – with varying degrees of success – to being privately ownedcorporations Internally, there is a strong parallel to be drawn betweenthe divestment of SOE’s non-business units, such as welfare centersand schools, and the People’s Republic of China (PRC) government’sown retreat from socialism There is the replacement of the internalmechanisms of governance associated with social, non-business object-ives, (in which the shareholders are there to serve the interests of otherstakeholders), by mechanisms to maximize the value of the enterprise

to all stakeholders

Externally, there has been a similar change of purpose with increasingpolitical recognition that smoothly functioning capital markets under-pin economic growth, and that well-regulated markets function better– provide more efficient allocation of capital – than badly regulatedones.

Despite the positive moves these trends have entailed, the stockmarket remains dominated by SOEs, and the ownership and control ofthese companies is still overwhelmingly in the State’s hands Theopaque ownership mechanisms employed by the State, and the lack ofclarity in its continued purpose of ownership, are major obstacles tofurther progress

1.9.2 Hong Kong

The families that built modern Hong Kong still dominate its stockmarket With an average holding of 32.1% of the listed companies theycreated, they concentrate cash-flow rights in a proportion of 28%.Nonetheless, their companies have served Hong Kong well, and abalance must be struck between the family’s interests and those ofminority shareholders

The former British colony’s legal system was maintained after Chinaresumed sovereignty in 1997 At the time of the handover, ten pieces

of legislation regulated corporate affairs The enactment of the rities and Futures Ordinance (SFO) in 2002 was a major step forward inthe consolidation and clarification of both the detail and the intent ofthe law A major advancement in this package of legislation was thecriminalization of certain acts of malfeasance by directors, makingHong Kong one of the first jurisdictions of those surveyed to take thisstep

Secu-Corporate governance is, however, a rapidly advancing field, and theStanding Committee on Company Law Reform is considering furtherways of strengthening minority rights There are two broad streams totheir recommendations: on the one hand, to increase transparency anddisclosure, especially in the area of connected transactions; on theother, to provide statutory recourse to shareholders who have reason tobelieve their rights have been violated

Family ownership of firms, an under-developed culture of holder activism, and a scarcity of truly independent directors remain asobstacles to improvement With many areas of governance encom-passed in the listing rules, rather than given statutory authority, there

share-is still room for improvement

1.9.3 Indonesia

With 15 families controlling an estimated 62% of the market ization on the larger of the country’s two stock exchanges, and withun-listed SOEs accounting for almost the same capitalization as thatstock market, Indonesia has a concentration of ownership second only

capital-to China in the countries we survey

The extreme rapidity of Indonesia’s economic development in the1990’s led to a situation in which the regulatory environment hadsimply failed to keep up with the country’s economic growth The

1997 crisis, the subsequent crumbling of the Suharto regime, and theultimate democratization of the country, all contributed to anenhanced awareness of the need to improve corporate governance

As a result, the country has seen a rapid move towards the uptake ofinternational standards in this area with significant improvementsbeing made in clarifying board structures, diversification of ownership,including the opening up to foreign ownership and control of manypreviously protected industries and companies; disentangling bankownership and tighter regulation on the banks; the introduction ofaudit committees and auditing standards in line with InternationalAccounting Standards (IAS), and improved disclosure and reporting;and stronger regulation

Many companies, however, remain staunch resistors of change Forexample, 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 tees Until ownership becomes more diverse, and enforcement stronger,

commit-it is unlikely that the change of mindset at the heart of good corporategovernance will take place

The keiretsu resembled spider’s webs, with the banks in the middle

largely supplanting the role of the market in terms of corporategovernance With privileged and detailed information on the affairs

of companies through insiders on their boards, banks were able toexert strong – often decisive – influence on corporate strategy They

withheld credit from under-performing keiretsu, while ensuring they

only very rarely went broke, and similarly extended cheap credit towell-performing parts of the group

This arrangement was bolstered by a bureaucracy that managed industrial policy Able to protect the economy from foreigncompetition, the bureaucracy also injected huge sums of public moneyinto industries that it believed had a future

micro-With the opening of the Japanese market, however, this systembegan to unravel While the export sector of the economy containedmany companies that were able to compete on the world stage, thedomestic companies often crumbled in the face of international com-petition 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 tion regulating corporate conduct, the Company Code While this hasremoved or mitigated many of the obstacles to better functioningmarket discipline – including takeovers, bankruptcies, shareholder suitsand board independence – the driving force in business and politicsremains the competitiveness of Japan as a whole rather than thestrength of her markets This deeply entrenched philosophy is a majorfactor in preventing Japan from maximizing the benefit to be obtainedfrom her reforms

legisla-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 ment was, however, the opposite of transparent It became increas-ingly the case that businesses were favored on political rather than onmeritocratic grounds, resulting in a heavily skewed allocation ofresources

govern-The result was a paper tiger and, in 1997, Malaysia was pummeled bythe Asian crisis Refusing the auspices of super-national organizations

in its aftermath, Malaysia is unique amongst the countries surveyed inthat she largely retained her existing corporate governance regimeduring the ensuing re-structuring

This regime was Anglo-American in origin, thus suggesting strongershareholder protection; but had a major deficiency in the vulnerability

of its regulatory bodies to political interference on behalf of businessesthat were politically well-connected However, lately, there seems to be

a concerted effort by the Malaysian Ministry of Finance (MOF) totighten up issues related to investor protection For example, in 2001new listing requirements were issued by the Kuala Lumpur StockExchange (KLSE) which amongst others require all listed companies tostate in their annual reports how they have applied, and the extent ofthe application of the Principles and Best Practices of the MalaysianCode of Corporate Governance (see http://www.combinet.net/govern-ment/finalver/Malaysia.htm.) Other new developments include theestablishment of a minority shareholders’ watchdog group to protectthe interest of minority shareholders of public listed companies.Clearly, these two factors should see major shifts, for the better, in theinvestor protection and corporate governance practices in Malaysiancompanies

A final point worth noting is that since the Malaysian contributionwas written the then Prime Minister Mahathir has stepped down Hissuccessor, Abdullah Badawi, does seem to be moving away from thissystem of political patronage to a system that genuinely embracesshareholder value as the motor of corporate development

1.9.6 Philippines

The AFC in late 1997 hit the Philippines hard – foreign capital fled thecountry in large amounts, and interest rates shot up, leading to dra-matic declines in company profitability in subsequent years Like inother 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 aprivate 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 im-mune to the lending boom that swept the region just prior to the 1997crisis

Other major problems are the weak accounting system standards,compliance and audit quality which are all in need of substantialimprovement (World Bank, 2001) This contributes to poor disclosure.However, it may be noted that the Philippines was in many waysmore successful than other economies in the region in responding to